There's good news and bad news about Limited Partner ship Agreements (LPAs), those essential documents that codify the rules and agreements between limited and general partners. The consensus from market practitioners is that while, to widespread regret, they appear to be getting longer and longer, it's because increasingly relevant content is being included – which ensures they cover most, if not all, of the eventualities that today's market dynamics can throw at them.
So what are the main differences in LPAs from say ten or 15 years ago? The first is undoubtedly consistency. There is some degree of constancy in the way in which modern LPAs are drafted. According to Sandra Pajarola, head of private equity direct investments at Swiss-headquartered Partners Group, legal advisors are now far more likely to be delivering relatively homogenous documents: “Ten years ago, there were many different lawyers within private equity, each creating their own, varied documents. Nowadays, lawyers read each other's documents more and LPAs are becoming more standard.”
Consistency in documentation has evolved not just from the fund formation specialists' pinching the best bits of each other's language (although that has certainly been a factor), but also as a result of the maturity and institutionalisation of the industry as a whole. Blair Thompson, fund formation specialist and partner at UK law firm SJ Berwin, says: “Private equity – particularly European private equity – has become much more of a mainstream activity and people in the business now have a number of years' more experience.” Crucially, the know-how garnered by private equity managers and investors in the last ten years has been of a practical, rather than theoretical, nature.
While LPAs have adapted with changing times and new legislation, they also had to be developed to accommodate situations that are increasingly likely to arise in the dayto- day life of a fund. Says Thompson of the Freedom of Information Act (FOIA) that obliges some US and now also UK public sector institutions to disclose details of their private equity investment activity: “FOIA is a good example: where previously a clause dealing with disclosure provisions might run to a paragraph, now FOIA clauses may take up a page, listing out various scenarios – based on fund managers' real experience of trying to operate those clauses.”
Other clauses attracting increased attention include termination provisions, corporate governance and terms governing the transfer of limited partners' interests. Whilst discussions about some issues – reporting requirements, investment policy restrictions – will often originate from LPs, others will tend to come at the behest of the GP. The growth in the secondary market and the increasingly frequent sale of partnership interests for example means that GPs' lawyers are spending more time finessing and adding to the sale and transfer provision clauses within the LPA.
MORE, NOT LESS
The scale of a fund's limited partnership agreement depends on a wide range of factors but the overall length of these documents seems to be increasing, before even considering the proliferation of side letters tacked onto a typical LPA. SJ Berwin's Thompson estimates that in the last ten to 15 years, the length of a typical LPA coming out of his firm has risen from perhaps 40 to over 60 pages.
This in part seems to derive from a wariness to streamline the language, the principle here being that a belt-and-braces approach will never return to haunt you. According to Michael Harrell, co-head of the private equity funds group at New York-headquartered Debevoise & Plimpton LLP: “Where firms have used the same form for many funds, the LPA can look like an old sailing ship with lots of barnacles attached.”
Harrell also makes the point that while select provisions in LPAs change over time, for established private equity firms the basic structure hasn't changed enormously: “For a firm that is raising fund number nine or ten, it's often a case of changing the Roman numeral and making a few minor tweaks before sending the documents to investors.”
LPAs will never be able to cover every scenario – some new development will always crop up that no-one thought of
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The most significant change within the LPA from Harrell's perspective has been in the drafting of economic provisions. Over the last two decades he has seen the model shift from an allocation-driven format to a more userfriendly, distribution-driven model. “Originally, LPAs were written like partnership agreements for tax shelters with the economic deal embedded in complex tax allocation provisions. However, modern LPAs contain a distribution waterfall that describes how the cash proceeds or securities will be distributed to the partners and the tax allocations are forced as much as possible to follow the distributions.”
The distribution waterfall is also one of the major differences between traditional US and European partnership agreements. In the US, GPs normally get paid carried interest (carry) on a dealby- deal basis, once they have passed a hurdle return rate for the fund's LPs (normally 8 percent per annum), and hence receive profits earlier on in the life of a fund. The typical European model requires a fund manager to pay back all contributed capital to limited partners before the GP receives any carry.
Harrell believes one of the consequences of establishing a reasonably tried and trusted distribution-driven model is that economic provisions in LPAs have become shorter.
The overall increase in length of LPAs is due to the additional detail in the governance provisions of the LPA. Much of this additional detail has been included as a result of the increased assertiveness of LPs and greater responsiveness from GPs, says Harrell: “LPAs have gotten longer primarily because most agreements now anticipate a lot of the comments and requests that limited partners tend to make.”
THE TERMS THAT MATTERA ranking of LPA provisions deemed most important by GPs and LPs respectively reveals much commonality – as well as areas where the sides disagree.
|General Partners||Limited Partners|
|1 Waterfall structure, carry calculations||1 Waterfall structure, carry calculations|
|2 Management fees||2 Clawback provisions|
|3 Clawback provisions||3 GP conflict issues, including allocation|
|4 GP capital commitment||4 Key man provisions|
|5 Limitations of liability for GPs||5 Management fees|
|6 Indemnification by GPs, LPs||6 GP capital commitment|
|7 Investment strategy, limitations and||7 Side letters and MFN|
|8 Fundraising period, investment period||8 Investment strategy, limitations and|
|9 Permitted activities of GPs||9 Permitted activities of GPs|
|10 LP approval rights||10 Portfolio company fee offsets|
RELATIONSHIP FIRST, LPA SECOND
In parallel with improvements in LPA drafting, so the lines of communication and discussion between LPs and GPs have advanced too. Notwithstanding publicised cases in 2004 including Forstmann Little's showdown with the State of Connecticut in the US and the revolt of 11 limited partners against UK GP Albemarle, LP/GP disconnects rarely reach the public domain. As one practitioner puts it: “The private equity industry isn't generally antagonistic. While there are lots of behind-the-scenes negotiations, LPs and GPs rarely get into the sorts of disputes that need to go to court.”
Over-analysis of the internal mechanics and nuances of a limited partnership agreement can mask a more fundamental point – and one that arguably can never be documented. Says Debevoise's Harrell: “An LPA sets forth the framework for the relationship between a fund sponsor and LPs – but it cannot create or be a substitute for that relationship.” While the past decade may have been marked by evolutionary changes in the area of LPA drafting, Harrell believes that bigger changes have taken place in the overall relationship and levels of communication between GPs and LPs. These parties have a more regular – and much more informed – dialogue today.
“Where firms have used the same form for many funds, the LPA can look like an old sailing ship with lots of barnacles attached.”
One reason why disagreements between a GP and its LPs are best served by discussion not litigation is that private equity is a cyclical business. It is in no GP's interest to air soured relationships in a courtroom. Conscious that, as in all contract disputes, the contractual interpretation will be against the drafter, general partners will not want to garner a reputation for intransigence – or crafty LPA negotiation – because other investors will notice. And that will be a consideration when the GP raises its next fund. As Sandra Pajarola puts it: “The good funds tend to maintain a fair standard when negotiating LPAs.”
As the central, guiding document in the relationship between limited partners and fund managers, LPAs have come a long way since the early days of the industry when, as one general partner admitted, “they were fairly shambolic”. While industry-wide consolidation of LPA terms and conditions may not be a reality in the foreseeable future, as the private equity industry continues to mature, so too limited partnership agreements are evolving as comprehensive, upto- date documents, capable of providing a stable, dependable framework for the co-existence of the GP and the LP. After all, these two parties are expecting to have to live together for ten years or more. Best to have competent paperwork to support them.