Limited partnership agreements have been in a long-term trend to the detriment of limited partners.
The trend is being pushed by "big law" and denied by placement agents as just "market." The Institutional Limited Partners Association would like to change things.
The passivity of the institutional investor community has made limited partners like the proverbial frog put in water that is slowly raised to a boil before the frog knows to get out. According to an ILPA survey, half or more of all LPs do not negotiate the fund documents and others may not read the documents at all, presumably rationalizing that the agreements must be fair if everyone is signing.
Many general partners claim not to have read their own limited partnership agreements, saying they left it up to their lawyers. Yet when they read their agreements, many will agree that terms are unfair, even abusive.
Most of the resistance to eliminating such terms has not been from the GPs, but from their lawyers who seem to be more concerned about impressing their GP clients as "tough" than helping to create symbiotic partner relations. The drafting is clearly adversarial.
The myth persists that the carried interest aligns the interests of the GP and LPs; but that profits interest is a call option that misaligns interests (in effect, the LPs grant a call option as partial compensation because if investments lose money, LPs bear 100% of the loss but get only 80% of the profits). Both the economics and legal terms seriously misalign GP and LP interests.
Early attempts to create coordinated "best practices" terms and documents were met with threats of antitrust litigation. In 2010, the Institutional Limited Partners Association developed a set of principles focused primarily on GP compensation. The Wall Street Journal reported "at least three large private-equity firms have retained outside counsel to examine potential antitrust issues." No litigation was filed, but the threat had the expected chilling effect.
Here is a partial list of what an investor can expect to see in proposed limited partner agreements:
- Portfolio company monitoring fees without offset to the management fee.
- Prepayment of carried interest, for example by taking profits on unrealized investments.
- Clawback of overpayment of carried interest net of presumed income tax.
- Several, but not joint liability for GP obligations.
- Recourse lines of credit used to artificially boost internal rates of return and overcome the hurdle rate.
- No GP removal, even for cause, until final non-appealable judgment.
- Sole discretion for any kind of investment.
- No- or low-fee co-investments for large investors only, not pro rata.
- No requirement to share limited partner list among LPs.
- Extreme exculpation language.
- Waivers of fiduciary duty and near total indemnifications.
The last two points are particularly troubling. In a fiduciary duty survey conducted by the ILPA, 54% have seen worse language in limited partner agreements on fiduciary duty issues as compared with a few years ago. LPs should rightly wonder why GPs require so many kinds of protection.
GPs have no incentive to control the legal costs because fees are included in fund formation costs typically borne by the LPs. In other words, LPs are paying for both their own legal fees and the GP legal fees. Multiply this by the number of LPs across multiple funds and clearly a lot of investor money is being wasted. It is not just general partners' lawyers that may resist adoption of industry-standard forms; even some of the law firms that represent LPs resist because it will reduce their own fee income.
The adoption of best practices industry-standardized fund documents is long overdue. These should be fair and evenhanded agreements. This would be a major change from today's GP-generated agreements and will not be well-received by GPs or attorneys because it will kill the cash cow.
Various professional groups have long had their own standard contract documents, but to my knowledge none of these have run afoul of antitrust regulators. Some industry standard form contracts have alternative provisions that give the ability to modify them with a sort of "slide in and slide out" of specific provisions, such as multiple options for choices about how to handle specific topics, thereby allowing partial customization. ILPA should consider such an approach rather than a single set of terms, to allow for fair and reasonable alternatives to fit specific fund circumstances.
LPAs are like prenuptial agreements: The parties go into arrangement hoping for the best but preparing for the worst. Fund problems do not arise often, but when they do, today's LPs will have limited rights and remedies without reformation of what is "market" terms and conditions. There is an adage: "Either read it or sign it, but not both." It is a Hobson's choice and not how fiduciaries must act.
There is an enormous economy of scale to be had with template documents. If each limited partner must individually review and negotiate the terms and conditions, the cumulative costs are huge and largely unnecessary. Individually borne costs discourage many investors from actively resisting unfair terms.
Even for investors that are not ILPA members, it would be in their interests to be publicly supportive of ILPA's efforts. The effort is long overdue and sorely needed.
Jeffrey E. Horvitz is CEO of Moreland Wealth Services Corp., Beverly Farms, Mass. This content represents the views of the author. It was submitted and edited under Pensions & Investments guidelines, but is not a product of P&I's editorial team.