What is the real meaning of transparency?

More expense provisions in LPAs come at the cost of clarity over what investors have to pay, says Jennifer Choi, managing director of industry affairs of the Institutional Limited Partners Association.

Jennifer Choi

ILPA continues to believe that disclosures related to fees and expenses can and should be clearer and more uniform. We are encouraged to see continuing migration towards transparency generally and the ILPA standards specifically in regular reporting to LPs. Investors are receiving more granular information on costs, as well as portfolio level data, and on a more consistent basis than ever before. The survey at the focus of this supplement indicates that 76  percent of respondents are now using some version of ILPA reporting standards or moving their reporting closer to an ILPA-standardized format.

Worryingly, however, the drive toward transparency on fees and expenses has tipped over to burying investors in pre-emptive disclosures in fund documents. While expansive expense provisions in limited partnership agreements – extending to a page or more in many cases – may insulate against some compliance risks, it comes at the cost of clarity for investors into what actual and specific charges they should expect to pay over a fund’s life. Over-reliance on pre-emptive disclosure also brings to the fore questions about the reasonability of certain expenses borne by the fund.

As a result, and in light of “sole discretion” clauses appearing in more and more partnership agreements, many LPs are finding themselves drawn into discussions during fund negotiations on the rationale for certain allocable expenses, or how offsets are applied to management fees, no matter how likely or unlikely such charges may be.

Many such questions are a matter of nuance. What’s the market rate basis for the fees assessed for in-sourced legal and accounting support for the fund?  Should fees paid by the portfolio company to members of the GP serving as interim portfolio company management be offset against the management fee? Under what circumstances is private air travel more cost-effective than commercial travel? Should the fund bear the cost for the GP being a registered investment advisor? When is it rational to allocate broken deal expenses to co-investors, eg, distinguishing between syndication and co-underwriting? For LPs seeking co-investment as a way to achieve more favorable economics, when is it reasonable for GPs to charge organizational costs and fees on that incremental capital?

One point in particular eliciting more focus during fund negotiations is the treatment of  management fees upon the raising of a successor fund and at the end of the investment period.  The time to raise a fund has shrunk from 20 months on average in 2013 to only 12 months in 2017, and intervals between fund numerals are their lowest on record, raising concerns about “stacking” management fees, ie, collecting management fees at full rates on two funds at the same time. It’s encouraging to see that LPs invested in the successor funds often get a fee break, but unfortunate that this break isn’t uniformly being extended to LPs in the previous fund.

The allocation of costs can be a nuanced issue, and expansive expense provisions in LPAs that do not precisely reflect what LPs will actually be charged should not be the sole determinant for such decisions. Where management teams elect to exercise their discretion or defer to outside counsel’s reading of the contract rather than bringing nuanced questions to LPACs, GPs risk erosion of trust in the partnership.

If expenses must be paid back to LPs before the GP can take carry, there is a natural disincentive curbing aggressive practices, but given increased complexity of fund structures and fund economics, LPs will remain vigilant for business models predicated on LPs bearing a disproportionate share of a firm’s overall operating costs or fund structures favoring fee income over carried interest.

For additional articles, go to Fees & Expenses Survey 2018 .