The Institutional Limited Partners Association’s guidelines for fund terms and conditions have caused LPs to take a harder look at their rights in governance matters. Specifically, some LPs are seeking to negotiate stricter fiduciary duties in new funds, as well as the right to approve conflicts of interest through advisory committees.
In the past, GPs have tended to use the same standards of care from one fund to the next – it hasn’t been an area that attracts much scrutiny, says Craig Miller, a partner at law firm Manatt, Phelps & Phillips. But now LPs are asking for specific language prohibiting “gross negligence, fraud, and willful misconduct”, rather than allowing provisions that allow the GP to reduce all fiduciary duties to the fullest extent allowed by law. Some LPs are even asking that simple negligence, rather than gross negligence, be the standard.
But LP attitudes towards conflicts of interest provisions is the bigger change, Miller says. Most fund agreements require that GPs notify their LP advisory committees of any situations that present a conflict of interest at year end. But LPs now want the GP to present conflicts of interest to the committee for approval.
“I think with any established fund, there has always been some LP advisory committee role,” Miller says. “What we’ve seen is that in terms of what’s presented to the LP advisory committee for their prior approval or consent, versus what’s presented to them after the fact as mere information, has changed.”
There are several types of situations which would require LP approval under these new terms. One would be if a member of the GP wanted to make a personal investment that fell within the fund’s investment purpose. This has happened in the venture capital community in the past, and if the manager earns a good return on a personal investment, the LPs will want to know why he didn’t give the fund the opportunity to invest.
“The overlap of personal investments relative to the investment focus of the partnership is a matter of concern,” Miller says. “LPs want to make sure the managers aren’t violating their duty of loyalty to the fund by capitalising on personal investments and not taking advantage of investments for the fund as a whole.”
Of course if a manager does invite the fund to invest alongside him there’s also the worry that he’s trying to get the fund to prop up the company to protect his personal investment.
Another potential conflict of interest that has become a particular area of concern in recent months is when a follow on fund seeks to invest in a portfolio company in which a predecessor fund has a stake.
“Particularly since we’ve been in the down cycle, you definitely see more concern from LPs that new vintage funds will be used to protect old vintage funds’ performance,” Miller says. “That’s an area of concern where LP advisory committees are becoming increasingly active and wanting to make sure they have the opportunity to review and approve investments. New investors don’t want to see their funds being used to cover up older vintage fund investments without their input. The perception from LPs is that general partners can use new money to enhance the ability to raise future funds and generate management fees. LPs don’t want that ability to be unfettered.”
GPs generally don’t like to give LPs authority in their day-to-day investment decisions; their view is that having to seek approval for transactions makes them slower and less competitive. But as power shifts to LPs, they may have to get used to it.