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Bulletin

Recent Developments in Private Equity and Fund Formation - The Institutional Limited Partners Association Publishes ILPA Principles 3.0

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Investment Management Bulletin

ILPA & ILPA Principles 3.0

The Institutional Limited Partners Association ("ILPA") is a global organization, founded in 1990, exclusively dedicated to advancing the interests and maximizing the performance of limited partners ("LPs") on an individual, institutional and collective level through guidance, networking and advocacy. ILPA has more than 515 members representing over US$2 trillion of private equity assets under management.

The ILPA Principles aim to fuel discussions between LPs and General Partners, or managers ("GPs") to achieve effective private equity funds through alignment of interest, governance and transparency and are the result of extensive dialogue with a range of stakeholders across the private equity industry. The ILPA Principles were first published in September 2009, and were updated in January 2011 ("Principles 2.0") following additional feedback from the LP and GP communities.

The ILPA Principles 3.0 ("Principles 3.0") serve as an update to the Principles 2.0, expanding and clarifying existing industry themes and addressing emerging practices and concerns in the market.

Institutional investors generally view the ILPA Principles as representing the gold standard for private equity funds and, as such, should be carefully considered by GPs, alongside other industry guidelines and codes of practice, when proposing terms to their prospective investors.

Highlights of ILPA Principles 3.0

We have not sought to summarize the full content of the Principles 3.0 preferring to identify certain topics which we believe to be of particular interest to both GPs and prospective LPs.

Management Fees and Other Expenses

The Principles 3.0 note that management fees should be based on reasonable expenses related to normal operating costs of the fund. Unlike a GP's participation in the carried interest, management fees are thought to be contrary to the alignment of interests between the GP and the LPs. This incongruity forms the rationale for a number of the takeaways on this subject:

  • since the GP is paid management fees, it should bear the costs and expenses related to the investment activities of the manager on behalf of the fund, rather than allocate them to the fund. Such costs include travel, industry conferences, cost of research and information services, computer software and costs and expenses associated with any remedial actions required as the result of an audit or a regulatory exam;
  • management fees payable to a GP managing predecessor funds should base initial management fees in a follow-on fund on invested capital rather than committed capital. Management fees should be reduced for follow-on funds and in the event of the extension of the fund's investment period. No fees should be charged after the expiration of the original term of the fund without the LPs' consent;
  • portfolio companies should not be charged fees. Any such fees not fully offset should be disclosed to LPs and distributed to them at the end of the term;
  • 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 should include: LPAC meeting/annual investor meeting, third-party administration, travel (related to potential investment which are past the initial term sheet), interest expenses and fees, audits, legal expenses, indemnification, insurance and litigation expenses and regulatory expenses;
  • generally, the following expenses should be fully offset or covered under the management fees: consultants' fees, environmental, social and governance ("ESG") related expenses, placement agent fees, operating partners/consultants and unforeseen expenses; and
  • the cost of enforcing clawback guarantees should be a GP expense rather than a fund expense.

GP Ownership and GP Removal

A new principle provides that GPs should proactively disclose the ownership of the management company and notify all LPs if this changes over the life of the fund. More specific restrictions on transfers of GP interests included in the Principles 3.0 address a concern for the alignment of interest with the LPs in the fund.

ILPA recommends that GP removal without cause require a supermajority  (75%) vote of LPs. In the case of GP removal for cause, the Principles 3.0 recommend 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.

Consistently with Canadian market practice, the Principles 3.0 provide that, in the case of removal for cause, the GP should see a meaningful forfeit of or reduction to carried interest, to ensure sufficient economics remain to incentivize a new manager. The Principles 3.0 go even further however, recommending a reduction to carried interest even in the event of a GP removal without cause.

LPAC Best Practices

ILPA provides more detailed guidance on the composition and structure of the LPAC. Notably, the GP should detail how members of the LPAC are selected and should appoint a workable number of members that account for investor representation in terms of commitment size (including collective representation of smaller investors and rotating seats among a broader group), type, tax status and relationship with the GP in their selection.

Some of the new best practices since the Principles 2.0 include:

  • better articulated LPAC mandates and clearer defined meeting agendas including in camera sessions between the LPAC members (excluding the GP, but followed by a report to the GP) and between the LPAC and the auditor and reports on any material ESG incidents and/or risks to the fund's portfolio;
  • the appointment of a rotating LPAC chair;
  • greater accountability of LPAC members in terms of minimum participation thresholds, with consequent penalties for repeated failure to attend meetings or vote on matters presented; and
  • disclosure by LPAC voting members of any interest held by them in the GP.

In our experience, the recommendations of ILPA with regards to LPACs are generally consistent with Canadian market practice. GPs have generally been open to provide LPACs with the tools to effectively carry out their role.

Co-Investment Allocation

The Principles 3.0 go into greater detail on the duties of the GP and best practices on co-investment by any investors (including existing LPs) alongside the fund.

For example, GPs should disclose to all LPs in advance the allocation framework of any interests and expenses for participating co-investors, including whether any prioritization is applied, how opportunities are allocated and how conflict and risk issues (e.g. concentration limits) are mitigated. Further, GPs should provide prospective investors with the strategic rationale for not allocating the entire investment opportunity to the fund.

In the event co-investments are offered to any other vehicle managed by the GP, GPs should disclose this fact to the LPAC, particularly where there may be a conflict of interest, and include an explanation as to why it has been offered to more than one vehicle or an entity beyond the fund, especially if the deal does not exceed a fund's agreed concentration limits.

Fund Term

The extension of a fund's term should be limited to two extensions of one-year increments and should first be approved by the LPAC and then ratified by a supermajority of LPs. The requirement for the ratification of a supermajority of LPs and the limit to a number of two extensions are new compared to the Principles 2.0.

The GP should notify the LPAC and the LPs of its intention to request an extension of the fund's term as early as possible and at a minimum of 1-2 quarters in advance of the fund's expiration date.

Following the expiration of the term, the GP should fully liquidate the fund within a one-year period, unless the LPs consent to a longer period.

As previously mentioned, ILPA is of the view that no fees should be charged after the expiration of the original term of the fund without the LPs' consent.

Subscription Lines of Credit

In light of low interest rates, fund-level credit facilities ("Subscription Lines") are becoming more commonly used by GPs, and are put in place for longer periods and larger amounts. Considering this relatively recent trend, the Principles 3.0 included several recommendations relating to Subscription Lines:

  • Subscription Lines should be used primarily for the benefit of the fund as a whole. They should be of short duration and should not be used to fund early distributions;
  • specific information on Subscription Lines should be disclosed to LPs in annual and quarterly reports, and their terms provided to LPs upon request;
  • regular reporting should be provided with performance information (i.e., IRR and TVPI or MOIC figures), with and without the use of the Subscription Line in order to inform performance comparisons on a vintage year basis and relative to other funds; and
  • LPs should be able to opt out of the Subscription Line when a fund is set up, or upon initiating such a Subscription Line.

With Canadian private equity funds increasingly having recourse to Subscription Lines, it will be interesting to see how these recommendations will affect current market practice. While we can see some of the recommendations being adopted easily by GPs, we expect other recommendations (for example, providing LPs with the ability to opt out of the Subscription Line) may encounter resistance from the industry.

GP-led Secondary Transactions

The Principles 3.0 provide that GPs should engage the LPAC as early as possible regarding any proposed secondary sale transaction. They further provide that any conflicts should be disclosed, mitigated and approved by the LPAC before the transaction is presented to all LPs. Disclosure to LPs should include: the number, range and content of bids received; economics and/or any "stapling" (LPs allocating primary capital), and any other meaningful changes in terms vs. the original fund.

As GP-led secondary transactions are becoming more common, earlier this year, ILPA issued its first series of recommendations in respect of GP-led secondary fund restructurings (the "Report"). Click here to consult the Report(PDF). The recommendations provided in the Principles 3.0 provide a snapshot of the recommendations provided in the Report.


 

This bulletin provides the highlights of the ILPA Principles 3.0 released by the Institutional Limited Partners Association on June 27, 2019. Click here to consult the full report (PDF).

Do not hesitate to contact the authors to discuss this bulletin, or if you would like to know more on any of the ILPA recommendations.

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