Model LPA – useful protection or unnecessary guide?

With concerns about a looming recession and the end of the business cycle, limited partners are becoming more cautious when selecting investments and negotiating fund terms with their private equity managers. 

The Institutional Limited Partners Association (ILPA) recently launched the Model Limited Partnership Agreement (LPA), which is a legal template that sets out new standards for alignment of interests between LPs and GPs. Central to this is benchmark language and terms aimed at reducing the complexity, cost and resources required to negotiate the terms of investment in private equity funds. 

While the Model LPA is a Delaware-law-based structure, it actually takes a major cue from a more European tradition by being a "whole-of-fund" waterfall LPA.

Says Edyta Brozyniak, a partner at MJ Hudson: "The 'whole-of-the-fund' waterfall in this first version of the Model LPA illustrates a strong belief that this type of waterfall, albeit not that common in many US-centric funds, is most equitable and protects the investors, especially in any economic downturn."

Weather-proofing
A downturn is anticipated by many market participants, as evidenced by a Natixis global survey of institutional investors published in December. A very large proportion (83%) of responders said they are expecting a financial crisis within the next five years, and 58% believe that a recession will happen within the next three years. Thus, investors are on the hunt for anything that could waterproof their portfolios from the next recession and give them an extra layer of protection.

"The Model LPA promotes a better protection of investors, especially in a downturn, with the emphasis on the return of all drawn-down capital first before the manager receives carried interest, with the payments into escrow and a GP clawback," says Brozyniak. "The returns to the managers is more aligned with the returns to the investors, with more certainty that at the end of the fund the investors will not end up underpaid compared with the GP."

LPs also seem to think that the standardised document can be a useful benchmarking and comparison tool when selecting a GP. Limited agreements tend to be unique per fund, but the standardised document can result in a tool that would give LPs an assurance that a manager maintains high transparency and governance standards.

Furthermore, the Model LPA can be a useful tool for GPs that use the legal document to minimise the number and scope of side letter agreements with their LPs. It can also be helpful for emerging GPs that are raising their first fund, and who would find the concepts and managers' protections useful when negotiating with big investors.

"The Model LPA appears to contain most of the key provisions that a lender would want to see in respect of defaulting partners," says Reed Smith partner Leon Stephenson. "It contains the ability of the general partner (GP) to impose penalties on defaulting partners – like forfeit of interest – and also contains express overcall rights, allowing, for instance, the GP to make up any shortfall by drawing down against non-defaulting partners."

If it ain't broke
Not all aspects of such a standardised document will be met by universal praise. For instance, Stephenson cautions lenders to take particular note of the reference in the Model LPA to short-term borrowing being limited to six months: "Such a definition doesn't accord with reality. In practice, funds view up to 12-month borrowing as short term, and so it is likely that the ILPA has made the model too restrictive."

Stephenson adds that the Model LPA does not seem to address the need for fund financing. He says that it seems likely that most funds will need more flexibility and additional powers to ensure they can incur the necessary finance to operate and administer the fund.

Others have more fundamental reservations. With LP agreements being heavily negotiated, Alexandrine Armstrong-Cerfontaine, a partner at Goodwin, says she is not too sure if a standard solution would be adequate for private equity funds: "Every private equity fund is unique, it is the result of a negotiation, and the outcome of that negotiation is a balanced document in the end. Standard terms without considering local tax and regulatory requirements in different European countries, which impact on the terms of any LPA, are not very helpful."

Goodwin partner Michael Halford agrees that the limited partnership agreement is a bespoke and dynamic document, which is constantly developing and unique to each fund depending on the situation and requirements of both the investors and the GP. He adds that an ideal closing partnership agreement for an LP might not be an ideal close for a GP. "It's overly simplistic to say that if you change the starting point of the limited partnership agreement then that will minimise costs," he adds.

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• Topics
• Fundraising
• LPs
• GPs
• Goodwin
• MJ Hudson
• Reed Smith