ILPA’s hits and misses

Now nearly two years out since the Institutional Limited Partners Association (ILPA) unveiled an updated set of best practice principles for GPs to consider, it’s worth exploring which of these investor-friendly principles have actually made their way into fund documents, and which have been sticking points during negotiations.

The arrival of the principles caused a splash in early 2011 when ILPA – whose several hundred members control the vast majority of commitments to private equity funds around the world – said its “2.0 principles” would feature more focus, clarity and practicality, three factors that would contribute to their wider adoption. To that end the LP trade body solicited feedback from GPs, LPs and industry third parties throughout 2010 following release of the original principles in late 2009.

Unfortunately, GPs and LPs don’t always agree on best practices; even within their own respective communities fund managers and investors have found room for debate. Not to be discouraged, ILPA set a useful starting point in the construction of its principles by saying they would promote strong governance, appropriate transparency and the alignment of interests between LPs and GPs. No fund manager, and certainly no institutional investor, could find harm in that. And so in the past two years more and more GPs have publicly pledged their support of the principles, even as some would go on to quietly grumble that LPs have overestimated their bargaining position at the negotiating table, or that certain principles were not practical in action.

Roughly 240 industry organisations have endorsed ILPA’s updated best practices guideline, according to the group’s website. GPs that have endorsed them include Apollo Management, Coller Capital, Pantheon, Apax Partners, Oaktree Capital Management and First Reserve Corporation. Last year industry titan Kohlberg Kravis Roberts threw its weight behind the principles, describing its endorsement at the time as “general support for the efforts of ILPA”.

What endorsement does not mean however, is any pledge to adopt every ILPA principle.

NO UNIVERSAL ADOPTION

Instead the principles are more of a starting point (particularly for LPs) to use during fund negotiations. Their arrival came against a backdrop of tightened fundraising conditions and a general increase in the sophistication of private equity investors. These factors have moved the needle in LPs’ favour in certain areas.

For instance the 2.0 principles have successfully compelled GPs to enhance their annual reports by including disclosures around material risks and how they are managed. Funds with cross-border investments now often include details around how foreign exchange risk is hedged. Likewise GPs now include lengthier disclosures on their environmental, social and corporate governance standards. While the market was already headed in this direction, the ILPA principles have added fuel to the trend, says private funds lawyer Josh Sternoff of law firm Paul Hastings.

Investors’ ability to (in effect) fire a fund manager or dissolve the fund with reason (as opposed to a “no fault” removal) is another area the principles have had an impact, says Sternoff. A term now featured more often in fund agreements (that was added to the 2.0 principles) is the ability for LPs, subject to a majority vote, to remove a GP for just cause (fraud, a material breach of agreement, gross negligence, etc.).

One ILPA principle that has been a tense point during negotiations is a distribution waterfall that provides investors all of their capital contributions, plus a preferred return (typically of about 8 percent) before the GP can start collecting carry. Popular in Europe, this approach reduces the chance of a fund manager having to make clawback payments, which allow LPs to recover money in the event GPs receive too much carried interest.

However the standard in the US has still been the “deal by deal” distribution model, says Michael Harrell, co-chair of Debevoise & Plimpton’s private equity practice.

The reason why may be that the “return all capital first” approach has the effect of delaying distributions of carried interest to GPs, often for many years, explains Harrell. “Such a delay affects GP incentives and could adversely impact the ability of some private equity firms – particularly small and mid-sized firms that do not have multiple products or lines of business – to attract and retain the most talented investment professionals.”

Harrell says a return all capital first arrangement could also have the unintended effect of encouraging a more rapid disposition of investments than what is appropriate. Consequently “some LPs and many GPs could well take the view that, at least for certain firms, the distribution model that ILPA says “must” be recognised as a best practice is not necessarily consistent with the goal (unstated by ILPA) of maximising investment returns”.

A strong LP advisory committee is a recommended best practice that has received wide adoption, but not to the delight of all investors. According to sources LPACs are typically dominated by large institutional investors who could use the committee as a vehicle to exert influence. Smaller LPs worry these larger investors will work to only get themselves the best deals. In turn, smaller LPs may be overly deferential to the GP’s judgment when it comes to controversial fund matters, says Paul Gajer, head of law firm SNR Denton’s private funds practice.

“The GP may be the only personal relationship a smaller investor has going into the fund. In that scenario they are much more comfortable leaving matters to their chosen GP, as opposed to an advisory committee full of unfamiliar faces,” says Gajer.

ILPA executive director Kathy Jeramaz-Larson says the dominance of large LPs on advisory committees is a reflection of their stronger bargaining position during fundraising, and not necessarily something ILPA has an opinion on one way or the other. “What the principles say is that if an LP has a seat on the committee, the guidelines represent what LPs feel are the best practices on how the meetings should be run and what the responsibilities of GPs and LPs are to those meetings”.

An even more contentious ILPA proposal (that was also included in the 1.0 principles) has been the push for GPs to give back 100 percent of deal fees to offset the management fee. Historically  private equity firms would share 50/50 the cash they  receive from portfolio companies for advisory and monitoring services, but the market has since moved to an 80/20 share to the benefit of LPs. Creating a 100 percent offset industry standard as ILPA recommends has however proven difficult, says Gajer. “An 80/20 split is consistent with GPs’ typical carried interest of 20 percent of fund profits. Moreover the 100 percent offset operates to eliminate the incentive for GPs to get portfolio companies to pay service costs they get from the GP.”

The 2.0 principles also propose that fund managers provide LPs quarterly projections for capital calls and distributions. Larger funds may be able to accommodate such a request, but in the middle market it’s too difficult for GPs to predict the kind of deal flow they expect to provide any meaningful estimates, says Gajer.

As a compromise more limited partnership agreements have included caps on how much money a fund manager could call in any one year, a comfort for LPs who may not be able to meet one lump payment.  Gajer adds that GPs also use credit lines with banks to help smooth over capital calls. “That way you’re not requesting money from your LPs every week; instead you take out a short loan to put everything in one notice per quarter”.

How ILPA’s principles will be embraced in the years ahead remains to be seen. On that note Jeramaz-Larson says ILPA will continue to review submitted comments on its principles on an ongoing basis and on an annual basis, review “any updates that need to be denoted”.

Considering their flexible nature, it would be surprising to not see more fund managers endorse their existence going forward. Certainly from a pure investor relations standpoint, the principles offer a way for fund managers to stand shoulder to shoulder with LPs without having to concede everything on, what some GPs describe as, an LP wish list.