Terms for a changing market

In 2004, US sponsors who launched new funds pioneered a number of new terms and conditions – to accommodate regulators and LPs, gain an edge over the competition, or both. Louis H. Singer of law firm Orrick reflects on the main developments.

In a year in which leading investors increasingly sought competitive advantages for their portfolios, and sponsors considered new vehicles or dusted off old ones (with “business development companies” being the most notable), the basic format for US private equity funds, the Delaware limited partnership, remained the same. In some cases, the terms and conditions of limited partnership agreements resembled new wine poured from old bottles. But for most new funds, there were important changes that were proposed and then negotiated among participants in the market for institutional private equity funds.

Fund sponsors who proposed new terms in the course of raising a fund for the most part did so for one or more of three reasons:  first, as a reaction to changes in law and government regulation; second, as a result of outside forces affecting the limited partner community; and, finally, as a result of strategic considerations leading sponsors to seize an advantage, conform to the market or create inducements for investors.

Changes in law and regulation

Delaware continues to be the jurisdiction of choice in the US, not only because of what the law provides and how it is interpreted, but also because it continues to be examined and amended.  (A comparison might be made to New York State, which, to the concern of many private equity professionals, proposed new publication requirements for limited partnerships that would create additional costs in qualifying a fund to transact business in New York without apparent benefit.)

Delaware amended its limited partnership statute in 2004 in a manner that affects the fiduciary duty of general partners. Although the Delaware Act now states that a limited partnership agreement may eliminate the fiduciary duty owed by the general partner to the limited partners and the partnership, it has an important qualification:  it may not eliminate the 'implied contractual covenant of good faith and fair dealing”. 

Where does that leave limited partners, who have, after all, delegated investment discretion to the general partner of the fund?  The answer lies in another important principle of Delaware law:  freedom of contract. Limited partners, aided by their counsel, should review the terms of new partnership agreements with increased care to determine whether the standard to which the general partner is held, including all qualifications to such standard, are acceptable.

The US enacted another broad federal tax act last year, entitled the “American Jobs Creation Act of 2004”. While this was not the comprehensive tax overhaul being discussed by the current administration and Congress, it does create certain complications for sponsors in respect of how they structure their internal economic arrangements.  On the other hand, it should not have a significant impact on the terms offered to investors in funds. 

At the same time, the changes related to section 754 of the Internal Revenue Code will have the effect of requiring downward basis adjustments (similar to the adjustments required when a section 754 election is in place) in the event of a transfer of an interest in a fund that has a significant unrealized loss in its assets.  The mandatory basis adjustment can be avoided if the fund qualifies for and elects treatment as an “electing investment partnership.” In this event, the transferee partner will not be allowed to claim tax losses upon the sale of partnership assets until such losses exceed those recognised by the transferor partner or its predecessors.

The most significant regulatory change in the private investment fund market – the adoption by the Securities and Exchange Commission of a new rule regarding registration under the Investment Advisers Act of 1940 – will not affect most advisors