Finding fiduciary balance

First thing’s first: no one denies GPs owe some irrevocable fiduciary duties to investors. More specifically US-based fund managers owe LPs a duty of good faith and fair dealing. That is the law.

But in Delaware – the jurisdiction of choice for US private equity funds – the law allows firms to draft partnership agreements that can “expand or restrict or eliminate” traditional fiduciary duties like loyalty and care. Most GPs with enough clout to exercise this right do, and those that can’t wish they could, legal sources tell PE Manager.

What's important to note however is that Delaware domiciled fund managers experience a Catch 22 when deciding which fiduciary duties to take on in the partnership agreement. Set the fiduciary bar too low and risk an investor relations fiasco; set the bar too high and LPs may have the legal authority to question certain investment decisions.

Not all in the LP community are happy with this arrangement, but remain silent for fear of losing access to top GPs. What they want is a unified stand against ‘fiduciary lite’ partnership agreements – a goal only made possible if enough LPs are first made aware of the cause. The Institutional Limited Partner Association recently circulated an opinion piece which argued not enough LPs have the resources to carefully review partnership documents. If they did, the piece argued, more investors would call for change. One LP source discussing the piece on the condition of anonymity agreed GPs that carve out certain fiduciary duties risk upsetting their LP base.

Unfortunately for GPs the issue is not as simple as appeasing investors’ wishes. Fund managers do not create limited fiduciary duties because they have little interest in protecting investors’ capital, but as a safeguard against LPs second guessing their investment decisions. Take a duty of loyalty for instance: if a firm managing multiple funds made a successful healthcare investment using capital from only one of those funds, investors in the other funds may launch a claim against the firm for not thinking of their interests on an equal basis. The GP meanwhile may have simply made the decision based on how much healthcare exposure each fund had, a perfectly practical justification. In this sense writing into the partnership agreement that the GP has sole discretion in such matters is a way to limit their legal liability.

In the end LPs may be receptive to these concerns, but at the same time want a clear explanation of how such investment decisions are made – an issue exacerbated as custom account arrangements give rise to more conflict of interest issues. For GPs, the partnership agreement should address such questions, and as the law demands, clearly outline what fiduciary duties they are subject to.