A shocking pattern has been developing for the last decade for institutional limited partnership agreements for private equity — and presumably venture capital and real estate will be next. In the 1990s, most partnership agreements were about 35 to 50 pages; today the agreements are more like 80 to 120 pages, accompanied by much-expanded subscription agreements. Part of this change is due to additional governmental requirements, such as the Patriot Act and anti-money-laundering requirements. But the real culprit is something more insidious.
Many of the large law firms that represent the general partners, the law firms that draft these agreements, have implicitly decided that partnerships don't have partners anymore — they have sheep to be shorn. The key pitch from some of these leading law firms as they compete for the lucrative fund documentation business is that they can get a better deal for the general partner than can their law firm competitors. This induces them to promote ever more LP-unfavorable agreements. At the same time, the mostly unnecessary expansion of the documents has created an expanded fee base for the lawyers.
So who is the loser? The LPs. They are getting unfair deals and they are paying for the privilege because most of the fund “organizational” costs are borne by the partnership itself. On top of that, based on our experience with hundreds of fund documents, the cost of legal review is probably up fivefold in the last 20 years, while returns from private equity have plummeted. The law firms representing the GPs can take solace their brethren in law, the LPs lawyers, are also getting part of this rapidly expanding fee pie.
The most egregious provision we have seen creep in to these new-style agreements is the wholesale elimination of any fiduciary duty whatsoever. Most limited partnership agreements for U.S. private equity funds are formed in Delaware law. The Delaware Revised Uniform Limited Partnership Act, Section 17-1101, which became effective August 2004, provides that:
(d) To the extent that, at law or in equity, a partner or other person has duties (including fiduciary duties) to a limited partnership or to another partner or to another person that is a party to or is otherwise bound by a partnership agreement, the partner's or other person's duties may be expanded or restricted or eliminated by provisions in the partnership agreement; provided that the partnership agreement may not eliminate the implied contractual covenant of good faith and fair dealing.
(e) Unless otherwise provided in a partnership agreement, a partner or other person shall not be liable to a limited partnership or to another partner or to another person that is a party to or is otherwise bound by a partnership agreement for breach of fiduciary duty for the partner's or other person's good faith reliance on the provisions of the partnership agreement.
(f) A partnership agreement may provide for the limitation or elimination of any and all liabilities for breach of contract and breach of duties (including fiduciary duties) of a partner or other person to a limited partnership or to another partner or to an other person that is a party to or is otherwise bound by a partnership agreement; provided, that a partnership agreement may not limit or eliminate liability for any act or omission that constitutes a bad faith violation of the implied contractual covenant of good faith and fair dealing.
In other words, if the GP and LPs agree in writing, the LPs can waive virtually all fiduciary duty standards other than bad faith or unfair dealing. Not long after the Delaware statute was amended to allow the waiver, we ran across a first-time fund that had such a provision that waived all fiduciary duty that the GP might have had as to the partnership, the partners, the businesses in which they invest or anybody else. The LPs that invested were mostly institutional, experienced LPs. The GP seemed surprised as we were the only potential investor who had noticed and the GP had not read the agreement either. Apparently, none of the LPs who invested actually read the agreement, because no rational investor could read it and sign it. Amazingly, the fund closed with the provision intact. We pondered whether the LPs that were pension funds might have breached their own fiduciary duties of prudence and care.
More recently, we have seen this provision, and many of the other distasteful provisions, buried in out-of-the-way places in partnership agreements, even under “general provisions” hidden just below the boilerplate paragraph on where to send notices. Sometimes the offensive terms are put in with other non-controversial but unrelated sections. No one could believe this was not intentionally deceptive on the part of the drafting law firm.
But this fiduciary duty waiver is just the most egregious. Indemnification and exculpation provisions have expanded into one-sided protection clauses for the GP only. Catch-up calculations are being diluted by allowing the GP wide discretion to pick the drawdown and capital-return dates for purposes of gaming the hurdle internal rate of return, or IRR. Discretion provisions have been expanded to allow the GP to do almost anything. Nearly inscrutable language makes reading these documents akin to translating from Aramaic. And these time-bomb provisions are being camouflaged amid language that is more typical and even put in the subscription agreements so as not to raise red flags from hurried readers who might just skim instead of read carefully.
The institutional LP community has realized that it is almost prohibitively expensive to review properly the new style of limited partnership agreements. There is no economy of scale as each LP has to pay for its own legal review, and will be paying the GP's law firm, too, via fund organizational expenses. LPs may think that at least some of the other LPs are reading and negotiating the terms and language. Think again. In some cases, no one seems to be carefully reading the documents, or everyone just assumes it isn't likely that these horrendous terms will ever be invoked. Maybe they are right because the GP that actually has to use these overkill protections may never be able to raise another fund.
At minimum, LPs should understand that they are now in a position to either read the most toxic agreements or sign them, but once you read them you will have a hard time signing them. A better solution would be for the leading LPs and the various LP associations to create a best-practices template document, perhaps with choices of provisions on key points, and require the GP to explain why it is using terms and language that differ from what the LP constituencies have already approved.
We estimate that this will save between 1% and 2% of total fund commitments in legal costs. Given the vast amounts of money raised by private equity funds, this is not trivial.
But if this collectively rational behavior is too much to hope for, perhaps the first lawsuit where the LPs are sued by their constituents for breach of fiduciary duty, when they find they are barred from suing the GP, will get the attention of the institutional community.
Jeffrey E. Horvitz is vice chairman of Moreland Management Co., Beverly Farms, Mass.