From an investor point of view, participating in private equity requires commitment. The decision to become a limited partner in a private equity fund means capital going into the fund is tied up for the long term. Discretion over how the money is run lies with the fund's manager, who as general partner is paid a fee for performing this role. Once the document governing the fund's conduct, the limited partnership agreement, is signed, there is limited scope for investors to take an active role in the fund's business and to keep checks on the manager's decision-making. That's commitment.
Prior to the market crash that the industry is currently recovering from, no one thought this much of an issue. It was simply the way the industry worked. As long as the amount of money coming out of a partnership was substantially greater than the money going in, what did it matter that investors often didn't know much about, let alone have a say in, what happened to a fund along the way? Wasn't it in fact one of the industry's strengths that investment managers were not constrained by the kind of consent and disclosure obligations that burden corporations?
‘Yes’ was most people's answer to that. It arguably still is: private equity partnerships rely on their managers' ability to invest quickly and without having to go through long-winded approval processes with their investors. “Private equity managers often make money because they are nimble, streamlined operators,” says Nigel Hatfield, a London-based partner in the private equity funds group at Clifford Chance. “Building an infrastructure which is potentially cumbersome and time consuming could negatively impact their ability to win deals.”
Investors acknowledge this. But the recent difficulties they have experienced in the asset class have led many to conclude that giving general partners too long a lead can be dangerous, and that they as limited partners should make best use of any means available to them to exert more control.
The most powerful instrument investors can use to do this is the LP advisory committee, a board usually comprising several of the fund's investors. However, just how powerful a vehicle this committee really is, and how much influence it does and ought to have, is subject to debate.
Many practitioners believe that the LP committee should act as a body exercising genuine corporate governance over the management of a private equity fund. It is the LP body that should make sure a fund's declared strategy is being pursued, investments are valued properly, conflicts of interest avoided.
One investor subscribing to this view is Jens Bisgaard-Frantzen, managing partner at ATP Private Equity Partners, the fund investment arm of giant Danish pension fund manager ATP. “The advisory board should monitor how the fund strategy is being executed” in terms of risk profile, deal size, the proportion of lead and follow-on investments in the portfolio and the composition of the investment team.
Hatfield at Clifford Chance also thinks that the advisory board is the appropriate vehicle for LPs to keep checks on the manager. He says it is the board's task to “review the progress of the fund” and to ensure it achieves its investment objectives while operating strictly within the constraints set by the fund's original investment strategy.
Kelly DePonte, a principal at San Francisco-headquartered placement agent Probitas Partners, adds that the board can play an important role in acting as an “early warning system” in situations where managers are, inadvertently or otherwise, in danger of creating conflicts of interest: “GPs are good at investing but are often not so clever at understanding the possible ramifications from an LP's point of view,” he says. “LPs can play a vital role in exposing potential firestorms.”
Sceptics maintain that while all of this is good in theory, it doesn't work so well in practice. They point to the fact that advisory boards operate in a legal vacuum, where they do not have the actual power to impose sanctions on managers that they consider in breach of the partnership agreement.
Because, as Josyane Gold, a partner at the private equity group of SJ Berwin notes, LP committees have no status in limited partnership law, it is left to each partnership to specify the circumstances under which GPs should seek committee approval for a proposed course of action. Often these principles are embedded in a constitution that may either be written into a fund's limited partnership agreement itself, or is drawn up at the first committee meeting once a fund is up and running.
Jonny Maxwell, chief executive of Edinburgh-based fund of funds manager Standard Life Investments (Private Equity), is one of the most vocal champions of the view that advisory boards perform a role that is indeed critical and must be taken seriously.
Maxwell agrees that the absence of legal powers enabling LPs to vote on and then force action is a serious limitation. That is why his group places a great deal of emphasis on the importance of there being an appropriate constitutional frame-work instead. Prior to going into a fund, he says, investors ought to come up with a list of non-prescriptive corporate governance principles and have the fund embrace it as a means of pre-emptive self-regulation.
Maxwell and his colleagues at Standard Life work with such a list, and use it also in connection with the advisory committees of their own funds (see also At the very least, left).
Still, the absence of any real legal power to penalise managers is the core argument of those who believe advisory boards are more or less toothless. As one critic puts it rather drastically: “Without any authority in law, advisory boards serve very little purpose. They are pure window-dressing.” This professional goes on to suggest that for LPs to have genuine influence over a manager, they would have to sit on the board of a private equity firm's management company where they would have to be indemnified against litigation in order to protect their limited liability status.
However, this view is at odds with the vast majority of opinions expressed in interviews for this article. Most LPs as well as GPs appear to accept that despite the legal restrictions, the advisory board is indeed a meaningful institution whose members' judgement and attitudes managers ignore at their peril.
Following the market turmoil of recent years, the idea that it is necessary to take a more active, though perhaps not outright ‘activist’ role, in the funds they invest in is now widespread among the buy side. This is partly reflected in the gradual change that has occurred in the way limited partnership agreements are structured in order to ensure all parties' interests are aligned.
An important example is the recent rise of provisions enabling limited partners to remove managers in the event that their conduct is deemed inadequate. Legal professionals note that so-called ‘no fault divorce’ clauses, i.e. provisions that allow a supermajority of LPs to vote either to suspend the investment period or to remove the GP, in either case without cause, are now standard in European partnership agreements. (They have long been common in the US.)
Invoking this clause requires a consensus among LPs that to do so is justified. This consensus cannot be established without significant LPto-LP communication. The LP advisory board is the obvious vehicle to orchestrate the necessary dialogue.
It is also worth noting that a manager's removal is an extreme measure that investors will only consider once trust in a fund's management has completely collapsed. The advisory board has a responsibility to prevent such a crisis by taking its own role seriously and staying close to both the general partners and the investors whose interest they are expected to protect.
Neither should one forget that although investors say not every GP treats his advisory board with the respect it deserves, most managers are aware of the need to work with the board rather than against it. Frank Morgan, head of US operations at secondaries specialist Coller Capital observes, GPs know only too well that they will jeopardise their fundraising prowess – and hence the longevity of their firms – by ignoring their LPs and the advisory board representing them. Taking shortterm action may be difficult for LPs – penalising a firm further down the road by refusing to invest in their next fund is not.
WHAT GPS WANT
It is perhaps not surprising that, far from relating anecdotes of problems stemming from overly belligerent advisory boards, managers are more likely to complain about a lack of competence and engagement on the part of investors that limit a board's effectiveness. This may be a convenient excuse for some GPs. But even LPs support the view that investor inertia, insufficient know-how and a tendency to discount their own influence as committee members are often the reason why their impact on a fund's affairs may be negligible.
Part of this issue is that boards often comprise representatives of those institutions that made the largest capital commitments to a fund, rather than individuals who are best suited to the tasks at hand. ATP's Bisgaard-Frantzen argues that more flexibility not least on the part of the managers would be helpful here: “GPs should come to see the advisory committee less as a requirement and more as something valuable to be used actively to gain advice on best practice. The bulk of GPs still allocate seats on the basis of the amount of capital committed, but we would encourage them to focus more on insight and international experience in private equity.”
Maxwell agrees: “It's not the investors who commit the most money to a fund who should sit on the LP committee. They need to have the experience to add value. Certainly, we will only invite experienced LPs to sit on our committees.”
And George Anson, London-based managing director at fund of funds powerhouse HarbourVest Partners, notes: “There is a danger that the committee can become de-based when it's just used as a training ground for junior staff.”
This isn't always the institutions' fault, however. Practitioners like Anson acknowledge that internal staff turnover can be a problem. In a recent interview with Private Equity International, Anson recalled a general partner's insistence that every member of his fund's original LP committee participated throughout. This proved illusory: “After five years, all seven committee members had changed, except me,” Anson said.
Bisgaard-Frantzen says a periodic vote on whether board representatives should retain their seats and the removal of committee members for repeated failure to attend meetings would help ensure quality. Others advocate that general partners adopt the kind of compensation schemes for advisory board members that corporate entities provide for nonexecutive directors.
Investors with a strong presence in the asset class like HarbourVest and ATP typically seek representation at board level in every fund they invest in. Says Anson: “We're often the largest investor in a fund and many of our clients expect us to be involved. We would never turn a board seat down because of a lack of resources.”
Obviously not every LP has the capacity to do this. Some may be too small, while others are simply invested in too many partnerships to be actively involved in all of them.
Others still may simply not want to participate for fear of legal reprimands if things go wrong, preferring instead to play a passive role. “These days, everyone is looking over their shoulder at the exposure they may be assuming,” notes Josyane Gold at SJ Berwin.
And Jonny Maxwell sounds a note of caution: “The fiduciary responsibilities of board members have never been tested. But this may happen. After all the venture disasters that have occurred, people may point to the advisory boards and ask, ‘why did you let this happen?’”
So far there has been no evidence of this. If it does occur, it will certainly spark another debate as to what the LP advisory committee's role should be, and whether it is adequately equipped to play it.
AT THE VERY LEAST …
The following is an extract from the terms of reference for LP advisory committees / boards as used by Standard Life Investments (Private Equity) Ltd (‘SLIPE’).
SLIPE endeavours to have these terms of reference embraced by the funds it invests into and also uses them in connection with its own advisory committee.
The terms are adapted as required for individual funds' specific requirements.
ADVISORY COMMITTEE MINIMUM TERMS OF REFERENCE
The principal roles of the advisory committee will be:
FUND STRATEGY AND PERFORMANCE
The advisory committee will receive a copy of the valuation pack prepared by the general partner/manager each half year in advance of the relevant meeting.
The advisory committee will:
CONFLICTS OF INTERESTS
The advisory committee will review any potential or actual conflicts of interest between the general partner, manager and the partnerships.
ADHERENCE TO THE LIMITED PARTNERSHIP AGREEMENT
The advisory committee will review the general partner's and the manager's adherence to the limited partnership agreements.
Source: Standard Life Investments (Private Equity) Ltd