Stepping up your game

All those involved in the raising of private equity funds, their investment, and their administration, know that the private equity landscape has dramatically changed over the last two years. While the private equity industry waits to learn the outcome of the fierce debate over the EU AIFM directive, there have been more recent changes to recommended best practice to concern us.

The role of the independent administrator is changing as the private equity industry moves from a largely self-regulated environment to one where a framework of valuation principles, best practice, transparency and corporate governance will be required. These dynamics have now been added to by the recent issue of two sets of guidelines: the ILPA Principles and the IOSCO Report (as defined below).

This article considers various patterns that are emerging for private equity in the context of the current economic climate and the ILPA principles and the IOSCO Report.

New principles for private equity managers

In September 2009, the “Private Equity Principles” were introduced by the Institutional Limited Partners Association (ILPA). ILPA represents more than 215 member organisations worldwide managing approximately $1 trillion of private equity assets with a view to increasing best practice from a private-equity investor perspective. The ILPA Principles were closely followed in November 2009 by a consultation report on “Private Equity Conflicts of Interest” by the Technical Committee of the International Organisation of Securities Commissions (IOSCO Report). The ILPA Principles and the IOSCO Report have been introduced against the backdrop of the financial crisis which itself has also been a catalyst for a number of evolving trends in the private equity funds market.

ILPA Principles

The ILPA Principles cover a number of areas of private equity including best practices and preferred terms.

The document is divided into three parts. The first part summarises best practices in private equity partnerships and focuses on three themes:

(i) Alignment of interest between manager and investors;

(ii) Corporate governance; and

(iii) Transparency.

The second and third parts of the document set out specific fund terms in more detail. The second part covers (in Appendix A) the three themes summarised above and establishes specifically recommended “Private Equity Preferred Terms”. The last part (Appendix B) describes limited partner advisory committee (LPAC) best practices through formation, meeting protocol, LPAC duties and LPAC member responsibilities. We will focus here on Appendix A’s Private Equity Preferred Terms (PE Preferred Terms).

(i) Alignment of interest

This portion of the PE Preferred Terms, dealing primarily with economics, focuses firstly on carried interest and distribution cascades. It recommends, as standard, a model of all contributions plus preferred return being paid back first as best practice. This is a model which has traditionally been treated as a “European” model. Where a deal-by-deal model (the traditional North American standard) is chosen, PE Preferred Terms suggests features such as a return of all fees and expenses (rather than just pro rata for the realised investment); valuation of all unrealised investments at lower of cost or market; and carry escrow accounts with standard reserves in order to cover clawback liabilities.

The PE Preferred Terms then cover management fees and expenses, suggesting that a fee model based on reasonable operating expenses and salaries be provided at fund formation, with a significant step-down upon formation of a follow-on fund and at the end of the investment period. Placement agent fees and general partnership insurance should be borne entirely by the GP.

On the theme of alignment of interest, the PE Preferred Terms then move to non-economic considerations, such as suggesting that fund term extensions be permitted in one-year increments only, that the GP have substantial cash invested and that principals be restricted from transferring their ownership of the GP.

The PE Preferred Terms also mandate no subsequent fund closing until after the investment period and predisclosed, pro rata, co-investment arrangements.

(ii) Governance

The second theme following alignment of interest is governance. The PE Preferred Terms takes issue with provisions which attempt to constrain GP fiduciary duties such as allowing the GP to reduce all fiduciary duties to the fullest extent allowed by law; allowing the GP to use its sole discretion in weighing its own self-interest against the interests of the fund and obliging LPs to acknowledge and waive broad categories of conflicts or affiliated transactions (something quite common in investment-bank-sponsored funds). In addition to recommending avoidance of these practices, the PE Preferred Terms also suggest presenting all conflicts to the LPAC for prior approval of any material conflicts and all affiliate and non-arm’s length transactions.

The PE Preferred Terms also tackle the problem of “style drift” from investment purpose, suggesting that any changes to investment strategy be disclosed and approved by an LP supermajority.

The PE Preferred Terms recommend no fault rights: (i) upon LP majority-in-interest approval for suspension of the investment/commitment period and termination of the commitment period, and (ii) upon LP two-thirds-interest approval for GP removal and fund dissolution. The PE Preferred Terms also place reliance on checks and balances such as an independent auditor, independent counsel and LPAC oversight.

Appendix B sets out LPAC best practices, including formation, membership, rights to call meetings, creating agendas, quorum and voting protocols, minutes of meetings, reimbursement of expenses and indemnification, decision reporting to LPs generally and general duties (including audit, conflicts, GP operations and costs disclosure, LPA compliance, personnel changes and valuation policy and practices). Your administrator will be able to offer support and guidance on converting best practice into operational reality.

(iii) Transparency

The third and final area covered by the PE Preferred Terms is transparency, which requires that fund marketing materials should include values for unrealised portfolio companies in prior funds including explanations of values that deviate from audited statements; performance information using both IRR (gross and net as well as derivation) calculations and multiple of invested capital modelling; benchmarking; descriptions of any pending or threatened litigation and disclosure of agents and sub-agents. Many of these requirements are not expected to present significant challenges in the context of current Channel Islands regulatory requirements, particularly in light of the extensive due diligence which is increasingly common from sophisticated LPs.

The PE Preferred Terms also look for greater transparency relating to the GP and the management company. For example, organisational structure and arrangements of the fund, GP, affiliates and principals should be specifically disclosed as part of due diligence including capitalisation of the fund. Again, many of these issues are already being currently requested by LPs in due diligence questionnaires.

Ongoing reporting transparency is another PE Preferred Terms area of concern. Detailed quarterly reports (within 45 days of quarter-end) should cover such aspects as P&L statements and year-to-date results; GP expenses; management discussion of changes over quarter; and explanation of valuation changes. Detailed annual reports (within 75 days of year end) should cover audited financial statements including a number of items which are referred to in Appendix A. Surprisingly, the PE Preferred Terms fail to cover the issue of side letters in any detail.

IOSCO Report

This report set out to identify the risks and prevent these where possible in the structure of a typical private equity fund. The IOSCO Report travels through the typical life of a private equity fund and sets out the inherent risks at each stage. It suggests the disclosure of all remuneration arrangements at the fund raising stage, clear terms, increased negotiation and verification, ongoing reporting and further independent reporting. The IOSCO Report was open for consultation until 1 February 2010 and the report is due to be finalised once comments have been considered. At the time of writing (May 2010) it remains to be seen whether any changes will be made due to comments received during the consultation process.

Effect on fund structures going forward

Fund managers need to be aware of the increased scrutiny by investors as a result of the emerging trends in realignment between buy-side and sell-side interests. It is likely that the entrenchment of these trends in fundraising by the issuing of the ILPA Principles and the IOSCO Report will lead to changing terms in private equity and greater negotiations in relation to their terms. Since the credit crisis, investors have had much greater bargaining power and it is clear that if the terms of offer are not adjusted to recognise the new market paradigms, investors will be unwilling to make an investment commitment. The more dynamic wealth managers have begun to use fund structuring techniques as an opportunity to access new capital and it is likely that those who are attuned to meeting revised investor expectations will be most successful in raising new funds.