ILPA has been working productively over the last months – and has made a number of recommendations that are important for the private equity fund structuring practice. These include the new compendium of principles, called ILPA Principles 3.0, which builds on and develops previous recommendations. Fund managers (GPs) and fund investors (LPs) are well advised to take a closer look at these recommendations – as they will have an influence on the drafting and negotiation of fund documents.
Who is ILPA?
ILPA stands for “Institutional Limited Partner Association”. It is the world’s most influential industry group taking care of the interests of institutional investors in the sector of alternative investments. ILPA has over 500 members from more than 50 countries that manage in aggregate more than USD 2 trillion of private equity investments.
ILPA understands its role as informing investors and the market as well as increasing understanding of investor concerns. ILPA also aims to establish best practice standards from an investors’ perspective for fund investments. This includes various publications, such as sample reports for capital calls and distributions as well as quarterly reports (2011), reporting templates for fees, costs and carried interest (2016), sample questionnaires for due diligence (2018), recommendations on current specific issues (use of credit lines  and so-called GP-led secondaries ) and, more recently, model agreements.
However, the most important ILPA publication is the compendium “ILPA Principles” – a set of recommendations for the structuring and drafting of fund agreements. ILPA first published them in September 2009 (ILPA Principles 1.0) and then in January 2011 (IPA Principles 2.0). This was at the time of the financial crisis. Since then, not only the dynamics of the balance of power between GPs and LPs has shifted considerably towards fund managers. In addition, a number of important developments have occurred in daily fund practice that were not addressed in previous recommendations.
ILPA Principles 3.0
It was therefore welcomed by the asset management industry when plans were announced that ILPA intends to update its previous recommendations after a break of several years. At the end of June 2019, the new ILPA Principles (ILPA Principles 3.0) were published. ILPA has left the basic structure of previous principles unchanged. The recommendations are divided into three principles: alignment of interests between GPs and LPs, governance and transparency.
Alignment of interests
ILPA’s main objective is to draft fund agreements in such a way that a balance of interests is achieved between GPs and LPs. This concerns in particular the structuring of the fund economics. Particularly noteworthy here is the substantial capital commitment of the GPs in the fund’s capital – to ensure that GPs and LPs are “in the same boat”. In essence, the Principles 3.0 repeat the recommendations made previously. The new aspects include in particular:
- Carry clawback (i.e. repayment obligation in the event of excess payment of carried interest): all repayments should be gross of taxes paid (as already in Principles 1.0) and should be paid within two years of the obligation at the latest;
- Preferred return (“hurdle rate”): should be calculated from the time when the investors’ subscription capital is “at risk”. When using a credit facility, this means that the focus should not be on the time when the capital is called by investors, but rather on the time when the credit facility is secured with the investors’ undrawn capital commitment;
- GP ownership: explicit disclosure obligation for changes in the ownership of the GP or the management company, in particular in case of transfer to third parties (also with regard to carry entitlement). This recommendation addresses the increasingly observed trend of minority holdings of specialized investors in fund management companies.
The main objective of fund governance is to maintain a balance of power between GPs and LPs. To this end, the following new aspects have been identified:
- Restriction of the GP’s sole discretion: ILPA emphasizes the GP’s fiduciary duties towards the fund and opposes efforts (especially in U.S. funds) to exclude them by contract.
- Suspension or termination of the investment period (no fault suspension/termination): simple majority (instead of 2/3 majority) of the investors should now suffice.
- Removal of the GP without fault (“no fault divorce”): requirement of a lower qualified majority of the investors’ capital (2/3 majority instead of 75% majority requirement).
- Investor Advisory Committee: ILPA further upgrades the section on the investor advisory committee with detailed proposals.
- Amendment of the limited partnership agreement: requirement of a “qualified majority” of the investors’ capital (without detailing the exact majority requirement); previously ILPA had considered a simple majority sufficient for amendments to the fund agreement, with the exception of specific points.
- GP led secondary transactions: recommendations for the involvement of investors and the investor advisory committee, detailed proposals for conflict management and transparency, structuring of the deal procedure and the advisors involved in the transaction.
- Co-investments: GPs should disclose rules for the allocation of co-investments when funds are established.
Having a transparent reporting system for funds is becoming increasingly important. ILPA highlights in this context:
- Management fee / other costs: A number of detailed proposalsaddress the calculation of the management fee and the disclosure of costs (fair and not misleading). This is not surprising, given the growing attention that regulators have also paid to the detailed disclosure of cost allocation between funds and management.
- Credit facilities: ILPA reiterates the recommendations already made in the specific recommendation of 2017.
- ESG Policies & Reporting: ILPA recommends regular updating of the GP’s ESG policies. The consultancy costs in connection with ESG due diligence should be borne either by the management fee or by the portfolio companies themselves.
From ILPA Principles 3.0 to ILPA Model LPA
Unlike previous versions of the ILPA Principles, ILPA has not left it at rather general recommendations, but has proposed concrete contractual clauses. In December 2017 ILPA had already published a model subscription agreement for private equity funds. At the end of October 2019, ILPA published a first model limited partnership agreement. The agreement is based on ILPA’s Principles and puts the Principles in practice – by proposing detailed contractual clauses. A future newsletter will analyze the model LPA in greater detail.
The publication of the updated ILPA Principles is welcomed by the private equity industry. The changes to the existing recommendations are rather limited and focus on certain specific points – the general direction is left unchanged (evolution instead of revolution). However, a number of developments in recent years (secondary transactions, ESG, credit facilities) had only played a minor role, if any, in the previous version of the ILPA Principles in 2011. Investors welcome the now very detailed recommendations on these points, which are very important in practice. However, a number of equally important points (e.g. dealing with the growing number of side letter requests) were not or only briefly addressed by ILPA. It should also be noted that ILPA Principles represent a desirable best practice from an investor’s point of view – which deviates in certain aspects from the current market standard. Thus, the ILPA Principles (especially in combination with the ILPA model LPA) offer an important orientation for investors in fund negotiations. But at the same time – from the point of view of the GP – they can only be the beginning and not the end of LPA negotiations.
Incidentally, it looks as if ILPA will continue at high speed in 2020. The first German ILPA conference was held in Frankfurt am Main at the end of January, followed by another European one in London. ILPA has stated its desire to gain new members in the form of investors from Europe. ILPA is not running out of topics: At the end of February, ILPA published a “Diversity and Inclusion Roadmap” for the private equity industry. Stay tuned – future developments will have to be watched closely.
P.S: Diversity is also becoming more important for the private equity industry in Germany. In March, the winners of the inaugural “PE Diversity Awards” were announced in Frankfurt am Main.
A German language version of this article was first published in the WM Private Equity Newsletter. The author is grateful for the granted permission to a secondary publication in the PE Magazine.
ILPA and other influences on LPA terms