ILPA Principles 3.0 Released: New Guidance on Private Equity Fund Terms – First Experiences
The Institutional Limited Partners Association (ILPA) has released version 3.0 of their ILPA principles on 27 June 2019. These principles refer to the terms and conditions of private equity funds, which are usually set out in limited partnership agreements (LPA) and which form the legal and commercial framework of the investment of an investor as limited partner (LP).
Even though ILPA is an organization of LPs (representing 500 LPs / 2 trillion US-Dollar of AUM), the ILPA principles should not be seen as a pure investors’ wish list. Primarily, they are an important tool if it comes to the negotiation of fund terms or side letter provisions between the initiator of a fund (resp. its manager and/or general partner (GP)) and its potential investors. Since they are built around basic principles (alignment of interest, governance and transparency) and also reflect the feedback from GPs, they do not only deliver arguments to support the position of LPs, but can help to find a balanced, reasonable solution for controversial aspects.
ILPA 3.0 is a complete rewrite of ILPA Principles 2.0 from 2011, more than doubling the size from 20 to 43 pages. However, the new principles are widely considered to be an evolution rather than a revolution. We believe this is true. However, it’s worth noting that the new principles comprehensively tackle quite a few areas for the first time, such as co-investments, subscription lines of credit and GP-led secondaries. In addition, a few principles might turn out to be highly controversial as they can be seen as a shift away from current market standards to a more LP-friendly environment. This article will put some light on a non-representative variety of these new or controversial items.
1. Subscription Lines of Credit and Preferred Return
Subscription lines of credit became more and more popular in recent years. They are used to bridge the gap between the funding of an acquisition (or the date when fund expenses become due) and the actual drawdown from the LPs. Subscription lines of credit have a positive effect on the IRR and can therefore be used by the GPs as an instrument to enhance the IRR.
ILPA recommends that such facilities should have a short duration (up to 180 days) and should be limited to a maximum percentage of the overall commitments (20 percent). Furthermore, the GP should give LPs the option to opt-out of the credit facility when a fund is set-up. The GP should provide LPs with the terms of such facilities, e. g. anticipated size, proposed limits on duration, parameters around use of proceeds, and disclosure of costs incurred by the fund relating to the use of such facilities.
ILPA further proposes that GPs should provide quarterly and annual reporting of the fund-level leverage as well as performance information with and without the use of such facilities, in order to facilitate the comparison of fund performances.
For carried interest calculations where a credit facility is in place, the preferred return should accrue from the date that the capital is at risk (i.e. the date on which the facility is drawn), rather than the date when the capital is ultimately called from the LPs. The previous version 2.0 of the ILPA principles only stated, that the preferred return should be calculated from the day capital is contributed to the point of distribution.
This proposal, which was already included in the 2017 ILPA guidelines on subscription lines of credit, might become a tough negotiation point, since it is rarely seen in the market. On the one hand, it seems to be reasonable to say that the time of drawdown of the facility shall be relevant, since these facilities are usually secured by LPs’ commitments, which are put at risk thereby. On the other hand, it ignores that subscription lines of credit are also in the favor of the LPs, since they facilitate the liquidity planning and avoid fre-quent drawdowns. The GPs and the LPs would have to give up these benefits, if the ILPA proposal is implemented, since it makes the use of subscription lines prohibitive.
A compromise could be to report the IRR with and without subscription lines of credit to provide greater transparency and comparability. This approach would be consistent with the practice of more and more LPs such as ATP Private Equity Partners, the fund of funds arm of Denmark’s largest pension who recently announced that it will require all GPs to provide the IRR adjusted by subscription credit lines. In addition, the ILPA recommendations as to the duration and limits of credit lines should be implemented, in order to mitigate the potential impact on the IRR.
The question as to the relevant point in time also arises with regard to so called interim contributions, which are contributions of the GP to bridge the gap until drawdown from the LPs and which will be repaid, including interest, from subsequent drawdowns from the LPs. Similar to subscription lines of credit, one can argue that the IRR should accrue for the LPs as from the date of the interim contribution rather than the drawdown since the commitments of the LPs are at risk as from the former date.
2. Co-Investment Allocations
ILPA 3.0 sets out best practices on co-investments, dealing with the rising request for sig-nificant discretionary and non-discretionary co-investment opportunities alongside the fund. Co-Investments are a tool to grant certain LPs the benefit to invest a higher portion of capital on a case-by-case decision based on lower fees and lower carried interest.
Where rights to evaluate or take part pro rata in co-investments have been granted to certain LPs, GPs should disclose such arrangements to all LPs. Furthermore, ILPA suggests that all suitable investment opportunities received by the GP, key persons, fund managers or affiliates shall first be allocated to the fund, if the opportunity fits the fund´s investment strategy, investment size and the fund has available remaining commitments.
Interestingly, the ILPA principles state that affiliates of the GP should be permitted to par-ticipate in co-investments and that co-investments can be offered to other vehicles managed by the GP. From our point of view, this could open a backdoor for co-investments by team members and key executives. If possible, such co-investments should be avoided from the LP’s perspective, since they would enable the GP and the team members to cherry-pick by an increased investment the most promising investments, which puts the alignment of interest at risk.
According to our observation, GPs actually are charging higher management fees and carried interest to co-investment schemes as they did in the past. Nevertheless, co-investments will remain attractive, irrespective if a discount on fees and carried interest is granted or not, since they enable co-investors to deploy more capital within a shorter timeframe than LPs without a co-investment opportunity. As the latest Alternative Investor’s Survey of BAI (Bundesverband Alternative Investments e.V.) has revealed, a slow drawdown and deployment of capital and its negative impact on the J-curve is one of the main concerns of institutional investors investing into private equity. However, the de-scribed trend makes it necessary to carefully review the fund terms, whether or not costs and expenses as well as transaction fees and other fees, which are to be set-off against the management fee, are reasonably and consistently allocated and shared between the main fund and co-investment vehicles.
3. Fiduciary Duty of GPs and Indemnification
Concerning the fiduciary duties of GPs, ILPA emphasizes the importance of the principle that GPs owe a fiduciary duty to LPs, in spite of the current trend in many funds to narrow or limit GPs’ fiduciary duties. The principles also recommend that fund documentation should reinforce rather limit the fiduciary duties of GPs to LPs and that the gross negli-gence, fraud and willful misconduct or breach of the LPA should be the minimum in terms of the exculpation standard agreed by LPs without any qualifiers with respect to prior knowledge or material adverse effects.
A breach by GPs or behavior constituting gross negligence, fraud or willful misconduct should be excluded from the protections of indemnification and exculpation clauses, even if permitted by law and any indemnification should be capped at a percentage of the total fund size resp. drawn capital.
These recommendations draw the attention to the fact that the liability can be excluded in many jurisdictions to a very large extent. In other jurisdictions, this is not possible. For instance, under the governance of the AIFM Directive, it can be argued that fiduciary duties as described in Art 12 of the AIFM Directive cannot be limited. Therefore, the provisions dealing with the limitation of liability must be always reviewed in the light of the applicable law in order to adequately protect investor’s interests.
The general principles and rules with respect to the allocation of expenses between GP and the fund are basically unchanged. However, ILPA now provides some examples how to allocate costs and expenses among the GP, the fund and other players. From the per-spective of ILPA, the following costs and expenses should be borne by the GP in principle:
- Industry conferences, computer software and subscriptions, cost of research and information services, entertainment, investment consultants;
- Cost and expenses associated with maintenance of required books and records, ex-penses incurred in fulfilling regulatory compliance requirements (e.g. registration or maintenance of registration);
- Cost and expenses associated with any remedial actions required as the result of a regulatory exam (e.g. SEC audit);
- Travel costs related to sourcing deals, networking, and preliminary due diligence;
- Consultant’s fees, except for specialized consulting services.
Many of these items are probably very controversial. Anyway, instead of focusing on the specific costs items and trying to negotiate each of them, it might make sense – as stated by ILPA itself – to take a more holistic view, e.g. to agree with the GP to apply the same cost allocation principles, which have been applied with respect to predecessor funds, provided that such past practice seems to be acceptable for the particular LP in the light of the overall fund performance.
Beside the aspects outlined above, the ILPA Principles 3.0 cover a wide range of other is-sues, including
- Non-financial disclosures: incident reporting and regulatory compliance;
- ESG reporting: guidance on environmental, social and governance policies and reporting;
- Cross-fund investments: recommendation of limiting the number of overlapping investments between funds as well as avoiding transfers of assets between funds;
- GP-led secondaries transactions: disclosure requirements and dealing with conflict of interest;
- LPAC (Limited Partner Advisory Committee): new principles provide greater guid-ance on the operations of the LPAC.
The full ILPA Principles 3.0 can be found here.
Noerr’s renowned Alternative Investment practice bundles Noerr’s long-term expertise in areas such as fund structuring, tax and regulatory advice, LP due diligence, side letter ne-gotiations and related matters. Our experts would be happy to discuss with you any of the issues raised by the ILPA 3.0 principles or any other related topic. To contact our experts, please click here.
This article has been prepared for general circulation to clients and intermediaries, and does not take into account the particular circumstances or needs of any specific person who may read it. Nothing in this article constitutes legal, accounting or investment advice.
Any questions? Please contact: Dr Georg Christoph Schneider, Sebastian Voigt
Practice Group: Private Equity