Guest viewpoint: Jennifer Choi & Brian Hoehn

Since the Institutional Limited Partners Association (ILPA) Principles were published in September 2009, the industry has undergone fundamental changes. Private equity has become more regulated and has embraced transparency, in particular around costs.

At the same time, fund structures have become more complex, and the evolution of general partners (GPs) and their platforms present unique challenges to alignment of interests. The latest edition of the ILPA Principles, the third version, furthers the original aim of the guidance – to strike a greater balance in GP-LP relationships – by tackling these industry challenges. It also raises the bar in terms of expectations for attention placed on best practice. 

The concepts within ‘ILPA Principles 3.0’ are intentionally aspirational from the LP perspective. The ILPA believes that it is incumbent upon all industry stakeholders to seek a mutual understanding of how to achieve better transparency, governance, and alignment within their relationships.  There are three areas that present opportunities for LPs and GPs to do just that. 

Fiduciary duty
Fundamentally, fiduciary duty comes down to how conflicts of interest are managed. Decisions made by GPs should take into account the impact on the fund as a whole, and the source and value of any material benefit, accruing to the GP should be disclosed to LPs. But, increasingly, fund documents permit the GP to disclaim fiduciary duty to the fullest extent allowed by law and award the GP with sole discretion on whether conflicts are enumerated and mitigated. 

Such disclaimers have degraded trust in the partnership and, as a consequence, investor confidence has suffered. Moreover, such provisions present a dilemma for LPs. As fiduciaries themselves, LPs cannot abrogate their own duty by effectively delegating to a third party which bears no duty itself. In the extreme, this situation can force some LPs to walk away from attractive investments.

The ILPA Principles 3.0 assert that limited partnership agreements should reinforce, rather than dilute, the fiduciary duties of GPs to LPs. Both GPs and LPs have a role to play in ensuring that fund documents detail the standard of care owed to the fund by the GP. In addition, Principles 3.0 recommends that provisions allowing the GP sole discretion should only be permitted where LPs have an attestation that their interests and the fund will not be adversely affected. By following these provisions, LPs will have confidence that the GP will invest with the best interests of LPs and the fund in mind. 

Reasonable fees and expenses
Another worrying trend has been the shifting of more fund expenses onto the partnership. These include many costs that were previously covered by the management fee paid to the GP. In response, the Principles delineate a framework for reasonability in how costs are shared.

Examples of costs that ILPA believes should be absorbed by the GP under the management fee include travel related to sourcing deals, networking, and preliminary due diligence, as well as technology implementation and regulatory compliance. The fund should bear travel and consulting expenses related to an investment only after the deal is beyond the initial term sheet. Costs related to limited partner advisory committee (LPAC) meetings or annual meetings of the LPs should be covered by the fund, but the costs of entertainment should not be charged to LPs. 

As in prior editions of the ILPA Principles, we reaffirm that no fees should be charged to portfolio companies, such as transaction and advisory fees. In the event they are, these fees should be fully offset against the management fee. 

Increased transparency
Finally, in order to act as effective partners and investors, as well as to fulfill their own fiduciary duties. LPs require access to adequate information regarding fund management. Specifically, at a minimum, LPs should be notified of any fees and expenses assessed, either to the partnership or any portfolio company. The ILPA reporting template provides this information in a standardised and recognisable format. 

The rise of co-investments, separate accounts and other bespoke arrangements with third parties has introduced potential conflicts of interest. ILPA believes that GPs should provide LPs with a framework for how co-investment opportunities will be allocated, as well as disclosures around how expenses related to such transactions are shared. 

Another area in need of enhanced transparency is the GP’s use of subscription lines of credit, building on ILPA’s 2017 guidance. GPs should provide all LPs with information on the utilisation of such lines, including costs as well as updates on the amounts invested but not yet called. Additionally, GPs should provide LPs with levered and unlevered internal rate of return information or, failing that, sources and uses of cash flows to determine the impact of the credit line on performance.

At a time when scrutiny of the private equity model is perhaps at its highest, LPs need to see into how GPs will address and disclose specific events that may affect the GP or the fund, such as those that present legal, reputational, or business risk, drawing on both ESG considerations as well as regulatory compliance risks. 

Last, but certainly not least, where GPs are seeking to create either liquidity or permanent capital for the platform, such as through a GP-led secondary or the sale of a minority interest itself, LPs should have full visibility into the transaction and any impact on the fund or on the incentives for the fund managers. 

Principles 3.0 is intended to offer a road map to optimal partnerships in the private equity industry, built on transparency and robust governance. ILPA encourages all players in the private equity industry to engage one another in the spirit in which the Principles are set forth and continuously improve the asset class to which we are all committed. 

Jennifer Choi is managing director, industry affairs, and Brian Hoehn is associate at the Institutional Limited Partners Assocation. The ILPA Principles 3.0 document is available for download on the ILPA website