When the Model Limited Partnership Agreement (Model LPA) was published by the Institutional Limited Partners Association (ILPA) in October last year, it was marketed as “setting a new standard” for alignment of interests between general partners (GPs) and limited partners (LPs) in the private equity industry. By providing a baseline for legal terms and conditions deemed fair by the LP community, the aim is to streamline negotiations.
Shorter side letters? Lower costs? This is music to the ears of both GPs and LPs, but the devil (as always) is in the detail. While many of the terms of the Model LPA are uncontroversial, others appear to depart significantly from current market standards for English partnership agreements.
Below we focus on some of the noteworthy provisions of the Model LPA, in particular those that affect fund economics and are likely to raise eyebrows amongst the sponsor community.
Under the Model LPA, management fees are payable only until the end of the initial term of the fund and not following: (i) the appointment of a liquidator (which is not the GP); (ii) the extension to the fund’s term; or (iii) during a key person suspension period (clause 8.3). The inability to generate fees during a key person suspension period may hamper a GP’s ability to hire suitable replacements. The absence of management fees during a fund extension is something we would typically only see in a small or first time fund.
In addition, the Model LPA suggests that the management fee should be payable from the date the fund makes its first investment, unless the initial closing date is more appropriate (clause 8.3.1). In our experience it is standard industry practice for fees to be payable from the initial closing unless it is effectively a pre-closing (in which case the term of the fund and other key metrics also only start from the date of first investment).
The Model LPA includes a 100% fee offset for amounts paid to operating partners (clause 8.4), as well as for more general transaction fees. Increasingly, GPs are engaging operating partners with specialised expertise to execute on specific strategic growth plans, paid for by the portfolio company. While a full fee offset for general transaction fees is now fairly standard, we are increasingly seeing exceptions in respect of compensation paid to operating partners given their “value add” to the fund.
The Model LPA is based on an all-contributions-plus-preferred-return-back-first model. In other words, a European-style whole-of-fund “carry waterfall”, with a 20% carry, 8% hurdle and an 80:20 GP catch-up (clause 14.3.3).
While this represents the general industry standard, the Model LPA has shifted the goal posts further in favour of LPs particularly vis-à-vis US managers who traditionally favour a deal-by-deal approach. For example, it includes an option to establish an escrow account for carried interest distributions and provides for the calculation of clawback on specific interim events and upon liquidation of the fund and final distribution (clause 14.7.1 and 14.7.2). This means that a GP may not receive any carried interest until towards end of the fund’s term.
There is no fixed market standard for the amount to be held in escrow (and no specific amount is suggested in the Model LPA), so this will ultimately depend on the parties’ relative negotiating positions, although the separate ILPA Principles still suggest a 30% escrow. As an alternative to escrow, the Model LPA suggests a personal guarantee by recipients of carried interest on a joint and several basis of 100% of the obligation. In our view, it is very rare to come across joint and several liability for the return of carry and is this unlikely to be acceptable to fund managers.
The Model LPA also suggests that, where a subscription line is used, the deemed date of contribution for the purposes of calculating the preferred return should be the date on which the subscription line was drawn down.
Standard of care
The GP must make decisions (including investment decisions) reasonably and in good faith and “with the care that an ordinarily prudent person in a like position would exercise under similar circumstances.” (clause 20.5). This standard of care applies in addition to any fiduciary duties owed by the GP under applicable law or the relevant regulatory framework. It is not industry practice for English limited partnership funds to include an affirmative statement of the standard of care owned to the fund.
As is typical, the Model LPA provides for an amount of partnership assets to be kept in reserve for the payment of partnership expenses. Such expenses are required to be “reasonably anticipated” by the fund manager and there is an option to cap the reserves at a percentage of commitments.
In our experience, it is more usual for the manager to have absolute discretion to retain amounts in reserve for the payment of fund expenses and any restriction on this (particularly a cap) is unlikely to prove popular with fund managers.
The Model LPA requires a GP to exercise “reasonable and good faith discretion” in entering side letters. In addition, all side letter provisions must be disclosed to all investors and the Model LPA includes a “most favoured nation” provision, making it available to all investors.
Notably, the “most favoured nation” right in the Model LPA is not qualified by size. In our experience, it is market practice to include a carve-out in respect of larger commitments to prevent small investors from using their “most favoured nation” rights to elect the benefit of side letter provisions negotiated with larger investors.
In addition, under the Model LPA, side letters with individual investors are treated for certain purposes as a part of the LPA, for example, non-compliance with side letters has the same consequences as non-compliance with the LPA.
In addition, the Model LPA also contains the following terms which in our view are atypical:
- Indemnification: The Model LPA provides that LP giveback in order to satisfy a fund’s indemnification obligations is only permitted after the fund has met its liabilities as far as possible from other sources (for example, from insurance policies or portfolio companies). In our experience, it is not standard practice to restrict the manager in this way.
- Investment restrictions: A fund is required to obtain a counsel opinion that in any jurisdiction where a portfolio company is organised the LPs’ limited liability will be materially recognised to the same extent as under the partnership agreement and that no LP will have to file a tax return or pay taxes solely as a result of such investment. Standard industry practice is for the fund manager to be subject to reasonable endeavours to avoid this, rather than being obliged to seek a counsel opinion.
- Notice of investments: The GP is required to notify the LPs at least 10 business days before the end of the investment period of any investments to be completed after the investment period. In our experience, it is not standard practice for fund managers to provide notifications in advance.
- “For cause” removal: This includes a breach of the standard of care (whether or not material) and does require a material breach of an obligation under the fund documents. There is an optional requirement for court confirmation that the relevant conduct has occurred (and no requirement for a final determination). A “for cause” removal results in an immediate and automatic forfeiture of the GP’s right to any carried interest (including any deposited in escrow).
- Time and attention: There are certain restrictions on the GP’s time before and after the termination of the fund’s investment period.
- Transfer of interests of LPs: A GP must not withhold consent unreasonably to a transfer to an affiliate or to a transfer which meets certain criteria. However it is more usual for the GP to retain full discretion to consent to transfers, except to affiliates or successor trustees subject to certain conditions.
- Conflicts: Disclosure of conflicts in the fund’s offering documentation prior to investment in a fund does not waive a conflict or otherwise reduce or eliminate the requirement for the investor advisory committee to provide its consent.
Osborne Clarke comment
Since the introduction of the original ILPA Principles back in 2009, whether an investor is in a positon to demand inclusion of the more LP-friendly terms suggested by ILPA (and whether a GP will accept them) has ultimately depended on their relative bargaining positions; this will remain the case with this new Model LPA. Factors such as the point in the economic cycle, the size and experience of the fund manager, and the parties’ own priorities will influence how negotiations play out. It is safe to assume, however, that the more established fund managers are unlikely to adopt this form and that very few managers will adopt wholesale all of ILPA’s recommendations.
Whilst the Model LPA may not lead to a fundamental shift in fund terms any time soon, GPs, fund managers and investors should nevertheless familiarise themselves with its terms (and the positions taken in the IPLA Principles v.3.0). Certainly, where there is room for negotiation, investors may well use the Model LPA as a starting point for their conversations. GPs and fund managers will in turn need to be prepared to explain why any departure from ILPA’s recommendations is justified.