Written by Jonathan McCullough, James McClary and Elizabeth Dylke
The Institutional Limited Partners Association (ILPA) recently released the latest version of its principles, ILPA Principles 3.0. The updated principles provide a detailed selection of best practices for participants in the private funds industry, and are informed generally by guidelines of transparency, good governance and the alignment of interests among partners.
When the private equity investment model was first introduced in the early 1990s, it represented a significant improvement for investors over the model for publicly traded investments or mutual funds. The interests of managers and investors were better aligned through the requirement for managers to invest alongside the investors, to be paid a fee which covered operating costs and only to profit out of performance after investors had received a target return. There is concern that over time, this alignment has been gradually eroded. Management fees from multiple funds became a source of profit, and that excess was often applied to satisfy the manager’s investment or ‘skin in the game’. The ILPA Principles 3.0 represent an effort by institutional investors to restore that alignment.
Here are some of the highlights of ILPA Principles 3.0:
Fair and Reasonable Management Fees Based on Actual Operating Costs
The rationale for management fees should be clear to Limited Partners (LPs), as excessive fees will create a misalignment of interests. Management fees should be based on normal and actual operating costs of the fund. Management fees should account for lower expenses incidental to the formation of a successor fund, at the end of the investment period and if the fund's term is extended, in which cases the management fees should step down.
A Substantial Investment by the General Partner and Maintenance of Alignment of Interests
ILPA recommends that General Partners (GPs) should make a substantial investment to the fund, contributed by cash and not by set-off against management fees or other specialized mechanisms. GPs should invest pro rata with the Limited Partners rather than ‘cherry picking’ investments. GPs should be restricted from transferring their economic interests in the GP and carried interest and LPs should be notified of any intent to transfer an interest in the GP to a third party.
Carried Interest Based on Net Profits and a Conservative Use of Credit
ILPA suggests that carried interest be calculated on a whole of fund or European model and based on net profits (not gross profits), factoring in the impact of fund-level expenses. Carried interest should be calculated on an after-tax basis and no carry should be taken on current income distributions. Subscription lines of credit should be used for the benefit of the fund as a whole, for the purpose of administrative ease rather than for the purpose of enhancing reported internal rate of return (IRR) by delaying drawing capital. Reporting of key metrics such as IRR should be made on both a levered and unlevered basis. The GP clawback of carried interest should be calculated on an interim basis and paid back no later than two years after recognition of the liability.
A General Partner With a Clear Fiduciary Duty Held to a High Standard of Care
The GP's fiduciary duty in managing the fund should be clear, and should be reinforced, rather than diluted by the terms of the limited partnership agreement (LPA). The fund governing documents should prominently disclose the standard of care owed by the GP to the fund, including any standard of care owed under statute. LPs should reject provisions in the LPA that allow the GP to be indemnified for conduct constituting a material breach of the LPA or for conduct constituting "gross negligence, fraud or willful misconduct".
Transparent Co-Investment Policies and Terms
ILPA recommends that co-investment policies be disclosed to LPs in writing at the time 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.
A Diverse and Official Limited Partnership Advisory Committee (LPAC)
The ILPA principles recommend that LPACs be composed of "a representational cross-section of investors", with the aim of incorporating representatives of different types, including a range of commitment sizes, tax status and relationships with the GP. While individual LPs represented on the LPAC are permitted to act in their own interests, in good faith the LPAC should operate as a committee, meet regularly and employ best practices. Best practices include the 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.
A Comprehensive and Accessible Environmental, Social and Governance (ESG) Policy
GPs should consider maintaining and periodically updating an environmental, social and governance policy which should be provided to LPs on request. The ESG policy should enable LPs to assess the degree to which the fund's investment strategy and operations are aligned with an LP's own ESG policies. The policy should identify procedures and protocols that can be verified, as opposed to simply a vague commitment of behaviour.
Overall, ILPA Principles 3.0 represents a thoughtful and reasoned approach to balancing the interests of managers and investors. In addition to some of the matters referred to above there are a handful of recommendations which do not represent current market practice and may face stiff opposition from General Partners in the negotiation of LPAs. These include:
- for cause GP removal or fund termination without a final court ruling on cause;
- reduction of carried interest entitlement on a without cause removal, to allow for incentivizing a replacement GP;
- no management fee or a negotiated management fee during a term extension; and
- clawback of carried interest without reduction for tax paid.
ILPA promotes an industry-wide adoption of its principles, with the understanding that sound practices and their impact on the reputation of the private equity industry are the shared responsibility of both general and limited partners. A full copy of the principles can be found here.