Bones of contention

If there is one clause in the Limited Partnership Agreement that can be a dealbreaker in European fundraising negotiations, it is the demand by state pension funds or sovereign wealth funds that litigation only be dealt with in their home courts.

Jason Glover, a top private funds lawyer and a partner in the London office of Simpson Thacher & Bartlett, struggles to think of a more contentious issue.

“On a highly successful fundraising that closed very recently, we lost an investor on precisely this issue. I can’t think of another clause, over the course of my career, that has resulted in the loss of more investors than the jurisdiction clause in LPAs,” Glover says.

European private equity funds typically include clauses that any litigation between limited partner and general partner will be heard in the court of the GP, but a US state pension fund may demand that the court of action be its home state. Given that the action may involve a jury trial, with jurors either being beneficiaries of the pension, or having family and friends who are, the concern is the extent to which a GP will receive a fair trial.

Coupled with the risk of punitive damages, fund managers are reticent in agreeing to such a provision. Yet some US state plans will claim that they are obliged by law to insist on one, and so in some instances that pension is refused access to a private equity fund.

These investor-specific demands top sister title Private Equity International’s list of the top five most hotly contested clauses in the LPA. And Glover says negotiations are getting harder: “The reality is that over the last three or four years, investors have started to raise far more comments than they used to, even on funds that are massively oversubscribed. The investors are much more alive to their fiduciary duties and responsibilities, which is good news for the industry as a whole, but as a result we receive extensive comments on the first draft of the LPA, even when the PE fund is a hot ticket.

“It’s as if the investor feels a need to demonstrate that they have asked for certain provisions, even if they know deep down that the general partner is not going to agree to them. But then going forward, investors tend to be pretty pragmatic in the negotiations.”

With the average size of private equity funds closed in 2016 reaching an all-time high of $471 million, and 48 percent of investors planning to increase their allocation to the asset class over the long term, according to the 2017 Preqin Global Private Equity and Venture Capital Report, it would appear that GPs are in the driving seat on terms.
But Nick Benson, a partner in the investment funds practice at Latham & Watkins, says there is no significant shift in where the negotiating power lies. “The balance of power is, and always has been, a question on a very specific basis between an investor and a GP. There’s no general extrapolation about a shifting balance, other than to note that there does seem to be a lot of appetite for commitments into quality funds, so that plays into the hands of the well-established GPs when they are negotiating on a successor fund.”

That said, even the most experienced GPs can find it difficult to flex their muscles on some of these bones of contention in LPAs.

1 ‘Regulatory’ demands
The problem with investor-specific demands is getting to the bottom of whether the LP’s hands are genuinely tied by legal restrictions on their activities, or there is in fact some room for manoeuvre. Many state pension funds and sovereign wealth funds do face very real restrictions on what they can and cannot accept, in which case the GP needs to find a way to accommodate them.

Glover says, “The first thing is to seek to establish whether what they are asking for is actually a wishlist, or is based on a legal restriction. It is often the case that so-called ‘standard provisions’ are readily accepted by many general partners, irrespective of the underlying merits of the request. The key is to establish whether the investor has the ability to engage in commercial negotiations, or if in fact there is an underlying legislative restriction that means that the provision is a must-have.”
Where they can, GPs will have to negotiate. Glover says that frequently US pension plans have some flexibility on where they themselves may bring an action, but are legally required to ensure that actions against them can only be brought in their local court. In such instances, a compromise is often reached whereby the European private equity fund can only sue the state plan in its local court, but the pension in turn can only sue the general partner in its home court.

2 Key-person clauses
These clauses continue to be very hotly negotiated by investors, and indeed were ranked number one in PEI’s most recent survey of LPs when investors were asked which fund terms they considered to be mandatory in LPAs. Much of the focus on these clauses comes down to the more enhanced nature of LP due diligence, including a greater focus on where and how value is created within a fund.

Lawyers say different investors will, naturally, take completely different views on how key-person clauses should be drafted, which further complicates the overall negotiations.

Howard Beber, co-head of the private investment funds group at Proskauer, based in Boston, says: “Certainly LPs are very focused on governance, and are pushing for no-fault rights, including no-fault removal of managers, and no-fault termination of the fund. You do typically see some no-fault means to terminate the relationship in most agreements, because for-cause provisions are typically very difficult to trigger.”

3 Borrowing
Financing is become increasingly popular. In the past, funds only used borrowing to bridge capital calls, but now LPs are being asked to get comfortable with more leverage.
Beber says: “The negotiations usually revolve around how much leverage is acceptable, and what information the LPs might be obliged to provide to banks and other lending institutions in connection with those borrowings.”
As funds seek to borrow larger amounts, so banks are seeking more assurances from, and due diligence on, investors, who may refuse to be obliged to provide a lender with any information that is not in the public domain.
Benson says: “Some investors like to see borrowings, but it does mean the fund bearing the costs of such borrowings, so it’s a question of weighing up the better IRRs against deploying their capital from day one. There’s no universal view, and that’s coming up a lot more often in negotiations.”

4 Co-investment
Another bone of contention is co-investment, which LPs remain keen to secure, but for which GPs are reluctant to make firm commitments. Glover says: “GPs can get themselves tied up in knots about co-investments if they’re not careful. We find managers either do a blanket clause saying they acknowledge that the LP wants co-investment rights but they have complete discretion as to how they allocate the opportunities, or they commit to a very prescriptive, detailed and time-consuming process on how they are going to allocate the opportunities.”

In funds that are not oversubscribed, LPs may be able to secure clauses that detail rather complicated procedures, and such mechanisms can end up being unwieldy for the GPs at the point when they find themselves overcommitted to a deal and trying to sell down the co-investment.

In the US, the Securities and Exchange Commission has weighed in on the issue, adding further formalities and complexity, says Beber: “The SEC has been very focused on full disclosure, including disclosure regarding how LPs are being treated by managers vis-à-vis one another with respect to co-investment opportunities and any other special deals. Managers now typically have well thought-out co-investment policies and procedures that are disclosed during the fundraising process.”

5 Fees and expenses
Finally, the other area where SEC intervention has compounded an already tricky area for fundraisings is in fees and expenses.

“Over the last few years the SEC has been very focused on disclosure around expense allocation, requiring that managers clearly disclose which expenses are covered by the fund and which are covered by the manager, and how expenses that may relate to more than one fund are allocated across funds,” Beber says.

“Of course, disclosure around operating partners – who they are, what they are doing and who is bearing associated expenses – is high on most LPs’ lists. In addition, LPs are requiring increased transparency and reporting on expense allocations and other matters, which can strain the resources of a firm’s back office.”

As investors and regulators have driven more transparency around fees and expenses, the issue has moved up the agenda in fund negotiations.

“As the provisions in the fund documentation have become more detailed, it has given both parties more material to haggle over,” says Benson. “So we find we are going through a whole long laundry-list of expenses that funds can charge, and debating things like whether it’s appropriate for GPs to use private air travel.”

Often LPs will seek to be prescriptive about when it is appropriate for GPs to recover travel expenses, and how it is appropriate for them to travel. That’s just the latest example of LPs driving the conversation in fundraising negotiations, even if they don’t necessarily secure the terms they want by the time they get to signing on the dotted line. ?

What really matters to private equity LPs

Sister title PEI’s most recent survey of investors revealed that for limited partners negotiating often long and complex LPAs, alignment of interests is paramount. The key-person clause, the level of the management fee and the structure of the carry distribution waterfall therefore rank as the top three LP must-haves for respondents.
While a quarter of survey respondents saw little or no change at all on terms, others reported significant moves in their favor over the past three years, on terms including no-fault divorce, transaction fees, fee offsets and carried interest.