ILPA report highlights new issues that have emerged in the 2010s, including additional concerns about GP conflicts and fiduciary duties, fee and expense reporting, subscription lines of credit, GP-led secondaries, co-investment allocations and change of control of the GP. Hogan Lovells is a recognized leader in representing both LPs and GPs in every aspect of the private equity industry, from fundraising and regulatory compliance to M&A and credit financing.
The Institutional Limited Partners Association (ILPA) has updated the industry best practices principles that it first released in 2009 and updated in 2011. As private equity has recovered from the financial downturn a decade ago, Dodd-Frank has subjected many GPs to investment adviser registration, and new market practices have emerged, the new ILPA principles are designed to update and expand prior versions, taking into consideration evolving industry dynamics, and developed with the input of both LPs and GPs to maximize alignment of interests. The full report is available here.
In addition to clarifying and expanding its recommendations on core matters, such as fund economics, key person provisions, LPAC responsibilities and fiduciary duties, ILPA identified nine areas in particular as new and emerging topics, including the following:
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GP-led Secondaries. As more widely detailed in an ILPA report in April earlier this year, ILPA recommends that GPs should ensure the processes for secondary transaction are fair and transparent. Conflicts should be disclosed and, where possible, mitigated and/or approved by the LPAC, and GPs should disclose to electing LPs material information relevant to making an informed investment decision, including the number, range and content of bids received; economics and/or any “stapling” (LPs allocating primary capital); and other changes in the terms versus the original fund. ILPA further recommends that LPs electing to roll their interests (rather than sell) be provided a “status quo” option to participate in the new structure with no change in economic terms.
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Subscription Line of Credit. With relatively low borrowing rates, GPs are more commonly using fund-level credit facilities in larger amounts and for longer periods. ILPA’s new principles recommend that GPs provide quarterly and annual reporting of fund-level leverage, as well as performance information (i.e. IRR, TVPI and/or MOIC figures) with and without the use of such facilities to allow LPs to make informed performative comparisons. ILPA also recommends that the GP allow LPs the option to opt out of a facility at the onset of a fund and, further, that the GP provide LPs with the terms for such facilities, anticipated size of facilities, proposed limits on duration, parameters around use of proceeds, and disclosures of costs incurred by the fund relating to the use of such facilities.
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Fee and Expense Reporting and Reasonability. The principles reiterate that expenses allocable to a partnership as a whole should be reasonable, clearly disclosed prior to the initiation of the fund (and at regular intervals) to all LPs.
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The ILPA principles recommend that travel related to sourcing deals, networking and preliminary due diligence should be paid by the manager, but that when a potential investment advances beyond the initial term sheet, those costs should be borne by the fund. ILPA recommends that the GP’s travel policy include parameters addressing the use of private planes and entertainment expenses.
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To the extent that co-investment or other special purpose vehicles participate in a broken deal, in most cases it will be appropriate to share broken deal expenses across these entities with the fund on a pro rata basis (though preliminary due diligence and sourcing, including travel, need not be considered broken deal expenses).
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Expenses specific to implementing technology for cybersecurity and software upgrades should be borne by the GP out of the management fee, as should the costs of satisfying firm-level regulatory requirements and communicating with regulators, as with other items of GP overhead.
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Co-Investment Allocations. GPs should disclose to LPs, through the PPM and LPA, a framework for how co-investment opportunities, interests and expenses will be allocated as among the fund and participating co-investors, including the factors the GP may use in allocating such opportunities. Where rights to evaluate or participate pro rata in co-investments have been granted to certain LPs, GPs should disclose such arrangements to all LPs. GPs should take care to balance interests across different investors and classes of LPs where GPs have previously granted preferential access to co-investment opportunities. Where co-investments have been offered to any other vehicle managed by the GP, ILPA recommends that GPs disclose to the LPAC any potential conflicts of interest (including an explanation of why such opportunity has been offered to more than one vehicle).
Hogan Lovells view*
While ILPA will not be seeking official endorsements as with prior versions of its principles, clients should familiarize themselves with the new ILPA principles, especially with respect to those areas that ILPA is newly addressing in its third release. Based on our own experiences representing both LPs and GPs, we believe that ILPA’s latest attempt to bridge LP and GP expectations through this third iteration of the ILPA principles is a timely and welcome addition that will provide clarity for market expectations as the industry and its participants continue to grow. Nevertheless, given the expansion of investment products since the release of the previous set of principles, including the growth of separately managed accounts, there will not always be a “one-size-fits-all” set of terms that will be appropriate in every case for every fund sponsor or investor.
* Disclosure: Hogan Lovells represents ILPA.
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