It Is (Still) Time for LP’s To Be Accountable...
“Blaming others for your problems is like blaming donuts for being fat.
It wasn’t the donut, it was the choice.”
We first wrote a version of this piece back in April 2019 when we had become increasingly frustrated with the trend among private equity general partners (GP’s) to skew their limited partnership agreements (LPA’s) in favor of themselves and against limited partners (LP’s). We have been investing in private equity for decades and have always favored GP’s who view their LP’s more as “partners” and less as “limited.”
Although progress has been made since we first issued this paper, we still have a long way to go. GP’s continue to propose LPA’s that are unbalanced in favor of the GP. Fortunately, the current tough fundraising environment creates more opportunities for LP’s to push back, and to paraphrase Rahm Emanuel, we would never want a crisis like this to go to waste. As such, the time has come (once again) to call out these practices and DEMAND CHANGE.
Some of the more egregious things we have seen recently include:
Continuation Vehicles: GP’s are now including provisions to allow a transfer of a fund’s investment to a “continuation vehicle” managed by the GP in perpetuity without adequate controls against abuse. In particular, while transferring an asset to an entity controlled by the GP could make sense under certain circumstances, these transactions raise concerns regarding valuation (and carry), payment of fees to the GP from the vehicle, non pro-rata sharing of expenses, and LP’s losing the ability to “opt out” on terms that are fair and equitable.
Carry Clawback Abuses: Few GP’s have recognized that conventional clawback provisions – which only require the GP to pay back unearned carry at the end of the fund’s life and net of assumed taxes that may be well higher than actual taxes paid – are inadequate to protect LP’s from losing the economic bargain of incentive arrangements. By delaying clawbacks far beyond the original term of the fund, the GP essentially receives an interest-free loan on amounts they owe the fund. To mitigate this risk, interim clawbacks and escrow provisions, along with the use of actual tax liability calculations, should be uncontroversial but only a small minority of GP’s agree to them.
Zombie Funds: With M&A markets not like what they were a few years ago, GP’s are increasingly using fund extensions and continuation vehicles to perpetuate a fund’s life and hold onto investments that should be liquidated. In its worst form, GP’s retain publicly traded securities rather than selling them on the open market or distributing them to LP’s. In many cases, the GP’s would rather wait for a better price only to increase its carry or worse dig itself out of a clawback situation. This is pure self interest, and the LP’s are paying the price.
Attached is a more detailed list of “legalistic” things LP’s should look out for when reviewing LPA’s. At the very least, if a GP is unwilling to make a change, they should at least provide as much transparency as possible about what they are doing as sunlight is often the best disinfectant.
A Compendium of Things To Look for in Private Equity LPA’s:
There is obviously no perfect LPA, and the best agreements align the incentives and the risk/rewards for all parties. For example, managers should not be incentivized solely to invest the capital, regardless of the quality of deals they can find. LP’s just need to answer a simple question: Is the expected NET return acceptable and will it outweigh any terms that are GP-friendly? Top managers can charge top fees and negotiate onerous terms (as long as they deliver), but they should not be paid for just showing up.
In our experience, GP’s who provide transparency, are reasonable on fees/expenses, and treat their LP’s as true partners usually are the ones who generate the best long-term returns. At the end of the day, it is the LP’s who sign these LPA’s and, to quote Nancy Reagan, sometimes LP’s need to Just Say No!
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Readers of our letters know that we are always looking for ways to improve and identify best ideas. In that regard, we hope these suggestions will prompt a broader discussion among private equity investors and GP’s that will make private equity investing more rewarding for everyone. Please email and share any feedback with us at PE@AIM13.com.
Thank you!
Alternative Investment Management, L.L.C.
www.aim13.com
(212) 557-6191