Introduction

The Institutional Limited Partners Association (“ILPA”) has recently released an update to its model limited partnership agreement (the “Model LPA”) for private equity funds and other closed-ended funds. One of the stated benefits of the Model LPA and the recent updates is to create a “baseline” to determine which terms are important and reasonable in negotiations between managers and investors. However, instead of reflecting “market” fund terms, ILPA appears to be continuing a campaign to “move” the private equity market by suggesting uncommon terms which it considers to be investor friendly.

Our earlier OnPoint (available here) analyzed the original version of the Model LPA, and this OnPoint focuses on the implications of the most significant recent changes to the Model LPA. These changes broadly fall into two categories: (i) generic updates to the Model LPA and (ii) a version of the updated Model LPA that contains “deal-by-deal” waterfall mechanics.  

Updates to the Model LPA – Highlights

The revised Model LPA contains the following significant changes:

• Clawback Guarantees. Under the updated Model LPA, the general partner (“GP”) is now required to procure personal guarantees from the ultimate carried interest recipients in connection with the GP’s clawback obligation. In our view, in many situations it will be overkill to have both a carried interest escrow account (which ILPA suggests to be at 30% of carried interest distributions) and personal guarantees from the carried interest recipients, particularly in respect of a fund that adopts a “whole of fund” distribution waterfall where the risk of carried interest overpayment is low. Typically, carried interest escrow accounts and personal guarantees serve as alternative protections and would rarely be implemented together. Prudent GPs, in any case, usually adopt a holdback provision in their carried interest documents allowing them to hold back distributions of carry to carried interest participants where the GP anticipates a clawback of carry, which reduces the need to secure personal guarantees.
• Fiduciary Duty. As we highlighted in our earlier OnPoint regarding ILPA’s original Model LPA, the Model LPA imposes a “prudent person” contractual standard of fiduciary duties on both the GP and the manager. The updated Model LPA goes one step further in delineating that GPs and managers may not put their interests ahead of the interests of the fund or the limited partners (“LPs”) when exercising their discretion under the Model LPA. Consistent with the view we expressed in our previous OnPoint, in our opinion ILPA’s approach of imposing a contractual standard of care in the Model LPA goes well beyond the typical standard imposed on managers, which is more akin to board of directors’ duties (which are subject to the business judgement rule) than the “prudent person” standard that is seen in an ERISA “plan assets” fund. It is already the case, in countries like the UK and the U.S., that fiduciary duties are implied by common law (as in the UK) or by regulations (as in the U.S. pursuant to the Investment Advisors Act 1940, as amended, and the SEC’s interpretations, most recently, Release No.IA-5248 of July 12, 2019) on GPs/managers.
• Economic Consequences for Termination for Cause. The updated Model LPA provides that a termination of the fund for “cause” will result in (i) the GP ceasing to receive further distributions of carried interest and (ii) the reallocation of amounts retained in the carried interest escrow account to the LPs. Consistent with the view we expressed in our previous OnPoint, the broad definition of “cause” included in the Model LPA could result in instances where it would not be fair to impose such a significant economic penalty on the GP under such termination scenarios. Even if the definition were narrowed, managers should be aware that it is a significant departure from market for a GP to lose all future and escrowed carried interest relating to existing investments as of the date of termination; it is far more common to see a percentage “haircut” applied to carried interest distributions following such a termination. In an attempt to restore some fairness, we have seen several instances where GPs have split out “for cause” termination scenarios to make clear which ones justify loss of escrowed carried interest and which do not.
• Listed Transactions and Prohibited Tax Shelter Transactions. The updated Model LPA contains new provisions which require the fund to avoid engaging in “listed transactions” or “prohibited tax shelter transactions” that the U.S. Internal Revenue Service has specifically identified. These transactions are essentially tax avoidance transactions and typically only U.S. tax-exempt investors (e.g., pension plans) would be concerned with potential exposure to such transactions through the fund. It is therefore unusual to find such provisions built into the Model LPA, which make the document unnecessarily long and complicated for investors who may not require such protections. This is a further example of ILPA’s attempt to integrate provisions in the Model LPA that investors and managers might appropriately prefer to be addressed in side letters.
• Governance, Control & LPAC Provisions. For good reason, the roles of LPs and GPs have always been set out clearly in LPAs. LPs provide capital and GPs provide investment expertise. The Model LPA provides that there may be a limit on the amount of reserves that a GP may retain and that LPs may, following a super majority in interest vote, call an early termination of the commitment period. Especially in times of market stress or dislocation such as the disruption being caused by COVID-19, GPs may decide to maintain higher levels of reserves with which to fund increased capital requirements of portfolio companies or costs and expenses of the fund associated with actions deemed necessary by a GP to preserve value. Thus a limit stated in the LPA may be breached and entail the GP seeking LP consent to amend the LPA to allow for a higher limit. We believe that allowing LPs to terminate the commitment period early allows them to second guess the GP’s view as to what is an appropriate timeframe for capital deployment. This creates uncertainty for the GP as well as blurring the line between the roles of LPs and GPs as mentioned above and, therefore, these provisions are undesirable from both the perspective of LPs and GPs.

Deal-by-Deal Model LPA – Highlights

As part of the recent update, ILPA also published an additional version of the Model LPA containing a “deal-by-deal” waterfall. This OnPoint does not discuss the pros and cons of using a “deal-by-deal” waterfall versus a “whole of fund” waterfall. However, the proposed mechanics from ILPA in the “deal-by-deal” waterfall version of the Model LPA provide impediments to making distributions of carried interest to a fund sponsor’s investment professionals. This could potentially lead to talent retention issues for any sponsor that adopts them, because the investment professionals employed by the fund sponsor could prefer to work for a competitor who is not subject to such impediments. 

Key elements of the “deal-by-deal” waterfall are the following:

• Distribution Waterfall. Perhaps unsurprisingly, ILPA has proposed a very GP-unfriendly version of this “deal-by-deal” waterfall whereby the following amounts must be returned to the investors before carried interest can be distributed: (i) the capital invested in the deal that has had a complete or partial sale or been subject to an extraordinary dividend, refinancing, capital restructuring and similar transaction, plus (ii) the capital invested in any other previously realized deals, plus (iii) unrealized losses plus (iv) all fund expenses (including management fees). Given all of the items that must be distributed to investors before carried interest can be distributed, we are of the view that this “deal-by-deal” waterfall will often result in the same timing and amount of distributions as a “whole of fund” waterfall. Although it is not uncommon for investors to request one or more parts of this formulation in negotiations, managers should be aware that there are often variations that can be used instead as a  formulation that is fairer to the GP, for example, using a formulation that takes into account (A) a pro rata portion of fund expenses based on the amount of realized deals compared to unrealized deals or (B) fund expenses directly allocable to the particular investment at hand which has been realized in whole or in part plus a pro rata portion of general fund expenses, instead of all fund expenses.
• Interim Clawback. The “deal-by-deal” Model LPA has also suggested annual interim clawbacks starting from the end of the commitment period. Given the impediments to distributing carried interest discussed above, our view is that annual interim clawbacks are excessive and will result in unnecessary administrative costs being incurred to carry out these obligations. The requirement for the GP to make clawback payments twice over the life of the fund (e.g., once at a stated anniversary of the end of the fund’s commitment period and once upon the termination of the fund) should provide sufficient protection to investors against over-distributions of carried interest, whether or not personal guarantees are also provided by carried interest recipients. In addition, as discussed above, ILPA’s recommendation of depositing 30% of GP distributions into a carried interest escrow account would provide a duplicative and unnecessary hurdle to distributing carried interest.  

Conclusion 

In line with our previous OnPoint on the original Model LPA, we continue to recommend that managers avoid adopting the Model LPA on a wholesale basis without fully understanding the associated issues. Given that the terms of each fund are different and should be considered on their own merits, it should not be assumed that the Model LPA reflects a “market” approach to the negotiation of private equity fund terms.