The private fund manager’s compliance workload is often discussed when compliance and finance folk meet, and the rhetoric is fairly standard – what the regulator wants, and how they can put its requirements into practice.
It may seem that the regulator’s compliance checklist is as opaque as the fees and expenses it accuses private funds managers of claiming. However, there is one thing almost guaranteed to feature, regardless of the area being examined, and that is whether a firm is doing in practice what it says it will in principle.
Limited partners advisory committee issues are no exception. The agency does not dictate the constitution of the committee, nor does it expect every one to have a uniform remit. But if the limited partnership agreement says the committee will be consulted on a particular matter, it must actually be consulted if necessary.
“When the SEC conducts an examination, it will ask for all LPAC approval materials, plus and minus two years, up front. Staff will examine them, and gauge them against the authority given to it in the LPA,” Norm Champ, partner at Kirkland & Ellis in New York and former deputy director of the SEC’s examination program, tells pfm.
If an LPAC has not been consulted on an issue that, according to the LPA it should have been, the SEC will then take a closer look, as demonstrated by enforcement action.
In 2015, it fined New York-based mid-market firm Fenway Partners for alleged failure to disclose conflicts of interest to the LPAC. Among the charges was a claim that the firm and two employees did not disclose to investors or the committee that they had caused three former Fenway employees to receive $15 million in incentive compensation from the sale of a portfolio company for services that they had almost entirely provided when they were Fenway employees.
A second case followed the same course; JH Partners was charged with failing to disclose and obtain fund advisory board consent for a series of transactions. The agency said both cases drove home the fundamental principle that as fiduciaries, private equity fund advisors must make “full disclosure of all material facts relating to its advisory services, including all material conflicts of interest between the advisor and its clients.”
Driving home the importance of the documentation that accompanies the LPAC, Jennifer Choi, managing director of industry affairs at the Institutional Limited Partners Association, tells pfm the remit should be documented in the agreement and its scope understood by the committee’s members.
“LPACs themselves should also appoint a chair to provide additional direction, a common focal point for setting agendas and driving deliberations on issues. If the LPAC has been thoughtfully constructed, and if the mandate is clearly understood by both GPs and LPs, the level of consultation should be appropriate,” she says.
But failure to consult is not the only shortcoming the SEC is looking for; it will also comb through the documents given to the LPAC when it is asked to make a decision on a conflict.
“The quality of the material given to the LPAC is important to the SEC, the LPAC had the authority to make a decision, you went to them, did you give full disclosure?” Champ says.
The golden rule for ensuring your relationship with the LPAC is SEC-compliant is clarity, he adds.
“When you’re giving the LPAC information, make sure it is complete. If you’re setting up your first LPAC, be crystal clear with investors about what it can do.”
As with most areas of compliance, there are steps that must be taken to keep the regulator happy and action a manager must take to ensure its investors are satisfied. In the case of the latter, the composition of the LPAC can be a bone of contention, depending on who is on the board and what their relationship is with the manager.
“LPACs are also often weighted toward the largest LPs in the fund, or toward the LPs with longstanding relationships with the manager. This may lead to conflicts for individual LPAC members when it comes to issues around co-investments or cross-fund investments. In such instances, are the LPACs ideally constituted to sign off on conflicts on behalf of all the LPs in the fund?” Choi says.
In its Private Equity Principles, the association says LPACs should represent a diversified group of investor, and that a reasonable number of non-voting observer seats should be made available to certain limited partners.
Additional concerns exist over whether LPs that are not on the committee can and should be able to view the decision-making documents the LPAC compiles.
“The next iteration of the ILPA Principles will address questions around optimal size, scope and mandate and how that is communicated within fund documents and to LPs directly. We will also take up the question of disclosures around LPAC proceedings – do LPs that do not participate on advisory committees have any visibility into the issues considered, and if not, should the industry revisit what is being shared beyond the LPAC?” Choi says. GPs can neutralize some of the discussion around how LPAC seats are awarded by setting a non-negotiable minimum capital commitment, she says, noting that this can also create conflict itself.
The role of the LPAC has evolved over time in two ways – it has become a formal instrument to advise the GP on issues such as conflicts of interest or material changes to the fund’s strategy. But LPACs have also become larger bodies as more investors have negotiated for seats, which in turn has made them more of a sounding board for the GP and less of a formal governing body.
For the GP, LPACs are a critical means of providing information to important LPs in the fund and getting input from a cross-section of investors on important issues. For the investor, membership is a way of gaining greater visibility into the fund’s operations and access to information that is not otherwise disclosed to investors. Observing the relevant rules benefits the fund manager twofold; not only does it remove the risk of regulatory disapproval, it can also improve GP-LP relationships. It seems like an easy win.