The small print looms large

Now that the tide of US private equity has receded from its frothy, late-90s heights, many limited partners are feeling exposed. What they have discovered is that, in a down market, the partnership terms and conditions to which they agreed do not provide them as much protection as might be desired.

In fact, as one would suspect in a hot private equity fundraising market, the terms and conditions of many partnership agreements heavily favour the general partners. Such is the dynamic of supply and demand. Limited partners who, during the late 1990s, would have agreed to almost any terms in order to gain access to prestigious funds are now wishing they hadn't been so accommodating.

These investors are becoming painfully familiar with bits of legalese to which they previously paid only scant attention. Now, terms like ?clawback,? ?no-fault divorce? and ?cross-funding? roll easily from the tongues of wary LPs. The following is a brief tour of some of the terms that are currently looming large, as well as some of the events that brought them into the spotlight:

?Clawbacks. Most partnerships have what is known as a ?clawback? provision, which calls for an accounting at the end of a fund's life to ensure that the GP group has not received more carry than it is legally due. If it turns out that the GPs have overpaid themselves, the LPs have the right to ?claw back? capital until the numbers are straight.

Recent market conditions in the US, particularly those affecting 1999- and 2000- vintage venture capital funds, have made clawbacks a real concern. Some funds that enjoyed enormous liquidity events early in their lives have now fallen on hard times. For these funds, the overall, aggregated IRR may be well below the initial IRR upon which early distributions were based. As such, GPs would have to give money back to their investors. There are potential problems with this ?true-up?: the GPs might not actually have the money anymore, and even if they do, terms of the clawback may not make it easy for LPs to go after the GPs' personal wealth. In addition, clawback terms usually allow GPs to return distributions on a net-of-taxes basis, meaning LPs do not ultimately get all their money back.

In an effort to mitigate the pain of clawbacks, some investors are attempting to make private equity partnership distribution terms more akin to those found in real estate partnerships. The later asset class usually mandates that LPs first receive distributions equal to their entire commitment, plus a preferred rate of return, before GPs can begin rewarding themselves with carry, thus negating the need for clawbacks. At the very least, some LPs are asking that carry distributed to GPs be placed in escrow to enhance the clawback guarantee. And while legal experts expect the net-of-taxes clawback to remain a standard term, many market participants would like to see greater uniformity in how the tax withholding is computed.

?No-fault divorce. Firing your GP group is not an easy task. The terms governing the firing of GPs mostly are designed to make such an action extremely difficult. Now that a great number of investment partnerships are proving themselves about as successful as the Titanic, some LPs are exploring ways to bail out. A no-fault divorce is usually enacted through a ?supermajority? LP vote. Usually, the support of between 75 per cent and 85 per cent of LPs (on a capital-weighted basis) is required to halt or wind down an investment partnership. Getting enough LPs comfortable with undertaking this extreme measure is a difficult undertaking. ?It's very difficult to get collective action at a 75 per cent level,? says Louis Singer, a partner at law firm Orrick, Herrington & Sutcliffe in New York.

One recent successful no-fault divorce occurred in LJM2, a private partnership created by Enron's former CFO, Andrew Fastow. His successor to that fund, Michael Kopper, was ousted by angry LPs earlier this year through a supermajor-ity vote and a Delaware Chancery Court decision.

?For-cause removal. While no-fault divorces can be enacted for any reason, if an LP group wishes to remove a GP group because it believes wrongdoing has occurred, it may have to do so ?for cause? (as long as this term appears in the partnership agreement). This, too, is a difficult task. Just to make a GP group liable, as opposed to removable, for problems in a partnership, the LP group must usually prove that ?gross negligence? has occurred. For a court to find gross negligence, LPs would be required to prove that the GPs blatantly breached their fiduciary duty, or even committed out-and-out fraud, as opposed to merely having made bad investments.

Successful removals for cause are few and far in between. One of the only well-known cases of this nature occurred in 1996, when LPs successful rid themselves of the management of Madison Group LP, a New Haven, Connecticut, buyout fund that allegedly purchased, and then ran into the ground, a number of companies already partially owned by the GPs.

While LPs may try to structure funds that are easier to wind down when the going gets rough, Singer points out that limited partnership agreements remain popular vehicles for long-term investment precisely because they enforce long-term investment objectives.

?GP legal fees. One frustration LPs may encounter when attempting to fire their GP, at least according to the terms of most partnerships, is that GPs may draw from the fund they manage to pay legal fees, in effect forcing LPs to pay for both sides of the battle. Singer says he thinks LPs may begin to ponder changes to partnership terms that would prohibit GPs from ?rubbing salt in the wounds of aggrieved LPs? in the event of a no-fault divorce or a for-cause removal.

? Cross-funding. Success has many fathers, but failure is an orphan, or at least LPs would prefer not to be given custody. When valuations are on the rise, the practice of investing in a good deal from more than one fund makes everyone happy. But when, for example, capital from Fund II is used to prop up a lousy investment in Fund III, or vice versa, LPs start to wonder whether they should have demanded terms that forbid cross-funding. This issue has touched the investors in Forstmann Little & Co.'s buyout fund, some of whom were angered that the firm committed capital from a number of funds in the same troubled telecom company. Forstmann Little plowed more than $1.5bn from a 1997 pool of capital into XO Communications, and later committed an additional $400m from a 2000 vehicle to an XO restructuring, which may wipe out the value of the stake held by the LPs in the 1997 funds. In 2000, Texas buyout firm Hicks, Muse, Tate & Furst raised eyebrows when it took a number of losing PIPE deals originally intended for its fifth fund and placed them in the firm's fourth fund.

Cross-funding is not always seen in a negative light. Silicon Valley venture capital veteran Kleiner, Perkins, Caufield & Byers recently proposed investing capital from Fund IX (vintage year 1999) alongside Fund X deals in order to give Fund IX investors access to better valuations, an action that many of its LPs reportedly applauded.

?Default penalties. This is a provision that everybody agrees is a good thing – everybody, that is, except the investors who can't make a capital call. Those unfortunate LPs, most of them individual investors, who are unable or unwilling to continue fulfilling the requirements of their partnerships, are encountering terms that dictate severe penalties for their recalcitrance. One common default penalty is for the value of their existing capital account with the fund to be cut in half, with the severed half of the account distributed to the other LPs. Some terms allow partnerships to sue deadbeat LPs to secure the required investment capital.

Of course, none of these terms would be at all interesting if US private equity funds were still getting the kinds of returns that they did up until the middle of 2000. Of all the lines that LPs now wish they had paid closer attention to in their partnership agreements, perhaps the most significant one was this: ?Past performance is not indicative of future performance.?

David Snow is the editor in chief of, a New York-based website providing news and information on the private equity industry.