There’s a new Rorschach test in the private equity market in the form of the Institutional Limited Partners Association Private Equity Principles. Say the words “ILPA guidelines” to five different market participants and you may get five vastly different reactions, from a triumphal fist pump to a string of expletives to an outbreak of hives.
According to ILPA, the principles are meant as a “best practices document” that will bring greater alignment of interests to the asset class, thereby helping it grow. But just like a Rorschach inkblot, not everyone sees the guidelines the same way. Among limited partners, some apparently see the principles as the basis for a sort of “check the box” approach to partnership negotiations, and GPs who fail to check enough boxes are told to take their subscription docs back to the shop for modification.
Other LPs find the principles to be a useful aspirational benchmark, but recognise the realpolitik of the fundraising market. They say that most highly sought-after fund managers simply won’t accept a large handful of the suggested terms and conditions, and that there’s not much LPs can do about this.
The reaction among GPs is even more varied and interesting. Some (but only some) are openly supportive – Avenue Capital and Ares Management have publicly endorsed the principles, for example. But according to an LP who helped craft the guidelines, a few major GPs are “fighting this thing tooth and nail”.
It’s not hard to guess which of the suggested “best practices” some GPs find most objectionable. The call for management fees to merely cover “normal operating costs for the firm” as well as the preference for the European-style, LPs-get-all-their-money-back-first waterfall distribution formula would, if made the industry norm, seriously challenge the business models of big, established US firms.
But a GP doesn’t score many points by arguing that the management fee should be a wealth creator. So instead some GPs are finding other fights to pick with the ILPA Principles, among them that the guidelines may represent a “collusion” among LPs, and that the guidelines risk “piercing the GP veil”.
Although I’ve heard the collusion argument insinuated privately, I’m still waiting for the first GP to stand up and publicly accuse limited partners of behaving like Standard Oil Trust circa 1890.
Even if GPs were successful at getting, say, the US Department of Justice to glance at the ILPA Principles, it’s hard to see how politically things could play out in the favour of the GPs. On the one side are labour-affiliated public pensions trying to lower the fees they pay, and on the other side are buyout mega-millionaires saying they are victims of a Sherman Act violation.
Then there’s the “piercing the GP veil” argument. This relates specifically to a section of the ILPA Principles that calls for establishing an influential limited partner advisory committee, paid for by the fund or the GP, that would police valuation methodology and possible conflicts of interest as they occur. That would greatly increase the power held by the LP advisory committees that are already a common feature of most partnerships. Typical LP advisory boards would have been notified by GPs at year-end of any situations that presented a conflict of interest, for example, rather than having had the ability to approve such situations as they pop up. A number of GPs absolutely hate this idea. Their pushback against it is to say that overly intrusive LP advisory committees would risk making the LPs themselves liable for the actions of the GPs.
It is unclear where the middle ground lies with regard to the LP advisory committee. To what extent investors should have control over the decisions of the people who manage their money is a question that gets to the very core of partnership investing. The ILPA Principles do not suggest that LPs should have any say over the core duties of GPs – that being investing – but they do suggest that these LP advisory committees are “ideally suited” to have oversight of almost all other functions within the firm, including expenses, fees, strategy changes and new business initiatives.
Clearly, there are GPs out there who don’t want to live in a world in which they can’t extemporaneously and without LP permission launch an infrastructure fund, do a PIPE deal or open a Mumbai office. However, many LPs believe they have been living in just such a world for a long time, and they are sick of it.
One thing is certain – any GP seen to be fighting hard against the ILPA Principles had better have a commendable track record, or they may find enthusiasm for their next fund to be tepid. LPs may not be colluding but they are talking a lot more than they used to.