If there is one clause in the Limited Partnership Agreement that can be a dealbreaker in fundraising negotiations, it is the one where state pension funds or sovereign wealth funds demand that litigation can only be dealt with in their home courts.
Jason Glover, a partner in the London office of Simpson Thacher & Bartlett, and one of the top private funds lawyers, says he struggles to think of a term more likely to lead to general partners and investors being unable to reach agreement, and resulting in investors walking away from even oversubscribed funds.
Glover says: “The choice of courts has been a contentious issue throughout my career. Indeed, on a highly successful fundraising that closed very recently, we lost an investor on precisely this issue. I can’t think of another clause, over the course of my career, that has resulted in the loss of more investors than the jurisdiction clause in LPAs.”
European private equity funds will typically include clauses that state that any litigation that arises between the limited partner and the GP will be heard in the court of the general partner, but a US state pension fund may demand, for example, that the court of action be its home state. Given that the action may involve a jury trial in that home state, with jurors either being beneficiaries of the relevant state pension fund, or having family and friends who are, the concern is the extent to which a firm will receive a fair trial.
Coupled with the risk of punitive damages being awarded, GPs are understandably reticent in agreeing to such a provision. Yet some US state plans will claim that they are obliged by law to insist on one, and so in some instances a US state plan is refused access to a private equity fund.
As a result, these investor-specific, quasi-legal demands top PEI’s list of the top five most hotly-contested clauses in the LPA. And Glover says fundraising negotiations are certainly not getting easier: “The reality is that over the last three or four years, investors have started to raise far more comments than they used to, even on funds that are massively oversubscribed. The investors are much more alive to their fiduciary duties and responsibilities, which is good news for the industry as a whole, but as a result we receive extensive comments on the first draft of the LPA, even when the PE fund is a hot ticket.
“It is as if the investor feels a need to demonstrate that they have asked for certain provisions, even if they know deep down that the general partner is not going to agree to them. But then going forward, investors tend to be pretty pragmatic in the negotiations.”
With the average size of private equity funds closed in 2016 reaching an all-time high of $649 million, and 70 percent of investors planning to either increase or maintain their allocation to the asset class over the long term, according to PEI data, it would appear that GPs are in the driving seat on terms negotiations.
But Nick Benson, a partner in the investment funds practice at Latham & Watkins, says there is no significant shift in where the negotiating power lies. He says: “The balance of power is, and always has been, a question on a very specific basis between an investor and a GP. There’s no general extrapolation about a shifting balance, other than to note that there does seem to be a lot of appetite for commitments into the quality funds, so that plays into the hands of the well-established GPs when they are negotiating on a successor fund.”
That said, even the most experienced GPs can find it difficult to flex their muscles on some of these bones of contention.
The problem with these investor-specific demands is getting to the bottom of whether the investor’s hands are genuinely tied by legal restrictions on their activities, or there is in fact some room for manoeuvre.
Many state pension funds and sovereign wealth funds do face very real restrictions on what they can and cannot accept, in which case the GP needs to find a way to accommodate them.
Glover says: “The first thing is to seek to establish whether what they are asking for is actually a wishlist, or is based on a legal restriction. It is often the case that so-called ‘standard provisions’ are readily accepted by many general partners, irrespective of the underlying merits of the request. The key is to establish whether the investor has the ability to engage in commercial negotiations, or if in fact there is an underlying legislative restriction that means that the provision is a must-have.”
Where they can, GPs will have to negotiate. Glover says that frequently US pension plans have some flexibility on where they themselves may bring an action, but are legally required to ensure that actions against themselves can only be brought in their local court. In such instances, he suggests that a sensible compromise is often reached whereby the European private equity fund can only sue the state plan in its local court, but the state plan in turn can only sue the general partner in its home court.
2. KEY-PERSON CLAUSES
Key-person clauses continue to be very hotly negotiated by investors, and indeed were ranked number one in PEI’s recent survey of LPs when investors were asked which fund terms they considered to be mandatory in LPAs. Much of the focus on key-person clauses comes down to the more enhanced nature of LP due diligence, inclu-ding a greater focus on where and how value is created within a fund.
Lawyers say different investors will take completely different views on how key-person clauses should be drafted, which further complicates negotiations.
Howard Beber, co-head of the private investment funds group at Proskauer, based in Boston, says: “Certainly LPs are very focused on governance, and are pushing for no-fault rights, including no-fault removal of managers, and no-fault termination of the fund. You do typically see some no-fault means to terminate the relationship in most agreements, because for-cause provisions are typically very difficult to trigger. As the industry has matured and things haven’t always gone right, limited partners have learned lessons along the way.”
A topic that is increasingly heavily discussed is that of borrowings. Benson says: “LPs are a bit more focused on their own compliance requirements, and may want to make sure there is little or no leverage going on at fund level, while on the GP side there’s an awareness and desire to make use of favourable borrowing conditions, and the availability of relatively cheap credit, to allow GPs to extend the amount of time they can operate without drawdowns, which in turn helps their IRRs.”
In the past, funds only used borrowings to bridge capital calls, but now LPs are being asked to get comfortable with more leverage. Beber says: “The negotiations usually revolve around how much leverage is acceptable, and what information the LPs might be obliged to provide to banks and other lending institutions in connection with those borrowings.”
As funds seek to borrow larger amounts, so banks are seeking more assurances from, and due diligence on, investors, who will in turn push back on that, and may refuse to be obliged to provide a lender with any information that is not in the public domain.
Benson says: “Some investors like to see borrowings, but it does mean the fund bearing the costs of such borrowings, so it’s a question of weighing up the better IRRs against deploying their capital from day one. There’s no universal view, and that’s coming up a lot more often in negotiations.”
4. CO-INVESTMENT OPPORTUNITIES
A fourth bone of contention is co-investment opportunities, which LPs remain extremely keen to secure, but for which GPs are reluctant to make firm commitments.
Glover says: “GPs can get themselves tied up in knots about co-investments if they’re not careful. We find managers either do a blanket clause saying they acknowledge that the LP wants co-investment rights but they have complete discretion as to how they allocate the opportunities, or they commit to a very prescriptive, detailed and time-consuming process on how they are going to allocate the opportunities.”
In funds that are not oversubscribed, LPs may be able to secure clauses that detail rather complicated procedures, and such mechanisms can end up being unwieldy for the GPs at the point when they find themselves over-committed to a deal and trying to sell down the co-investment.
In the US, the Securities and Exchange Commission has weighed in on the issue, adding further formalities and complexity to negotiations, says Beber: “The SEC has been very focused on full disclosure, including disclosure regarding how LPs are being treated by managers vis-à-vis one another with respect to co-investment opportunities and any other special deals. Managers now typically have well thought-out co-investment policies and procedures that are disclosed during the fundraising process.”
5. FEES AND EXPENSES
Finally, the other area where SEC intervention has compounded an already tricky area for fundraising is in fees and expenses.
Beber says: “Over the last few years the SEC has been very focused on disclosure around expense allocation, requiring that managers clearly disclose which expenses are covered by the fund and which are cove-red by the manager, and how expenses that may relate to more than one fund are allocated across funds.
“Of course, disclosure around operating partners – who they are, what they are doing and who is bearing associated expenses – is high on most LPs’ list. In addition, LPs are requiring increased transparency and reporting on expense allocations and other matters, which can strain the resources of a firm’s back office.”
As investors and regulators have driven more transparency around fees and expenses, the issue has risen up the agenda in fund negotiations. Benson says: “As the provisions in the fund documentation have become more detailed, it has given both parties more material to haggle over. So we find we are going through a whole long laundry list of expenses that funds can charge, and debating things like whether it’s appropriate for GPs to use private air travel.”
Often LPs will now seek to be prescriptive upfront about when it is appropriate for GPs to recover travel expenses, and how it is appropriate for them to travel.
That’s just the latest example of LPs driving the conversation in fundraising negotiations, even if they don’t necessarily get to secure the terms they are looking for by the time they get to signing on the dotted line.