Welcome to our Autumn 2010 newsletter
In this newsletter we bring you a joint article from John Fadely of Weil, Michael Henningsen of Park Hill, and Andrew Read of Langham Hall concerning the impact of the ILPA Principles on private equity in the current fundraising market. The article is a summary of a series of presentations given by John, Michael and myself in Hong Kong and Singapore over the last few months. We hope you find it helpful, and if you would like to find out more about the topic please don't hesitate to contact any of us.
Private Equity Fund Terms in the Current Market: Implications of the ILPA Private Equity Principles for Asia-based funds
The Institutional Limited Partners Association (ILPA), a large and influential organization of institutional investors that invest in private equity funds, among other things, released the ILPA Private Equity Principles in September 2009, followed by the endorsement of the ILPA Principles by many of ILPA’s members. Since then, the ILPA Principles have had a marked influence on negotiations between GPs and LPs regarding the terms of private equity funds, with LPs often citing the ILPA Principles in the course of negotiations and sometimes requiring fund sponsors to conduct a full-scale review of fund terms against the ILPA Principles.
Objectives of the ILPA Principles
The stated goal of the ILPA Principles is to improve the alignment of interests between sponsors and investors, governance and transparency. ILPA Principles addressing the alignment of interests focus, of course, on carried interest and management fees.
Regarding alignment of interests the ILPA Principles state, among other things, that:
GPs should have a substantial equity interest, contributed mostly in cash;
a substantial portion of carried interest should be used to incentivize the investment professionals working for the fund manager/advisor;
distribution provisions should be drafted so as to avoid triggering overdistributions to fund sponsors and, therefore, clawbacks of those overdistributions;
clawbacks should be calculated on a pre-tax and joint and several basis; and
increased taxation of carried interest should not be passed on to LPs.
Likewise, the management fee should cover only operating costs, and any transactional or monitoring fees earned by the GP or its affiliates should be offset in full against the management fee so that it is the sole source of fee income.
Regarding governance, the ILPA Principles state, among other things, that:
there should be no contractual dilution of the GP’s duty of care to act in the best interests of the LPs;
“style drift” should be avoided, i.e., a fund’s investments should be consistent with the investment strategy described when the fund was raised;
in addition to achieving industry diversification, sponsors should strive for time diversification by spreading out investments over the investment period;
LPs should be entitled to dissolve the fund or remove the GP pursuant to a vote of at least two-thirds in interest of the LPs (“no-fault divorce”);
to address the problem of collective action among LPs, any event triggering remedies under the key person clause should result in the automatic suspension of the investment period rather than requiring an LP vote to achieve suspension, with an affirmative LP vote required to reinstate the investment period;
a fund’s auditor should be independent from the sponsor and its affiliates; and
the advisory committee should have a contractual right to access separate and independent counsel, and advisory committee meeting processes and procedures should be standardized.
Generally, the ILPA Principles address transparency as follows:
the calculation of fees and carried interest should be transparent to LPs in audited financial reports and capital call notices, and should be subject to the review of LPs or even the certification of an independent auditor;
detailed valuation and financial information relating to portfolio companies should be made available to LPs on a quarterly basis; and
LPs should be entitled to greater transparency regarding information pertaining to GPs, including in regard to profit sharing arrangements.
This is merely a broad summary of the ILPA Principles. Provisions not mentioned in this article can be found in the ILPA Principles themselves, which are available on the ILPA website.
What Do the ILPA Principles Say About Investors?
In general, unlike other reactions to the financial crisis in other industries, the ILPA Principles aim to tighten the terms of an existing model so as to better align the interests of GPs and LPs, rather than attempting to reinvent the private equity model itself. This is in sharp contrast to financing models such as securitization, where there appears to have been a more fundamental misalignment of incentives, which are in turn expected to be followed by more fundamental changes to business practices aimed at realigning those incentives. At a more granular level, the ILPA Principles run the gamut from LP rights that were readily given to LPs upon request before the publication of the ILPA Principles, to those that are more aspirational (e.g., clawbacks on a pre-tax and joint and several basis, certification of fee calculations by an independent auditor, etc.) and correspondingly more aggressive.
Also, the ILPA Principles are significant as a demonstration by LPs of their increasing ability to act collectively on more than just an ad hoc basis. However, the fact that collective action will likely remain challenging for LPs to consistently achieve can also been seen in the ILPA Principles. Even though investors endorsing the ILPA Principles must endorse them in their entirety, in practice some ILPA Principles are less widely supported than others. For instance, while some LPs push fund sponsors to achieve time diversification, others prefer sponsors to develop an extensive pipeline of deals during the fundraising process (which itself has been extended, now averaging over a year and a half according to industry surveys) and accept that a high quality deal pipeline inevitably may translate into a disproportionately large amount of capital being deployed early in the investment period.
Are the ILPA Principles Suitable for Asia-Sponsored Funds?
The genesis of the ILPA Principles was the reaction of institutional investors to U.S. and European funds of increasing size that earned sizeable management fees for their sponsors, thereby diluting the alignment of interests that is supposed to be achieved through the sharing of carried interest between LPs and the GP. By contrast, in Asia:
Private equity is a new enough industry so that fund sizes are still relatively small (with the vast majority of funds under US$1 billion in size).
Relatively few sponsors have been in existence long enough to have developed broad income streams from multiple fund vintages, which allows Asian GPs to focus more on generating carried interest.
Asia’s geographic fragmentation increases operating costs, particularly for multi-country funds that need to maintain multiple offices, which, in addition to relatively smaller fund sizes, may justify charging a full management fee (i.e., 2% of capital commitments during the investment period of the fund, stepping down to 2% of unreturned capital contributions thereafter).
Due to the combined effects of smaller fund sizes, fewer vintages and higher operating costs, few Asia-based GPs fund their commitment by forgoing management fees, which eliminates yet another “alignment of incentives” concern raised in the ILPA Principles.
In many instances we have noticed intense competition among fund sponsors to attract investment professionals. The relatively stronger bargaining power of investment professionals in Asia may translate into pressure on fund sponsors to shorten vesting schedules and accelerate distributions of carried interest by returning first to LPs only capital contributions used to fund realized (as opposed to all) investments of the fund. (The ILPA Principles advocate the “all capital first” model, whereby LPs are entitled to the return of all capital contributions (and a preferred return) before any carried interest can be distributed.)
By contrast, certain other ILPA Principles may be quite relevant to certain Asia-sponsored funds and may present continued challenges to the sponsors of such funds in the course of negotiations with LPs. For example:
Key persons may have existing job responsibilities that cannot be set aside after a fund is raised, making it difficult for them to satisfy the ILPA Principle requiring key persons to devote substantially all of their business time to fund matters. This may lead to negotiations with LPs regarding time allocation.
Asia-based financial institutions sponsoring funds, as well as sponsors of both offshore and RMB funds, must strike a balance regarding the allocation of investment opportunities between the offshore fund, on the one hand, and other affiliates of the financial institution or the RMB fund, on the other hand. This can be challenging to reconcile with the ILPA Principle requiring no other investment vehicles to share investment opportunities within the fund’s investment scope, and often leads LPs to demand greater transparency regarding the investment allocation process.
The ILPA Principles advocate that all distributions to LPs should be made in cash and oppose deemed (non-cash) distributions, including deeming taxes paid at or below the fund level to have been distributed to that LP. The recent trend towards increasingly aggressive tax collection in Asia, including the potential taxation by PRC tax authorities under Circular 698 of gains generated through offshore exits, may lead Asia-based fund sponsors to resist this particular ILPA Principle.
For the reasons noted above, several ILPA Principles may be less relevant to Asia-based funds than to funds sponsored in the U.S. or Europe, while certain others – particularly regarding the mitigation of conflicts of interest – are quite relevant in many cases.
Although the ILPA Principles affirm – rather than challenge – the basic private equity model, they have indeed influenced the ongoing debate regarding many fund terms, including the amount and timing of the step-down of management fees for funds offered by well-established sponsors and LP voting requirements with regard to key person events, to name a few. Therefore, it would not be surprising for certain ILPA Principles, particularly those meant to address conflicts of interest, to continue to influence negotiations between LPs and Asia-based GPs regarding fund terms.
John Fadely (email@example.com) is a funds partner in the Hong Kong office of Weil, Gotshal & Manges, an international law firm, specializing in the formation of private equity funds. Michael Henningsen (firstname.lastname@example.org) is a Hong Kong-based director of Park Hill Group, a placement agent with global capabilities, and specializes in the placement of Asia-based private equity funds. Andrew Read (email@example.com) heads the Asian operations of Langham Hall, an international fund administrator providing operational support for private equity (including closed ended real estate) funds.