Managing your relationship with LPs

Explanation

Clarity over what is distributed, how it is accounted for in the calculation of carried interest, whether it could be subject to recall, and how a distribution may impact uncalled commitments to the fund are all important issues. Addressing these will help ensure that disputes do not arise as to the apportionment of profits and losses between the GP and the LPs and that there is clarity regarding the LPs’ outstanding obligations to the fund.

Recommendation

The fund documents should include adequate provisions on distributions. These provisions should address at least the following issues:

• how profits and losses will be allocated between the GP and the LPs (the inclusion of a clear statement of intent on how the operation of the carried interest allocation will work and/or a description of the distribution of proceeds waterfall will help this);
• when carried interest allocated to the GP may be distributed;
• GP clawback provisions;
• what special provisions may relate to distributions to the GP in respect of the GP’s investment in the fund;
• the extent of the GP’s discretion to make distributions;
• whether distributions can be made in-specie;
• how any distributions in-specie will be valued (generally this should be on a conservative basis or where freely tradable, reflecting the average daily trading price over an appropriate number of days). Due to restrictions on certain LPs concerning distributions in-specie, the process for making such distributions should be set out clearly in the fund documents;
• the extent to which distributions will take account of taxation liabilities;
• the extent to which the GP may be permitted to re-invest capital proceeds, dividend and other income, rather than distributing it;
• the format and content of distribution notices;
• LP clawback provisions;
• how distributions will be classified (e.g. income or capital);
• the source of the distribution (e.g. sale of a company, dividend payment, interest payment, etc.);
• when distributions will be made.

Explanation

Distributions are generally expected to be made as soon as possible after an investment has been realised and proceeds have been received by the fund. In practice, funds whose strategies result in ongoing income from multiple sources may pool such amounts while distributing the more infrequent capital returns as soon as practicable. Prompt distributions improve the internal rate of return of a fund.

Recommendation

Distributions should be made in accordance with the relevant provisions in the fund documents.

Before making a distribution, the GP should consider the fund’s reserves for follow-on investments and current and foreseeable liabilities and assets (including liabilities for tax, escrow and clawback provisions and contingent liabilities such as those under warranties and indemnities). Distributions should not be made if this would cause the fund to become insolvent or unable to meet its reasonable future liabilities.

Before making a distribution in-specie, any restrictions on transfer of the relevant investments should be considered.

Explanation

Reporting obligations are important for LPs wishing to monitor the status of their investment. The nature of funds means that valuing an investment on an ongoing basis is difficult and, without information from the GP, LPs cannot effectively monitor the performance of the fund or report to their beneficiaries in a satisfactory manner.

Recommendation

The Invest Europe Investor Reporting Guidelines and IPEV Valuation Guidelines should be followed.

It is typical for all LPs to be sent a list of all partners in the fund following final closing, but confidentiality requirements of individual LPs may prevent this.

The fund documents should contain provisions regarding the GP’s obligations to provide reports to LPs. These provisions should address the following matters:

• the frequency of reports to be made;

• the information to be contained in these reports;

• the form and frequency of responsible investment reporting;

• the basis of valuation that will be used for such reports;

• the manner in which the reports are to be made (e.g. in writing, by email, via a secure website).

GPs should also note that applicable legal rules (including under the AIFMD) may require periodic and ad hoc reporting and disclosure to LPs.

Explanation

In its relations with LPs, a GP should be proactively transparent within the confines of its obligations toward others, including a general principle of equal treatment of stakeholders. Established reporting obligations occasionally need to be supplemented by disclosure of significant issues or even consultation with LPs. The GP must take care not to breach confidentiality obligations, whether contractual or regulatory, and that its disclosures do no harm to the interests of portfolio companies.

Recommendation

The GP should seek transparency in its relationship with LPs by ensuring that all LPs receive all significant information regarding the fund in a clear and timely manner, provided that communicating such information is permitted by law. The GP must not breach confidentiality obligations binding on it but should seek to be relieved of such obligations if they prevent proper reporting to LPs.

Certain LPs and types of investor will require different information, or information presented in a different way, to satisfy their own tax, regulatory, commercial or responsible investment policy obligations. GPs should be receptive to such requests, but should also take care not to compromise fiduciary duties to portfolio companies (and thereby their other investors).

GPs should also consider the extent to which external specialist assistance (such as tax advice) is a cost to be borne by all LPs in aggregate or by those parties requiring the non-standard level of reporting. When committing to fulfil a special request on an ongoing basis, the GP should consider updating its general information to LPs accordingly, or alternatively disclosing special arrangements to other LPs, all in the interest of securing parity of treatment of LPs and timely disclosure of information.

Explanation

A transparent and trust-based relationship between the LPs and the GP is key, and this requires good and clear communication throughout the fund’s life.

Recommendation

Suitable arrangements should be made to respond to queries from LPs promptly as they arise, as well as complying with the obligations in the fund documents on reporting and, if relevant, meetings. The use of due diligence data rooms can be an effective and efficient way to provide information to prospective LPs.

It is recommended that an annual meeting of LPs be held. An annual meeting provides an excellent opportunity for the GP and LPs to meet together in person. There is no fixed agenda for annual meetings. As a guide, however, the general aim should be to update LPs on the progress of the fund(s) and provide an overview of developments in the market, responsible investment issues along with any relevant updates on the GP’s team or processes. It can be helpful to consult with LPs when preparing for the annual meeting to get a sense of the best balance to be achieved between overview and detail. It is also advisable to inform LPs, subject to confidentiality requirements, of investments and divestments as and when they occur. Where practical, consideration should be given to providing access through video, conference call or other, secure, interactive methods for those LPs who are unable to attend in person.

Regular conference calls or webcasts are an efficient method of keeping all LPs up-to-date between annual meetings. Having a secure area on the GP’s website, or using one of the secure electronic data site providers is an increasingly common way for GPs to make documents and notices available to LPs.

Explanation

Most of the time LPs’ interests will be fully aligned with each other. On some occasions, however, situations can arise where LPs’ interests can conflict. For example, if an investment has been made by two funds of different vintages managed by the same GP, then a conflict may arise between the funds (and hence the different LPs in each) with regards to the timing of the exit, or in relation to making any follow-on investment. Similarly, if an investment is being sold by one fund managed by the GP and bought by another that the GP manages, then conflicts may arise between the two funds over the valuation placed on the portfolio company.

If some LPs have co-invested in a portfolio company alongside the fund’s GP, circumstances could arise in which these LPs’ interests may conflict with those of LPs who have not co-invested.

Recommendation

Whenever any conflicts arise, it would be expected that the GP will consult with the LPAC of the relevant fund(s) and, where advisable from a limited liability perspective, seek its approval.

When LPs are consulted by the GP on a situation likely to involve a conflict of interest between any of the LPs, they should promptly disclose all conflicts they may have to the GP and the other LPs of the relevant fund(s). In this way the situation can be discussed in an open manner, subject to applicable confidentiality obligations. The context in which views are expressed can be better understood, so enabling conclusions to be arrived at which are based on as full an understanding of everyone’s position as possible.

Explanation

One of the ways the industry facilitates an interactive relationship between the GP and LPs is through the use of an LPAC. A well-functioning LPAC should help ensure good governance of the fund by addressing conflicts of interest and be a helpful resource for the GP. Just as GPs bring the benefit of their wider investment experiences to portfolio companies, LPs can provide useful insight from their fund investing experience to the GP on the basis of the more detailed information provided to LPAC members.

In some jurisdictions, maintaining the limited liability of LPs makes it important that LPs do not become involved in the management of a fund, i.e. LPs should not be involved in making investment or divestment decisions. This should be the sole responsibility of the GP. LPAC members provide advice in the best interest of the fund but they do not have fiduciary duty to other LPs.

Recommendation

The LPAC is most effective when it acts as a sounding board for the GP on all matters which impact the governance of the fund. The LPAC ought to be consulted on all conflicts of interest and other significant matters as set out in the fund documentation. In many cases the LPAC will be required to give its consent to the treatment of certain governance issues including conflicts of interest under the terms of the fund documents.

The LPAC should not become a barrier to the GP communicating directly with all LPs in the fund. For example, while the LPAC can provide a useful forum for discussion and feedback to the GP, changes which will impact all LPs need ultimately to be put to all LPs.

To be of greatest value to the GP, the composition of the LPAC should be thought about carefully to ensure a balanced range of perspectives are included. The individual members of the LPAC should have an appropriate level of fund investing experience so that a full contribution to discussions can be made.

The role and constitution of the LPAC should be described in the fund documents. It is usual for members of the LPAC to be indemnified by the fund and for it to be clear that there is no fiduciary duty owed by members of the LPAC to the rest of the LPs in the fund.

There should be a separate LPAC for each fund raised by the GP.

LPACs should be run on a good governance basis, with the agenda and supporting papers circulated ahead of the meeting. Members should declare any conflicts at the start of the meeting and formal minutes should be taken and circulated in a timely fashion. The minutes of any LPAC meeting may also be made available to all LPs.

LPAC meetings should be held at least once a year and should be capable of being convened, at the request of the GP or any of the LPs, at other times.

The LPAC may be chaired by either the GP or one of the LPs. The names of those LPs on the LPAC should be made known to all LPs in the fund. LPAC meetings should provide for discussion without the GP being present.

The number of members on the LPAC should be appropriate for the size of the fund but not so large as to make effective discussion difficult.

LPs on the LPAC must be careful to respect the confidentiality of the information received and discussions held in these meetings.

Explanation

A very important aspect of LPs’ due diligence before deciding to commit to a fund is determining the investment skill of the people managing/advising the fund. During the long life of a fund it is possible that some of the key members of the team may leave. If this happens it may result in a material change to how LPs regard the quality of the team managing/advising the fund.

Recommendation

The fund documents should identify the key individuals in the GP responsible for the day-to-day management of the fund. They are likely to be the most experienced people who are key to managing that specific fund.

Key Persons are expected to devote substantially all their business time to the fund. It would be normal that this includes provision for spending appropriate time with predecessor funds and, in due course, with successor funds. If it is agreed between the GP and LPs that a senior member of the GP is included in the Key Person provisions, who is perhaps not so directly involved in the day-to-day management of that particular fund, then a lesser time allocation is usually agreed.

The consequences and procedures for dealing with the situation when a Key Person ceases to devote the necessary time to a fund (the triggering of the Key Person provisions) should be clearly set out in the fund documents.

Usually, the triggering of Key Person provisions causes a temporary suspension of the investment period. The procedures for what happens next should enable the situation to be resolved promptly. The GP will normally tell all LPs promptly when the Key Person provisions have been triggered and set out the plan to address the situation. LPs should engage promptly with the GP to achieve a timely resolution. It is common to include provisions to enable a Key Person to be replaced and so avoid the Key Person provisions being triggered, or to resolve the situation if the Key Person provisions have been triggered.

It is normal to require a majority vote of all LPs or a decision of the LPAC to agree to any Key Person replacements, or to lift the suspension of an investment period. It is important for the good governance of the fund that LPs participate when a vote is required.