Pulling punches

The limited partner advisory board provides a conduit between a fund manager and its investors. But with LP hands tied by limited liability concerns, are these boards less than they're cracked up to be? By Andy Thomson, Associate Editor

Limited partnership agreements have real power, as AIG Capital Partners discovered earlier this year.

The steadily unfolding drama began when AIG Capital Partners’ closing of a new $900 million (€733 million) fund for investment in emerging markets coincided with an accounting scandal at the parent company. The fallout from this resulted in the departure of AIG chief Hank Greenberg, who had been a cheerleader for the eventual independence of AIG Capital Partners – an option investors supported.

When Greenberg exited, the private equity arm found that Greenberg’s empathy for independence was something the new leadership of AIG did not share. When AIG Capital Partners head Peter Yu and managing director William Jarosz protested the new stance, they were both fired. This was a crucial development in terms of the future of the fund, because under the limited partnership agreement, Yu was identified as a key man – meaning that when he was relieved of his duties, the fund became officially inactive due to the triggering of the agreement’s key man clause.

On May 19, at a meeting of the board, AIG put forward David Yeung as its chosen successor to Yu. A Dow Jones report said investors unanimously voiced their disapproval, leading AIG to agree to amend the limited partner agreement in order to allow investors to withdraw their commitments if they wished. The same Dow Jones report said the equity pool was subsequently reduced to just $250 million ($90 million of which had been committed by AIG).

This display of LP power was impressive and a reminder that when GPs stray from their original remit, investors do have means of redress. However, while the advisory board provided the forum for the LPs to express their discontent, their power to act derived from the LP agreement. Indeed, far from the picture conjured by its association with the AIG debacle, some industry professionals offer the opinion that the advisory board is something of a blunt instrument – or, as one intermediary described it, ?a marketing tool dressed up as corporate governance.

In the view of David Tegeler, a partner in the corporate department of Boston-based law firm Proskauer Rose, the main function of the LP advisory board is as a forum that helps ensure alignment of interest between GP and LP. ?It usually comprises representatives from significant LP groups, whose presence on the board is based either on the size of their commitment or the strategic value they are perceived to bring to the fund. From the LP’s point of view, it’s a sounding board that allows them to provide some input to the fund managers, while from the GP’s view it gives them the ability to take the temperature of the LP base without having to take a vote of all investors.

Reasons for calling a meeting of the board will vary from one fund to the next, but will normally be specified in the LP agreement. One common example is that of the departure of a ?key man specified earlier. Others include the need for a GP to check whether an investment could potentially be seen as representing a conflict of interest (for example, where its Fund 5 is making a follow-on investment in a Fund 4 portfolio company) and also potential strategic drift, including where a GP wants to increase the percentage of the fund that can be invested in one particular deal. Ian Worden currently a consultant but with 25 years investing experience working with various UK-based limited partner groups such as GRE Insurance, Hermes and Granville, and who has sat on numerous boards in Europe and Asia, relates a case of strategic drift he was involved in. He says: ?In 1999, I was on the board of a European buyout house that wanted to discuss doing a venture capital deal. The limited partners weren’t very happy with the idea, but the GP went ahead and did the deal anyway. There’s not a lot you can do. If firms don’t get the approval they want, they can always do the deal and then report back later.

The fact is, there is one very good reason why LPs know they cannot afford to become too proactive when it comes to the running of the fund: it would jeopardize their limited liability status. And that is a graver issue than having to put up with a misfiring GP strategy. ?There is pressure from the LP side to exert greater influence or control, says Richard Watkins, a partner at the London office of international law firm SJ Berwin. ?But there’s a fine line before you end up undertaking management actions. The legal position is that if you participate in management then you are by definition no longer an LP and have unlimited liability. You have to stay on the right side of the line – and if you start making decisions on behalf of the Fund, then that’s the wrong side.?

The significance of losing limited liability status is that it would mean that if the fund were sued, the LP in question could also be sued and the amount of potential liability would not be limited to that LP’s commitment to the fund – it could also mean individuals within the LP group being sued personally (putting the LP in the same legal position as the GP, but probably with much greater assets at risk). ?That could happen in any situation where an LP can be deemed to have influenced the decision-making process. says Grant Roberts, a partner at Newgate Partners, a London-based private equity advisory firm. ?Where the line is drawn is a grey area, and the consequence of crossing it is so great, that most LPs shy away from any involvement beyond responding to requests for advice or opinion from the GP.?

Roberts goes on to outline a situation in which this could arise: ?A manager wants to sell an investment, but you [the LP] say it’s not the right time so the manager decides not to sell it and then the company at some point goes bust. In theory, this action could be deemed to be management of the fund, with that LP liable for any losses that result.?

According to legal practitioners, the items that get discussed on an LP advisory board are very similar on both sides of the Atlantic. However, there are some intriguing comparisons to be made in terms of the respective legal and regulatory environments and how they dictate the willingness of LPs to play a more or less influential role in the day-to-day running of a fund.

On the one hand, say some observers, limited partners in the US are less likely than European counterparts to push the boundaries in terms of how much they can influence a fund manager because of that country’s litigation culture. Indeed, due to fears about possible legal reprisals, many US limited partners will not only shy away from discussing certain items once on the board but may well turn down an offer to join an advisory board in the first place (in some cases having received legal counsel that it would not be a good idea).

Says Richard Watkins: ?Advisory board members are very careful not to expose themselves to potential lawsuits as a result of the votes that they cast. This relates to a general caution as to the exercise (or indeed non-exercise) of a discretion or voting power granted to the advisory board, which leads to the Fund making or perhaps not making an investment, opening up those advisory board members to claims such as negligence from investors who suffered loss as a result.

Grant Roberts adds that legal action is the final option in the dispute resolution process. US investors are more likely to take such action, due to the business culture, whilst Europe’s loser-pays rules mean that one has to think more carefully before going down the legal route.?

However, while acknowledging that the litigation culture works against the operation of meaningful advisory boards in the US, David Tegeler says one also needs to consider the way in which funds are structured. In the US, the Delaware Act specifies safe harbor provisions, which are adopted by the commonly used Delaware limited liability company (LLC) vehicles. These provisions specify in precise terms the actions that a limited partner is and is not allowed to take on an advisory board. ?As long as you operate within the safe harbor, you are protected, says Tegeler.

By contrast, partnership laws in Europe do not tend to contain safe harbor provisions, meaning that in an English LP vehicle, for example, the parameters are not necessarily quite so clearly defined. This can be significant in certain situations. Tegeler outlines one such scenario: ?One common function of advisory boards is to either approve [portfolio company] valuations suggested by the GP, or approve the methodology behind those valuations. Investors in a Delaware limited partnership have guidance under the Delaware Act with respect to what actions they may take and still preserve their limited liability.?

Ironically, therefore, although US limited partners live in fear of the litigation culture, they are more likely to know where lies the line in the sand between rightful and wrongful actions than their European counterparts.

But the fact remains that even where the LP does not live in fear of legal action and is pretty clear on what he or she can and cannot do, the roles and responsibilities of a board member are restricted to a handful of core issues and fall short of enabling the LP to steer the GP away from acting in a certain way. So is the LP board indeed a mere marketing tool? Even among those who agree that it is, there are those who urge you not to underestimate its significance.

Kelly DePonte of San Francisco-based placement agent Probitas Partners says a number of US venture funds are either already suffering or could be made to pay in the future for not having taken their advisory boards sufficiently seriously in the wake of the tech downdraft. He says that when some of these funds realised they had raised so much capital during the boom that they were unable to invest it in tougher times, they simply went ahead and restructured (i.e., downsized) their funds in precisely the way they (and not their investors) saw fit

One anecdote now doing the rounds is that of a US venture fund that had raised over a billion dollars and simply told its limited partners that it had decided to split the fund in half, and not charge management fees until 2006, when it would begin investing the second half of the capital – which would in effect become the next fund. A source who was close to the ensuing brouhaha relates: ?The limited partners said, ?hang on a minute, we want to see how this fund performs before we commit to the next one?.?

Says Deponte: ?The advisory board should be used as an early warning system by the GP to figure out through a representative group of investors what’s on the minds of all its investors. If LPs feel sour about the way they’ve been treated, it will make the GP’s fundraising next time around a lot more difficult.?

This underlines the point that, although the advisory board may indeed be a marketing tool, it can also be a vitally important one. Use it in innovative ways and it could be a good way of winning friends in the limited partner community. Ian Worden relates that a Northern Irish private equity fund whose board he sat on conducted meetings of its advisory board at portfolio companies, in the process giving investors greater familiarity with the inner workings of those companies. ?That can be very useful in understanding technology-related businesses in particular, Worden says.

One group of GPs that would never tend to underplay the significance of the advisory board is funds of funds. For them, an ability to list all their LP advisory board positions is a useful part of their marketing when raising their own funds. Indeed, some funds of funds even demand that they will be invited onto advisory boards when making commitments. ?Funds of funds tend to take these things more seriously than others, confides one source.

For all that, a question mark does still hover over whether the LP advisory board is fulfilling the role that people not familiar with the asset class might assume. From the outside, it might be thought that such a board would provide checks and balances on the actions of fund managers. But this is only true to an extent. Take valuations, for example, where the limited partner is sought out not so much for an opinion as a rubber stamp. This limited remit of investors, many in the industry would say, is absolutely appropriate. Managers, so the argument goes, should be left alone to manage.

But with the broader regulatory environment becoming increasingly demanding, questions are bound to be asked about whether private equity firms have in place adequate corporate governance frameworks. And, if the LP advisory board does not satisfy corporate governance demands, then what does? ?There could be an issue here, says Grant Roberts. ?You would expect big [non-private equity] companies to have a high degree of mechanisms and controls because they are subject to regulatory and legal requirements.. But should one expect, for example, a very different level of governance in the major buyout funds? The biggest buyout funds now have hundreds of staff in multiple territories around the world, and closely resemble the industrial conglomerates of a couple of decades ago. But there are plenty that don’t have independent advisory boards of any kind.?

The LP advisory board undoubtedly has its uses as a forum for debating potential breaches of aspects of the LP agreement. It is unlikely to be seen by many, however, an effective corporate governance mechanism. Whether such a mechanism needs to be found is a consideration that may become more urgent as private equity finds itself in the full glare of the regulator’s spotlight.