Langham Hall Spring 2010: Development in Limited Partnership Agreement Terms for private equity funds

31st March 2010

Welcome to our Spring 2010 newsletter

Last time we wrote about the improvement in investor sentiment and the fact that fresh capital from investors was starting to emerge. Yet for every successful fund raising there are more managers who continue to be delayed or give up. One of the reasons for investor reticence is the fact that they are presented with LPA terms dating back to the boom fund raising years of 2007 and 2008. During the marketing phase, once they have seen terms which do not fully reflect the changing balance of power in favour of LPs, it can be difficult for the manager to recapture credibility. In this newsletter we explore some of these changes in LPA terms with a guest article from Sam Kay of Travers Smith LLP, we also have a piece from Daniel Biggs of Corporate FX discussing the importance of active management of FX in these volitile times. We also provide you with an update on CRC, reviewing the additional burden of CRC reporting for managers, with a few practical steps for them to work out what issues exist within their portfolio of assets and how to deal with them.

As ever, we welcome your feedback and look forward to working with you during 2010 and beyond.

Development in Limited Partnership Agreement Terms

It is a truth universally acknowledged that, in this brave new world, an investor in possession of good fortune must be in want of improved fund terms. With challenging conditions persisting, this theme will be at the forefront of the private equity and real estate fundraising market. As a result of the shift in bargaining power, a GP entering the market with an ill-advised offering will almost certainly sink an otherwise good fund. GPs and advisers must therefore keep a very careful eye on how fund terms are evolving. 

The marriage between GPs and LPs has always been complex. Both private equity and real estate are challenging asset classes because they involve long-term investments, the assets are inherently illiquid and the cost of acquiring, managing and disposing of those assets is high. Over time, the market has developed to provide for an alignment between GPs and LPs, in particular in the areas of GP commitments, GP rewards and preferential cashflows for LPs. However, as a result of the recent market disruptions, we are now seeing these three areas come under ever increasing scrutiny because investors believe that the alignment has faltered and that the present balance weighs too heavily in favour of managers. In particular: 

  • in order for new funds to attract the attention of investors, a large financial commitment from the fund manager and its executives is vital. Whereas the previous standard was for the fund manager to invest around 1% of total commitments, we are now seeing much larger amounts being demanded from investors. Clearly, the more the executives put their own money at stake, the greater the alignment;
  • although the "2 and 20" model is still referred to as the standard, funds have been subtly moving away from this for some time. Regardless of the level of fees, it is imperative for a fund manager to be able to justify those fees. Investors now expect to see operating budgets and understand how fees impact returns over the life of a fund. There is also greater pressure on transactional fees earned by managers from portfolio companies as LPs regard these as contrary to an alignment of interests. Rebates of 100% of these fees against the management fee are likely to become market standard; and
  • many commentators believe that 'deal by deal' carry arrangements, whereby the manager receives a carry based on the returns generated by each investment rather than the performance of the fund as a whole, are due to become a thing of the past. Investors are demanding that their principal is protected, there is no leakage in the distribution waterfall and they receive a preferred return before any carried interest or incentive payment is made. In September 2009, a group called the Institutional Limited Partners Association (ILPA) in the US published a set of guidelines for private equity investment. One of their key principles for aligning interests between managers and investors was for whole fund carry models to be regarded as best practice.

Over the last 12 months, some investors have been increasingly aggressive in their approach and there has been substantial pressure on a number of funds to provide greater investor involvement, changes in terms or reductions in commitments. The ILPA principles can be regarded as another example of this trend - over 100 respected global investors have now signed up to promoting the ILPA principles as best practice. Whilst it is true that investor groups have been proposing professional standards and guidelines for some time to encourage better reporting and governance frameworks (for example in the real estate market, INREV published guidelines in 2008 which themselves were an amalgamation and update of various sets of guidelines dating back to 2005), the ILPA principles can be seen as evidence of a hardening of investor resolve. As well as ways of improving alignment, in both sets of guidelines investors are seeking greater disclosure of detailed valuation and financial information, including a greater focus on understanding operating capability and exit strategy. For now, it seems that the days of funds being able to attract investors simply by using financial engineering to generate returns are over.

Although there is cautious optimism for both the private equity and real estate funds markets in 2010, investors will continue to flex their muscles and managers will need to work hard both to raise funds and obtain the best terms available. When you throw in the regulatory and tax reforms being suggested on both sides of the Atlantic, it's clear that there are interesting times ahead. 


Why Effective FX Management is Important

Over the last 18 months the markets have witnessed some historic events and exceptional volatility. We have seen the collapse of major banks and coordinated central bank activity that has rarely occurred before at these levels. As a result, particular asset classes have had to delay activity to allow time to decipher what has happened. However, during this period foreign exchange (FX) has managed to establish itself as an individual asset class. Within the FX markets liquidity remained high and the markets never really closed.  As a result of market changing times, investor sentiment has shifted to an asset class that has firstly performed and secondly is reliable. 

During this period we saw massive swings in the market due to the extreme levels of volatility not seen for decades, the main catalyst of which was the unwinding of the heavily leveraged carry trades. In a 3 month period during 2008/9 AUD/JPY lost roughly 50 percent of its value, GBP/USD also fell just over 30 percent in 5 months, while the world’s most liquid cross EUR/USD, fell close to 25 percent for the same period. As a result of these swings numerous companies ranging from SME’s to listed companies found themselves in trouble due to the lack of effective treasury management. 

Many have forecasted that the worst may be over, so where does this leave the FX markets? Due to the extreme price action seen over the past 18 months, hedging is now 100% on risk transfer, rather than some of the speculative interest was seen before. Two fundamental changes have also occurred in the market as a result of the credit crisis. Firstly, we have seen counterparties reduce their appetite to offer credit while enhancing appropriateness and suitability checks. Secondly, clients and customers are searching for more understanding on products and hedging strategies. These two factors are very important as the global economy continues to sail into uncharted territory.

Compared to the historic levels we have seen a marked decrease of volatility, although the market still remains precariously balanced. Recently we saw the Euro take a 10 percent decline against the Dollar on concerns surrounding Greece. Events like this have rarely happened before and there is still plenty in the markets to suggest we may see more erratic swings in price action again. Firstly the debt situation in Eurozone is still a concern. Even though a solution has been agreed, the lack of detail and the fact this hasn’t occurred within the group before leaves a lot of questions to be answered; in particular the effect on the single currency. Looking at other aspects, China has tightened its lending and this could have ramifications on the global recovery. Interest rates around the world remain at record lows and once the global economy starts to recover, interest rates across the world will increase. It is probable that the pace of interest rate increases is likely to differ around the world and this will add another dimension to the risk trend relationship which is currently present. Added to this is the situation surrounding the carry trade scenarios which will undoubtedly change. 

With the economy emerging from one of the worst recessions the world has ever seen, we are entering uncharted territory and many of the rules have changed. The worst of this credit crisis may well be over but there are still others who are calling for a double dip recession. Several uncertainties remain for the global economy and with this the potential for further volatility. As a result, cash hedging at particular levels is important to protect the performance of funds, assets and corporate business. Exploring these and understanding how they work can not only help clients but give them additional flexibility on delivery as situations are consistently changing. The perception of FX risk in terms of hedging has changed and moved away from complex structures and returned back to effective management and more vanilla methods such as simple options, as well as spot and forward transactions to cover bottom lines.


Carbon Reduction Commitment ("CRC") Action Required by Fund Managers

The CRC came into force with the effect of 1 April 2010 and over the last three months we have seen considerable interest from market intermediaries and our fund manager clients regarding not only the practical and operational considerations of CRC, such as identifying the “group” or measuring and collating actual electricity usage but also around the implications for reporting, accounting and taxation.  Managers remain uncertain about how CRC might impact them and what the key next steps are.

We highlight some practical steps that fund managers need to take now.  It is worth noting that whilst most businesses are aware that CRC groups need to register by 30 September of this year, the deadline for groups that wish to disaggregate a Significant Group Undertaking (an entity within the group which qualifies in its own right) is actually the 30th of June.   Thus managers need to review their funds and portfolio investments now to consider which entities they may maintain or remove from their CRC group.

As previously discussed funds and managers may find that investee companies are now considered to be within their CRC group due to the use of Companies Act definitions to establish group status.  This means that previously unrelated investee companies may fall within a single CRC Group with the fund or the manager as the parent and Primary Member. Indeed, managers of multiple funds may find that investee companies within different funds (with different investors) are now grouped together.

Managers will need to perform detailed analysis of fund documentation and agreements such as articles of association, partnership agreements etc. to determine where a CRC Group exists.

For some funds and managers, the existence of a CRC Group is likely to give rise to a significant administrative burden.  This will mean that the manager may be responsible for the compliance of all entities within a fund and will need to determine how costs of allowances and the recycling payments are allocated across the various entities. 

Under CRC this year, being the first of the three year transition period will be a monitoring-only year.  This means that no allowances will be bought and therefore no intra-group balances or allowances will be in place.  However, from next year, once entities will be required to purchase allowances, there may be some potential issues around both the accounting and taxation regarding the recognition of purchased allowances and the resultant net payments. 

For example, how will allowances be carried (or indeed valued)? What basis of amortisation or spreading would be appropriate as these allowances are released? How would recycling payments be recognised and allocated, especially where one member of a group is more efficient that another? How should intra-CRC Group payments be recorded particularly where CRC Groups do not mirror accounting or tax groups?  Where payments are made between CRC Group entities, how will these be treated for tax purposes particularly if entities are not in the same tax group? 

It is clear that managers will have their hands fall not only considering the operational implications of CRC but also on the commercial and reporting burden. Where appropriate, managers will need to engage with their accountants and tax advisors during this year to better understand their specific issues in advance of purchasing allowances.

As a reminder we believe the key steps that managers should take now include:

  • Analysing their fund structures and the nature and extent of their interests in portfolio companies and/or other properties;
  • Considering whether they come within the CRC scheme, based on their UK electricity usage for 2008;
  • Considering whether particular portfolio companies which are Significant Group Undertakings (SGUs) could be disaggregated to operate the CRC on a standalone basis and if so register these by the 30 June deadline;
  • Appointing individuals within the group to be responsible for CRC reporting and compliance;
  • Dealing with the registration pack and co-ordinating across the other entities within the Group, to ensure that reporting lines are in place. Registration is now open and needs to be completed by 30 September;
  • Reviewing current contractual relationships with investee companies to confirm who will be liable for separate entities liabilities under the scheme and clearly where possible seek to ensure that liability remains with the investee company rather than at fund or manager level.  Managers should also consider drafting intra-group agreements to ensure that all members of the group provide relevant data and amounts due where the liability cannot be passed down.

Clearly there is much to consider and we believe that over the coming months the industry’s understanding of CRC and its operational implications will become a key focus for fund managers and other participants.  Managers and service providers will need to work closely to develop efficient measurement and reporting infrastructures and ensure that all members of CRC Groups are treated fairly.