The limited partnership agreement (LPA) of a private equity fund structured as a partnership, deemed the constitutional document for the fund, is typically negotiated and determined by all partners at the stage when the fund is being raised. Preparations and negotiations leading to the conclusion of the LPA constitute a process where the general partner (GP) and limited partners (LPs) fight against each other for an arrangement that is in the best interest of each side.
The GP of a partnership fund has the discretion to make investment decisions for the fund independently, while LPs account for a lion’s share of capital commitment to the fund without being involved in the fund’s operation or management. In order to prevent the GP from abuse of power that might be detrimental to the LPs’ interest, and to encourage it to seek maximized return for the fund, the LPA governing the partnership between the GP and LPs, especially provisions relating to alignment of interests between the GP and LPs and those about fund governance and information disclosure, must be properly drafted. In the sections below we will see how LPs can protect their interest by ensuring proper drafting of core provisions in the LPA.
ALIGNMENT OF INTERESTS
Alignment of interests between the GP and LPs, an issue of utmost importance to be addressed under the LPA, involves core provisions that include, but are not limited to, those related to capital contribution from the GP to the partnership, management fee arrangements, and distribution of earnings.
The GP’s capital contribution to the partnership. To help achieve alignment of interests, the LPs may require that the GP accounts for a certain percentage of total capital committed to the partnership (customarily 1%, with upward or downward adjustment allowed depending on the size of the fund).
This arrangement can ensure, at least to some extent, that interest of the GP is aligned with that of the LPs. Some LPAs are even structured in such a manner that the GP is inferior to LPs in recovering its capital contribution. The purpose is to ensure that the GP exercises due care in making investment decisions in case of loss to the fund that results in total loss of the GP’s committed capital.
Management fee arrangements. The management fee applicable to a partnership fund is typically 2% per annum, usually calculated based on: (1) total paid-up capital; or (2) total committed capital. The latter applies during the investment period. During the exit period, a lower rate applies, and the management fee is calculated based on assets under management (AUM).
To facilitate alignment of interests by encouraging the GP to perform its management function more actively, arrangements can be made so that the GP’s income from the partnership comprises mostly of a carried interest based on performance of investments rather than a flat-rate fee on size of the fund. For this purpose, a management fee sufficient to cover management cost of the fund manager, but subject to an adjustment mechanism, is advisable for the LPs.
As distribution is concerned, the whole-fund waterfall and deal-by-deal waterfall models are most commonly used. Under the whole-fund waterfall model, 100% of the cash inflows from a realized investment is paid to partners of the fund until they have received an amount equal to their total capital contributions to the fund, and any excess capital is then distributed as returns or carried interest for the fund. The deal-by-deal waterfall model is an approach whereby 100% of the cash inflows from a realized investment is paid to partners until they have received an amount equal to their capital used in the realized investment, whereas the excess goes to partners as return or carried interest for the singled realized investment.
From the perspective of interest alignment, the whole-fund waterfall model is more favourable for LPs, because under the second one the GP is likely to receive carried interest before LPs recover 100% of their capital contributions.
Setting a threshold rate of return also helps in achieving alignment of interest. Once the capital contributions are returned, distributions will be made to the LPs until a specific preferred return (e.g., 8% per annum) is reached. Any amount left is finally allocated among the GP and LPs in pre-agreed proportions.
Given the relatively long-term and steady governance structure of a PE fund, its LPs may need an appropriate mechanism to cope with potential changes arising during the existence of the fund.
Provisions on key persons. It is not uncommon that LPs decide to invest in a fund because they are satisfied with the management team of the fund. If any change occurs to the management team, the LPs should be entitled to decide whether to accept the new team and proceed with their investments.
Advisory board. Investing activities of the fund may involve related-party transactions or conflicts of interest. Some funds allow the GP to address these issues in good faith at its sole discretion. For the purpose of protecting the LPs’ interest, an advisory board comprising of representatives of the LPs can be formed to make decisions relating to these issues.
The GP should disclose information about investments, basic financial conditions, costs and expenses of the fund to the LPs on a regular basis.
As the Asset Management Association of China (AMAC) continuously strengthens regulation over PE funds, managers (usually GPs) are required to fulfill disclosure obligation to the LPs, both at fundraising and operation stages of the funds. This includes performance and disclosure of an annual audit on the funds.
It should be noted that typically the GP requires the LPs to comply with the obligation of confidentiality with regard to the disclosures. If an LP is an investment vehicle (e.g., a linked fund, trust scheme or asset management plan) that is obliged to make disclosure to its investors, it should have sufficient ex-ante communications with the GP.
Liu Hui is a partner at Boss & Young
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