Institutional investors and other limited partners are often told they must accept certain terms and provisions in alternative investment fund documents because such terms "are market." Who is responsible for creating these market terms and what can investors do to prevent undesirable deal terms from becoming the market standard? In this episode of Public Pensions & Investments Briefings, Courtney Krause discusses unusual provisions in alternative fund documents, including limited partnership agreements, side letters and subscription documents. Courtney explores how market terms are created, provides examples of non-standard terms, and discusses how investors can work to keep these seemingly one-off provisions from becoming market standard in the future.

Transcript: Outliers and Oddities in Alternative Investment Documents

0:00:01.4 Courtney Krause: Today we are going to talk about Outliers and Oddities in Alternative Investment documents. We're going to explore some unusual provisions that we have seen in limited partnership agreements, side letters, and subscription booklets. While they have not yet become market standard, and in some cases we hope they do not, we wanted to provide early insight on potential shifts in the market. This podcast is meant to assist institutional investors and their legal teams to spot issues before they become tomorrow's market standard.


0:00:38.1 Speaker 2: Welcome to Public Pensions & Investments Briefings. Nossaman's podcast exploring the legal issues impacting public pension systems and their boards.


0:01:01.0 CK: Welcome back to Public Pensions & Investments briefings. I'm today's host, Courtney Krause and I'm a partner in Nossaman, San Francisco office. I represent institutional investors across all alternative investment asset classes and in all investment types, including commingled funds, co-investment vehicles, continuation vehicles, and funds of one. And we plan to have more podcasts later this year discussing some of those investment vehicles. So be on the lookout for those. One of the most commonly asked questions I get is, what trends are you seeing in fund documents? And this is a very valid question, but it doesn't always warn about icebergs that may be lying ahead. So on today's podcast I wanted to talk about outliers and oddities that I've seen in some fund documents because today's one-off provisions could become tomorrow's market standard. I think we've all been there. The deadlines to close these deals are really tight and sometimes you just give in on provisions that you might not have been really happy to give in on.

0:01:57.8 CK: For example, most of the time from the date we received fund documents to closing the fund, it was about a month. That timeline has shrank significantly and sometimes we have only two weeks, sometimes less to close a deal. So I understand the need for clients and investors to give in on certain terms. The problem there is that if you agree to a one-off term right now, it may come back to haunt you later. For example, a lot of the general partner law firms that we encounter keep records of past deals. So they will have side letters that they've entered into with some of our clients and they can go pull up those side letters and say, Hey, you agreed to that term over here in connection to this other funds. You have to agree here as well. So just be wary that when you are agreeing to those one-off terms, you don't want that to live on in perpetuity. So one of the things that, just as an example as, yesterday's one-off provision that has become today's market standard is conference and networking expenses. So if you pull out an LPA and flip over to the definition of partnership expenses, you're going to find two to four pages listing out every single expense that's going to be charged to the fund and therefore charge the LPs.

0:03:17.8 CK: If you look at funds from a couple years back, the LPA didn't have any language in there describing the cost of attending conferences, but in recent years that's become a standard expense that's listed in fund documentations. And when that started appearing, investors and their council started pushing back on those costs. But there was really limited success in removing those terms from the documents. And now it's become market standard that LPs and the fund are expected to pay for the GPs cost of attending conferences. But those costs have started to expand. So now we're seeing the cost of attending conferences, hosting conferences, sponsoring conferences and networking events. And it's very hard to say what exactly all of this entails. So for example, if you are a GP or a manager and you're going to host a conference, that's a pretty significant expense. You're going to rent the space, you're going to pay speakers, you're going to have attendees by allowing it to become a market standard that gives the GP room to kind of push it even further and include more costs sort of tangential to the cost that's become a market standard. So that's just an example of something that I've seen creep into the documents and then become the gold standard over time. So this leads to the question of, who sets these market standards?

0:04:42.9 CK: And I don't think this is a case of GPs getting together in a dark and smoky room and coming up with nefarious terms that they could foist upon LPs. This is really an issue of law firms setting the terms for these deals. And one of the trends we've seen in the market is a consolidation of law firms. So again, in the past there were a large number of law firms that represented general partners and drafted the fund document, and now we're seeing fewer and fewer law firms that provide this service because a lot of the lawyers are going to the same limited partnership agreement for all clients regardless of size, and regardless of whether or not the provisions in those form limited partnership agreements really make sense. So just by way of example, one law firm has standard language in its form that allows the GP to advance expenses for the benefit of the fund. So for example, the GPs found this hot new investment, they need to put the money in right away. There's not time to call capital from the LPs. And so the GP fronts the money and then the fund will pay the GP back. But while that money is outstanding, it will accrue interest which then must be paid by the funds and the LPs. So one of the things that I don't like about this provision is that there's no time requirement for the fund to repay the GP.

0:06:09.9 CK: For example, if the GP makes this advance, the interest is charging charging away. If there's no requirement for the GP to call capital right away, there's a small incentive for the GP to let it ride because they keep getting interest on that money. It'd be much better if the fund was required to issue a capital call within say 60 days of that advance to cut off the interest payments from accruing. And when we've raised this issue with council and when clients have talked to the GP's business teams, a lot of the business teams come back and say, this is not something we're ever expecting to do. It's just part of the form and it's there, but don't worry, we're not going to use it. So that's just an example of some of these law firms using their form LPAs in a way that doesn't necessarily make sense for all of their clients because there's GPs out there that aren't intending to use these provisions, they're just part of that particular law firm's forms. And there they are. We also see these same form limited partnership agreements being used for small funds, new funds, novel funds, and these are terms that may be acceptable for a much larger, more established fund. For example, a fund that they're raising fund 10, they're seeking to get $15 billion.

0:07:23.2 CK: These big marquee funds can have very aggressive terms because, you know, they've earned that right. Whereas some of these new managers, the risk is much higher and the term should be more LP friendly to reflect that risk. And I think a lot of times, certainly when we are on the phone with opposing council, the council for the GP, you know, council will tell us that's too bad, these are the provisions, this is market. But I think really the question that should be raised both by outside council and investors is, is this really market for this type of asset in this type of manager? Because sometimes it's not. When I started off speaking, I had discussed that, you know, today's one-off provision becomes tomorrow's market standard. So I thought it'd be interesting to go through a couple of sort of one-off things or oddities we've seen here at Nossaman in the last couple of months. And whether or not they become trends, I don't know, but I think there were very interesting issues and there's certainly things that investors and their council should be looking out for when reviewing fund documents. So I'm going to cover some things I've seen in limited partnership agreements, subscription booklets, and then talk finally about side letters and most favored nation, election rights.

0:08:42.7 CK: We see these things creep in across all of the fund documents and certainly you should be keeping an eye out on all of them. So to begin, I'm going to talk about a trend I've seen in limited partnership agreements, and unfortunately this is something I've seen in more than one limited partnership agreement. So it's possible that this may become a trend. Typically, if you see it once or twice likely isn't something you're going to see a lot, but once you kind of see it that third time, fourth time, definitely you should keep your eyes peeled because that's a sign of a one-off provision becoming a trend in the market. So the provisions I want to discuss today revolve around the LPA cure provisions. When you're reviewing limited partnership agreements, you typically are looking for exit rights. You know, what rights to the LPs have to exit the fund if something goes wrong? Most funds will have a for-cause removal provision or for-cause termination provision. Some funds also have a no-cause removal or a no-cause termination provision, but I'm not going to focus on that. So in connection with the for-cause removal of a GP or a for-cause termination, typically the GP has some right to cure and the cure generally involves terminating the employee at the GP that's engaged in this bad activity.

0:10:07.8 CK: And then the GP makes the fund whole for its economic losses. So just for an example, say the GP has a rogue employee, the employee has committed fraud, that would fall under the banner of a for-cause action. If the GP terminates that employee and then pays the fund back for any economic damages, it would be deemed cured and the LPs would not have the right to remove the GP or terminate the fund. I'm starting to see LPAs where that final piece, the requirement to make the fund whole for its economic losses has started to disappear from documents. It's not there and it's already a pretty high bar to meet the for-cause standard in most cases to trigger a for-cause removal or for-cause termination, there has to be a final non-appealable judicial determination. So that means you've gone through the entire trial process, all the appeals process and there's no more avenues that the GP could prove that it didn't do this thing. It's a very high bar and a lot of funds you see the cure provisions arise once that bar has been met. So that means the GP wouldn't have to terminate that employee that committed fraud until it's been legally determined that they did those things.

0:11:24.4 CK: I suspect that if there's an employee engaging in fraud, the GPs probably going to terminate them right away and you're not going to even get to this point. But it is disturbing that they've started carving out this requirement to make the fund whole for economic losses. And like I said, I've seen this in a handful of LPAs, it's too soon to say if it's a trend, but certainly something to keep your eye on, I usually argue. And we've been pretty successful in pushing back on the elimination of the cure procedure. So now I'm going to shift gears and talk about some trends we've seen in subscription booklets. So subscription booklets typically contain two discreet sections. The first section of the subscription booklet is usually 10-20 pages and it contains a written agreement, most of which contains representations and warranties and sort of standard legal language regarding the investor's enrollment in the fund. And then the second half of the subscription booklet has the questionnaire portion and that's where you write in your name, your contact information and check a lot of boxes regarding your status.

0:12:29.6 CK: In late 2021, we started to see a few managers roll out these online subscription agreements. And typically, what's involved in the online subscription agreement is, you are sent a link, you click on the link and then you create a username and password and log into a portal to complete the subscription agreements. And this seemed like a real novelty the first couple times we saw it. We saw different providers using this, different managers using this. There wasn't a lot of consistency. And the initial rounds where we saw this, it was somewhat optional because for a lot of the clients we interact with they're large institutional investors and they have a lot of internal procedures around how subscription booklets are drafted. And everyone takes a different approach to this. Some investors draft them themselves and have council review, some investors have council draft and then they review before it's sent to the other side. And in the online digital format, the procedures don't necessarily work because everyone needs to have a login to get into the document and it tends to be a little bit clumsy if the procedure involves multiple eyes and drafters to be involved.

0:13:45.6 CK: So when we first started seeing this, it seemed like a little bit of a one-off thing, but early last year in the first and second quarter of 2022, we started to see a surge of the online subscription booklets and we started to see a change where the managers and law firms were using one or two providers of these online portals. And so it seemed like this might be a big trend in 2022 where managers and law firms are going to start using these online subscription booklets, which for somewhat problematic for some of our clients. But it seems like that was a trend that started up and it kind of died down. We still do see these online subscription agreements. There was a period of time where when clients pushed back on using them, they were told no unless they really kept pushing and pushing saying no, like this does not work, we cannot use this document. There seems to be more flexibility now. I don't think they're going away, but I don't think this was the fire sale that we thought it was going to be where it was just going to take off. And if you want more information on online subscription booklets, kind of the pros and cons and things that we've seen. I wrote an article last year for the NAPA report, it's the April, 2022 NAPA report and we discussed online subscription agreements and what you can do as an investor to kind of tackle that format.

0:15:06.9 CK: A second trend in subscription booklets I've seen is a change in some of the language in the agreement portion. And the agreement portion, like I said before, is the first 10-20 pages that has all the reps and warranties. And the vast majority of subscription booklets typically have language in them requiring the investor to directly indemnify the fund and the manager, if the investor breaches its representations of warranties, that's become fairly common. Some clients can't provide indemnity so that will get captured in the side letter. Some clients ask to have the indemnification obligation capped at the size of their commitment. That can be documented in the side letter as well. And just to point out, this indemnification obligation in the subscription booklet is separate from the indemnification obligations that you see in the limited partnership agreement. In the limited partnership agreement, it's the fund indemnifying, the GP, manager, fund, etcetera. And in the subscription booklet it's the investor itself indemnifying the fund, GP or manager. So like I said, it's pretty common to see these indemnification provisions. Where we're starting to see the shift is where there's a requirement for indemnification expenses to be advanced to the GP manager or the fund.

0:16:26.9 CK: So that would mean if there's litigation involved between your client and the GP or manager, the client may need to advance all of the GP or manager's legal expenses to the GP or manager. But the subscription booklets don't have a requirement for the advance to be repaid if the LP is successful and the manager is not, I think that's very problematic. I think if you are in litigation and you're required to pay the other side legal expenses and then the other side loses, then they should have to pay for those legal expenses themselves because they've not been successful. And again, I've only seen this in a handful of subscription booklets and I think a lot of times investors, again, when they're rushing to close, overlook reviewing the agreement portion of the subscription booklet in detail and don't pick up on some of these things. So be sure to read those indemnification provisions and to the extent they're not favorable or not something that you can agree to, ask for it to be changed in your side letter of all the fund documentation subscription booklets tend to be more set in stone and aren't heavily negotiated. So the best place to modify the terms there's in your side letter.

0:17:42.1 CK: So speaking of side letters, bonds would go over a couple of trends I've seen in side letters. The first thing we've seen, and this was truly a one-off, but it is something to keep your eyes open for. Typically, and I think this is true for most investors, but typically our clients are asking the GP and manager for an increased standard of care and for an agreement regarding the fiduciary standards, and that goes into the side letter. And we were recently working on a fund and council gave a very favorable standard of care in the side letter. We were happy, the client was happy, but there was a separate provision of the side letter outside of the provision that related to the standard of care that expressly stated that the side letter did not modify the limited partnership agreement that contained the standard of care. So this gave us pause because the whole purpose of the side letter is to modify the language in the limited partnership agreement, and for them to specifically carve out the standard of care meant that the side letter didn't carry any weight regardless of whether they gave us this really great standard of care language.

0:18:55.7 CK: So we had a lot of back and forth with council where they tried to convince us that no, no, this language really was going to modify the limited partnership agreement, but eventually they took out the carve out, it was a little disturbing that the carve out was completely separated from the language addressing the standard of care in the side letter. So be sure that you're looking for some of these, like smoke and mirrors tactics where one provision gives and the other take it away. And then related to side letters, one thing to look out for also, which may be in the side letter or the LPA are trends in MFN elections. MFN means most favored nations. So these rights give you the opportunity to pick up benefits that were granted to other LPs in their side letters. Typically, there's standard set of carve outs, you can't just have carte blanche to go look at other LP side letters and pick all of their provisions. Typically, the side letter specifically says, you can't pick up this or you can't pick up that. So by way of example, most favored nation provisions usually say, if an investor has been granted a seat on the LP advisory committee, the other investors can't make that election. Or if an LP has received discount or their state specific regulations, those type of carve outs are very standard. And usually that's in the first paragraph of a side letter.

0:20:23.8 CK: Every now and then you'll come across an LPA where the most favored nation provisions are in the LPA rather than the side letter. But it's very important to read those together. So for example, a couple months ago I had a client working on MFN elections and this was for a fund that Nossaman had not represented this client in connection with the fund, but she had called up just for some advice and to bounce some ideas around and she had asked, have I ever seen such severe MFN election carve outs before? And so we opened up the LPA and the LPA's carve outs were much more severe than were standard. For example, it prohibited electing additional notice provisions, representation of warranties and other items that I would say are pretty standard items that get picked up through the MFN election process. And I was very surprised, I thought this was a little sneaky because while I didn't have a red line of the LPA against the prior funds LPA, it seemed to me that this restrictive language kind of got snuck in there and investors hadn't noticed it because while they were negotiating the side letter, they were only looking at the side letter and they weren't also looking at the LPA at the same time. And since the client called and gave me a heads up on this particular issue, I've seen this happen in one other fund.

0:21:44.1 CK: If you're dealing with a side letter where the most favored nation's provision is in the LPA, be sure to pick up that LPA and turn to that provision to see what the carve outs are. It's very important if it has stringent carve outs to ask for everything you might possibly need in your first draft of the side letter, because you aren't going to have the opportunity to pick it up during the MFN election process, which is more common when we get to some of these rushed closings, a lot of clients will say, okay, we can give up on this because another investor likely asked for it and we'll try to pick it up during the MFN election process. When you have very severe carve outs that restrict almost everything, you're not going to have the option to pick up those nice to have items during the election process. So certainly, keep that in mind when you're drafting your side letters. So now that I talked about some one-offs and oddities that I've seen in fund documents in the last couple of months, you might be asking yourself, well, what can I do to solve these problems or avoid these pitfalls?

0:22:47.7 CK: So I think the number one thing you can do is push back on these one-off provisions. And when I say push back, you know, call up the business team, ask them what is their rationale for including this provision in the fund document. It might be that the law firm put the term in and it wasn't something the management team asked for, or if it was something the management team asked for, maybe they have a very rational explanation of why it's there and can give you comfort around why that provision is in the document. When you're working on negotiating fund documents, don't always accept the law firm's excuse that this is a market term, like it may not be market for a new manager or a novel product. Again, that's another time, pick up the phone, talk to the business team on the other side. A lot of times we've seen, you know, when the law firms are really setting the terms, if the business teams just speak to each other, they're often able to resolve some of these issues, get the documents adjusted to everyone's liking and everyone leaves happy. Going forward this year in 2023, the market is likely to soften and this might be a time for LPs to push back and take advantage of the down market to push for more favorable terms. I think if the GPs are more desperate for money and investors, they may be willing to get their law firms to back down or they themselves might be willing to back down.

0:24:09.5 CK: And I think it's also really important to remember if you see something, say something, let others know when you're seeing these kind of one-off provisions in documents, 'cause it really helps when reviewing to kind of keep your eye out knowing, hey, you know, somebody else saw this fishy thing in a document, I haven't seen it yet because you might see it and it's helpful to know what others have seen and sort of where they landed on resolving the problem. Thank you to our listeners for joining us for this episode of Public Pensions & Investments Briefings. For additional information on this topic or other public pension issues, please visit our website @nossaman.com. And don't forget to subscribe to Public Pensions & Investments Briefings wherever you listen to podcasts so you don't miss an episode. Until next time.


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