The Institutional Limited Partners Association ("ILPA") is a global organization comprised of more than 5,000 industry professionals across more than 50 countries managing 50% of the global institutional private equity assets under management. The ILPA's objective is to engage, empower and connect limited partners ("LPs") in order to improve the private equity industry for the long-term benefit of all industry participants and stakeholders. To that end, the ILPA periodically publishes industry best practices based on the ILPA's key guiding principles of governance, transparency and alignment of interest of LPs and General Partners ("GPs").
The ILPA first released its principles in September 2009 and, after receiving feedback from LPs and GPs, published an update to the principles in 2011. In June 2019, the ILPA published a third version, ILPA Principles 3.0, which expands upon prior principles and attempts to address the evolving industry and policy dynamics impacting private equity fund partnerships.
This article provides a summary of the key recommendations in Principles 3.0. Several of the best practices proposed in Principles 3.0 are a marked departure from current market practice. The ILPA acknowledges that the principles are not to be applied as a checklist; however, they are intended to serve as a "road map" to inform and frame negotiations between LPs and GPs. Accordingly, fund sponsors and institutional investors should become familiar with the principles and consider their application when forming or investing in a private equity or venture capital fund. The full text of Principles 3.0 can be found here.
Key Economic Terms of a Private Equity Fund
- Waterfall Structure – Best practice is to use the LP friendly "whole of fund model" whereby LPs receive all contributions plus a preferred return back first, before the GP receives its carry.
- Calculation of Carried Interest – The carried interest should ideally utilize a "hard hurdle" pursuant to which the GP's carried interest is determined (i) based only on the portion of net profits (not gross profits) in excess of the preferred return, factoring in the impact of fund-level expenses; and (ii) on an after-tax basis with no carried interest taken on current income distributions. Furthermore, the preferred return should be calculated from the date capital is called from LPs to the point of distribution and based on the fund's cumulative investment history commencing when the LP's capital is put at risk via the partnership's initial investment.
- Subscription Lines – Subscription lines of credit should be for short duration (no more than 180 days), limited to a maximum percentage of fund commitments (20%) and used primarily for the benefit of the fund as a whole, such as to reduce administrative burden or for bridge financing, rather than to enhance reported internal rate of return (IRR) by delaying drawing capital or to fund early distributions.
- Recycling – Recycling provisions should have either a mutually agreed cap based on the GP's track record and fund strategy or a monitoring threshold such that LPs can more accurately project their cash requirements and should expire at the end of the fund's investment period.
- Clawbacks – All clawback amounts should be gross of taxes paid by recipients of the carried interest and paid back no later than two years following recognition of the liability.
- GP Commitment – GPs should make a substantial investment in the fund, contributed by cash and not by set-off against management fees or other specialized financing mechanisms. GPs should invest pro rata with the LPs rather than 'cherry picking' investments. GPs should be restricted from transferring their economic interests in the fund and LPs should be notified of any intent to transfer an interest in the management company to a third party.
Management Fees Payable to the GP
- Quantum – Management fees should be based on reasonable expenses related to the normal operating costs of the fund. Management fees should account for lower expenses at the end of the investment period, if the fund's term is extended and incidental to the formation of a new fund, in which cases the management fees should step down. For a new fund, GPs should provide LPs with a fee model to guide how management fees will be calculated over the life of the fund.
- Fee Offsets – No fees should be charged to portfolio companies but, if any portfolio company fees are charged, they should be 100% offset against the management fee and subject to appropriate disclosure.
- Other Fees – Fees originated by an affiliate of the GP or manager should be submitted to the limited partner advisory committee ("LPAC") for review and approval.
- Expenses Allocable to the Fund – Expenses properly allocable to the fund include reasonable costs associated with LPAC and annual investor meetings, costs of third-party administration if previously approved by the LPs, travel expenses related to potential investments which have progressed beyond the initial term sheet stage, interest expenses, audit fees, legal expenses and indemnification, insurance, litigation and regulatory expenses.
- Expenses Allocable to the Manager – The manager should be responsible, via the management fee, for the costs and expenses related to the general management and reporting of the fund and for the manager's investment activities on behalf of the fund. These expenses include not only the salaries and fees paid to the employees of the manager and the GP and any relevant advisers or affiliates but also costs related to industry conferences, research and information services, computer software and technology upgrades. Furthermore, travel expenses related to sourcing a deal, networking and "preliminary" due diligence as well as fees and expenses for due diligence related to environmental, social and governance (ESG) issues, placement agents, operating partners and consultants and for any unforeseen expenses should be borne by the manager.
Fund Term and Liquidation
- Fund Term Extensions – Extensions of the fund term should be permitted only in one-year increments, limited to a maximum of two extensions and first approved by the LPAC and then proceed only with approval of a supermajority (75%) of LP interests in the fund.
- Liquidation of the Fund – Absent LP consent following expiration of the fund term, the GP should fully liquidate the fund within a one-year period.
GP Ownership and Removal
- GP Ownership – LPs should be notified in a timely manner of any personnel changes within the GP or manager, not solely key persons, with the potential to impact fund performance, and immediately notified when key person provisions are tripped. Changes to key person provisions should be approved by majority in interest of LPs.
- Time and Attention – Key persons should devote substantially all their business time to the fund, its predecessors and successors within a defined strategy, and its parallel vehicles. Situations impacting a principal's ability to meet the specified "time and attention" standard as delineated within the LPA should be disclosed in a timely manner to all LPs and discussed with the LPAC.
- GP Removal – GP removal without cause should require a supermajority vote of LPs. In the case of GP removal for cause, a majority in interest of the LPs should have the ability to remove a GP upon a preliminary determination of cause, rather than a final court decision not subject to appeal. In the event of removal, whether with or without cause, the GP should see a meaningful forfeiture of or reduction to its carried interest in order to ensure sufficient economics remain to retain and incentivize a new manager.
- Fiduciary Duties – Limited partnership agreements ("LPAs") should strengthen fiduciary duties of the GP, disclose the GP's standard of care prominently and not waive broad categories of conflicts of interest. Indemnification expenses should be capped as a percentage of fund size and LPs should reject provisions which indemnify the GP for conduct constituting a material breach of the LPA, including the GP's fiduciary duties.
- Investment Management Considerations – GPs should establish a policy for allocating investment opportunities among funds and for limiting investment concentration in terms of industry and time of investment. Additionally, GPs should limit the number of overlapping investments between funds and should disclose these investments as well as the fees earned on them to LPs. Investment policies should be made available to LPs.
- Co-Investment Allocation – Co-investment policies, including how GPs will disclose and/or mitigate potential conflict of interest issues as well as any risks tied to a specific transaction due to the co-investment, should be disclosed to all LPs in advance of the initial investment. LPs should understand how co-investment opportunities will be allocated and whether differentiated economics relating to co-investments have been offered to other LPs. GPs should provide prospective co-investors with the strategic reasoning for the co-investment instead of a full allocation of the investment to the fund.
- Changes to the Fund – A supermajority of the LPs should be required or entitled to amend the LPA, dissolve the fund without cause, amend the investment strategy of the fund or reinstate the investment or commitment period. A simple majority in interest of LPs should be entitled to suspend or terminate the investment or commitment period of the fund without cause.
- GP-led Secondary Transactions – GPs should engage the LPAC and present their rationale for a proposed secondary sale of the fund as early as possible. The LPAC should review, mitigate where possible and approve any conflicts related to the transaction prior to it being presented to all LPs. The Principles 3.0 also detail expected disclosures to LPs and LPACs. To address the growth in the secondary market, the ILPA has issued specific guidance on GP-led fund restructuring transactions in a report which can be found here.
- LPAC Best Practices – LPACs should be composed of "a representational cross-section of investors", including a diversity of institutions and opinions, and the LPAC's roles and responsibilities should be clearly outlined in the LPA. Best practices for the LPAC include regular meetings, disclosure of the LPAC meeting agenda and minutes and the provision of an agenda to LPAC members in advance of each meeting, the appointment of a committee chair, in camera meetings without the GP, and in camera meetings between the LPAC and the auditor.
- Auditor Independence – The auditor should be independent and engaged by the fund, rather than the GP alone.
- ESG Policy – GPs should consider maintaining a comprehensive environmental, social and governance (ESG) policy which should be provided to LPs on request.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.