This summer's contracting credit market has ? temporarily, at least ? eroded some of the confidence in private equity that's accumulated over the past few years. The industry's critics had long been eying the boom warily, perceiving inherently high risk in the mounds of debt and ready supply of inexperienced capital. These critics are waiting to see the implosion of any of the recent mega-deals to substantiate their concerns.
While lawsuits brought by LPs against GPs are rare, they have taken place, and when they have taken place there has usually been the wreckage of a portfolio company nearby. Back in 2002, the State of Connecticut dragged Forstmann Little into the civil courts over the failure of XO Communications, an investment which the state treasurer branded a breach of fiduciary duty. In the end, no money was awarded to Connecticut, in part because the pension had received key details of the deal years earlier.
?Some investors have passed on committing to a fund because they felt key managers were spreading themselves too thin.?
The idea of fiduciary duty is never fixed, and even though Delaware courts allow GPs to opt out of many facets of that duty, exceptions should be spelled out in the limited partnership agreement. GPs would do well to craft their agreements with care, and amend them with caution. For as much as Delaware may be willing to redefine fiduciary duty, the Court of Chancery has made it clear that the idea of fiduciary duty remains very much in place. The need to clearly define fiduciary duty is made all the more pressing because, should the fortunes of the asset class decline in the coming years, plenty of constituents, not all of them motivated by economics, will be looking for reasons to take an underperforming GP to court.
Vague is in vogue
Room for interpretation is frequently a necessity for private equity as it is practiced today. From the point that senior partners often commit major amounts of their own capital to the fund, the asset class already blurs the line between the GP and LP. Likewise the existence of multiple funds of various vintages investing simultaneously argues for a novel approach when defining responsibilities and potential conflicts of interest. As a result, Delaware courts allow for a GPs and LPs to draw contracts that reflect the industry's unique needs.
Marco Masotti of the law firm Paul, Weiss, Rifkind, Wharton & Garrison in New York explains that, in the case of Delaware limited partnerships (DLPs), the general partner of the DLP does indeed owe a fiduciary duty, which includes a duty of care and loyalty, to the partnership and its investors. ?However, a GP and an LP can contractually agree to opt out of certain of those duties and they do so in the partnership agreement,? says Masotti. ?The exercise of drafting the partnership agreement is to know what to opt out of ? such as entering into certain transactions with affiliates. Once these carve-outs are clearly addressed in the language of the agreement, the GP should be protected from any claims for breaches of its fiduciary duty.?
Several fund formation attorneys noted that over the past two years or so the Delaware Court of Chancery has demonstrated that GPs can not only opt out of certain aspects of their fiduciary duty, but partnerships can also allow for certain conflicts of interest. ?Generally speaking, Delaware law embodies the principle of freedom of contract ? they don't want to get in the way of the business, so long as both parties acknowledge the terms,? says Prakash Mehta, a co-chair of investment funds private equity practice at Akin Gump Strauss Hauer & Feld in Washington, DC.
Those terms spell out what a GP's duty is, and what would constitute a breach. Delaware courts apply a contractual analysis in resolving disputes more and more often to determine only what was intended by both parties.
?Delaware law permits partners to contract around certain fiduciary duties. Now the term ?sole discretion? may literally mean ?sole discretion? without regard to any fiduciary duties,? says Malcolm Nicholls III of the law firm Proskauer Rose in Boston. ?That being said, from an investor relations point of view, GPs should still operate with these concepts in mind, whether required to or not, or they will have a tough time raising their next fund,? says Nicholls.
Legislating duty through the terms may leave great flexibility in drawing up the agreement, but it also adds genuine weight to what appears, and what doesn't appear, within that contract.
The language of the agreement should address the following three items in clear fashion: the proper allocation of funds and GP effort in lieu of other vehicles run by the firm, the nature of the GP's indemnification, and finally, how the GP should expect to resolve conflicts of interest that may not be spelled out in the agreement.
Most firms operate various funds of various vintages simultaneously, raising questions as to which fund will receive priority of a partner's time or premium deal opportunities. Plenty of LPs may be vested in more than one fund as well, but some first-time investors view this as a conflict of interest. ?Predecessor funds may take priority or a pro rata share when it comes to a given investment opportunity, but many LPs understand that's a natural part of this business. They're aware that they'll still receive an allocation should a subsequent fund be raised,? says Masotti.
He adds: ?However, LPs are very sensitive about time commitments of certain senior key partners. As a result, the agreements often require a contractual time commitment during the investment period phase, and it is often a negotiated point whether and to what extent it authorizes time for the oversight of multiple funds.?
One attorney noted that GPs are more forthcoming about their responsibilities now, and the agreements often require their time for the commitment phase or at least until the fund is 75 percent committed, when that partner is responsible for the oversight of multiple funds.
That may be suitable for a firm that may have a single investment mandate, where there's minimal overlap between funds, but what of the many shops branching out with vehicles for various geographies and other asset classes, such as distressed debt? ?The fact of the matter is when a single firm is launching a variety of funds in different asset classes or focused on different parts of the world, they typically hire a new team, with a track record in that geographic location or industry niche,? explains Bob Friedman of the law firm Dechert in New York.
?Limited partners have expressed concern with key managers spending time even on non-competing funds, and express concern about the percentage of a key managers' time commitment. Some investors have passed on committing to a fund because they felt key managers were spreading themselves too thin,? says Friedman.
However, many attorneys find that simply adding language that insures the GP will make a good faith effort to adequately spread opportunities, and their time, across the various funds will settle the matter.
Negligence, gross or otherwise
As much as the partnership agreement may try and address every potential conflict of interest, there should be broader language to address the liability of the GP, just in the case the unconsidered happens, with regards to fulfilling the idea of fiduciary duty. Given the authority of the terms in resolving disputes, the idea of a less specific ?standard of care? for all parties to agree upon would help indemnify the firm for those situations no one expects.
According to their reference book on Delaware Limited Partnerships, Martin Lubaroff and Paul Altman suggest two possibilities for that standard of care: ??some partnership agreements provide that general partners will not be liable to a limited partnership or to other partners unless it acts negligently, while other partnership agreements provide that a general partner will no be liable unless it acts with gross negligence or willful misconduct.? Defining that more holistic standard could help determine whether a party accusing the GP of breach would need to prove negligence, or willful misconduct in court.
The jury of LPs
Most partnership agreements already spell out the procedures for a resolution of any other outstanding conflicts of interest. Private equity firms have advisory committees made up of several LPs, often representing the most substantial investors, to consult on various matters. The partnership should provide for the procedures involved with consulting these committees. If the GP follows the procedures listed in the agreement for gaining approval by the advisory committee, their liability will most likely be substantially diminished.
?There's a real trend for creating these advisory committees and consulting them frequently. Many GPs view them as an insurance policy for major decisions,? explains Robert Minion of the law firm Lowenstein Sandler in Roseland, New Jersey. Experts in fund formation and Delaware law stress that formalizing when and how an advisory committee is to be consulted can go a long way towards preventing misunderstandings, as unhappy LPs pass on making future commitments more often than they take GPs to court.
Every contract has its limitations, and the advisory committee is one way the GP can attempt to amend the contract, in response to a new opportunity or shifting market conditions. ?There are two varieties of amendments: those that can be approved solely by the GP and those that also require a specified percentage of the LPs,? says Nicholls. ?For amendments requiring LP consent, typically either a majority or two-thirds in interest of the LPs is required.? One attorney noted that certain minor changes could be approved by the advisory committee but those rarely materially change the agreement.
However, Nicholls warns: ?For amendments that only require GP consent, special care should be taken in those agreements where the GP owes no fiduciary duty to the LPs for actions taken in its sole discretion.?
It is vital to include in the agreement language for amending the agreement, but some attorneys find substantial changes to the agreement rare. ?Few sponsors are going to amend the agreement, even with the permitted two-thirds majority. They don't disregard the third that didn't want the adaptation, as any amendment is a risk, so they'll usually check in with the advisory committee first and if the GPs are still comfortable, they may move forward,? says Carl de Brito of the law firm Dechert in New York.
Even with every conflict of interest spelled out, and the process for resolving every other conflict clearly articulated, there is no way for a GP and an LP to completely opt out of a basic fiduciary duty. ?The disclaimers may be more prominent, but no GP fully escapes their duty to act in good faith,? says Mehta.
Lubaroff and Altman explain in their book: ?The [Delaware] Supreme Court clarified that while a partner's or other person's fiduciary duties may be expanded or restricted by provisions in the partnership agreement, they may not be eliminated.? If the fiduciary duty may never be removed entirely, then the threat that someone will claim the duty has been breached can't be eradicated either. That said, under the current circumstances, the standard for what constitutes a breach remains high.
One attorney explained that proving a true breach of fiduciary duty usually involves an act of evident bad faith, citing Justice Potter Stewart's famous quote referring to pornography: he may not be able to define it, but he knows it when he sees it. Several legal experts believe that proving a breach of fiduciary duty requires evidence of egregious circumstances and clear intent.
Plenty of industry observers look back at the Forstmann Little lawsuit as an anomaly. LPs aren't quick to sue their GPs over an imploded deal, because it freezes the activity of the fund as a whole, jeopardizing the remainder of their investment. Furthermore LPs are frequently responsible for some, or all, of their GPs' legal fees. It is also important to note that the Forstmann Little case was brought by the state treasurer and attorney general, elected officials.
These politicians argued that they brought the suit on behalf of their constituents, many of whom participate in the pension program. The trial was decided by a jury, a body that can be fickle with its clemency and inexpert in their understanding of the industry, especially when what an LP risks or what a GP promises can be so vague. Ted Forstmann cited the partnership agreement's generic investment mandate in court while the plaintiff's attorney referred to the more specific parameters spelled out in the PPM.
However, the industry has gained maturity as it has grown. Several attorneys note that partnership agreements have swelled in size as they attempt to better address the complexities that have arisen over nearly three decades' worth of transactions. GPs' fiduciary duties may be more loosely defined, but are now considered with even more rigor, and with a better eye towards addressing controversies preemptively.
According to the Russell Investment Group, an investor services group, public pension funds have more than doubled their investments in private equity over the past decade, so there's a real likelihood for future controversies, including lawsuits brought by politicians looking to score points with their constituents. Fortunately, while few expect another lawsuit of the same nature as XO, plenty of effort is being made to prevent that worst case scenario from happening all the same.