The success of a general partner (GP) led fund relies on balancing the interests of the GP and the Fund’s limited partners (LPs). The governance of these funds varies from other corporate entities since these funds are often set up for a specific investment purpose and sometimes only for a defined time period. The LPs are typically the passive partner in these funds. Investment and management are delegated to the GP. Additionally, in limited partnerships the LP could lose their limitation of liability if they interfere too actively with management. This delegation of authority can result in a misalignment of interests between the GP and LP over time.
Align Investment Interest
To keep these interests aligned, funds often follow some variation of the “2/20” fee structure. In this structure the fund manager receives a management fee of 2% of the capital deployed in the fund to pay for salaries and overhead. The 20 represents a 20% return over a certain threshold to compensate the GP for the performance of the fund. There can be downsides to this fee structure. The GP receives the management fee regardless of performance and has in incentive to raise money to increase the size of the fund. The performance-based compensation could encourage the GP to make risky investment decisions or pursue other business opportunities if the hurdle is out of reach. Tailoring the fee structure to meet the need of the transaction can reduce this risk. The fund should ensure that the GP has adequate cash flow for operations. A waterfall structure for the performance-based compensation could mitigate risks and add accountability for the GP.
In addition to compensation, funds often implement some or all the provisions below:
Termination of Investment Period
Many funds have a time period of four to six years during which the fund makes new investments. Since it takes some time for the fund to realize its returns, this period ensures that the fund will be able to liquidate in about 10 to 12 years. This process can be accelerated if key persons of the fund have departed, and no adequate replacements are available.
A more draconian and uncommon alternative is to provide the LPs the right to suspend the investment period. This option is present in a minority of deals and typically requires misconduct from the GP (i.e. “cause”). Care must be taken to ensure that this action occurs when there is wrongdoing.
Replacement of the Fund Manager
In contrast to the option above where the GP continues to manage the fund’s investment, GP removal clauses allow investors to replace the fund manager. In this scenario, the fund will continue to operate under new management. The former management may retain some compensation for investments made prior to removal with the management fee and incentive compensation mostly moving to the new GP.
These provisions typically require a supermajority vote for cause. GPs are unlikely to consent for removal clauses without a finding of misconduct. These provisions should only be used when the conduct of the GP justifies removal.
Termination of the Fund
Terminating the investment period addresses concerns on the ability of the fund’s investment team to identify and make new investments. However, if the problems run deeper the investors may want to liquidate the fund and distribute the assets to the investors. Liquidating the fund could get complicated if the fund is investing in illiquid assets or privately held securities. Distributing such assets to the investors passes the problem of managing and disposing these assets to the individual investors, which can create additional problems. As a result, this remedy is generally triggered for cause and/or a supermajority vote and should be reserved for the most serious situations.
Investor Withdrawal Rights
How quickly investors can withdraw their investments could be a source of conflict between GPs and LPs. Some investments (e.g. real estate, startups, pharmaceutical development) do not lend themselves to easy liquidity and require long gestation periods before the GP may be able to pay out the investors. Even if the investment is in a liquid asset, the fund may want to have a “lock-up” period before the investor can withdraw their funds. Greater control over liquidity makes it easier for the fund to meet its investment objectives. Early withdrawals before the end of the lock-up period are often subject to a charge and other withdrawals may still be subject to the approval of the GP. These provisions need to be tailored for the economics of each transaction and if possible, provide some liquidity to the LP.
Information rights and Transparency
An essential component of effective governance is providing LPs with information rights and ensuring transparency in fund management. Limited partners typically have the right to receive regular reports on the fund’s performance, financial status, and investment activities.
This transparency fosters trust and allows LPs to make informed decisions.
The Fund’s partnership agreement often outlines specific information rights that LPs can exercise. These may include access to audited financial statements, details on portfolio company valuations, board observer seats and insights into the decision-making process of the general partners. Open communication channels between GPs and LPs are crucial for building a strong and collaborative partnership.
Tailor Rights to Each Transaction
The harmonious alignment of interests between the GP and LP is critical to the success of the fund. Governance rights serve as the bedrock for achieving this alignment by offering protection to LPs through transparency in the operation of the fund and protect the LP from GP mismanagement or misconduct. Most deals will have some mix of the rights above and these rights should be tailored for the specifics of each transaction.
In addition to the rights outlined above, some LPs may be able to negotiate additional rights through side letter agreements. Targeted governance rights have become more common as funds try to find a balance between the interests of the GP and LP.
If you have questions about balancing the interests of an Investment Fund’s GP and limited partners (LPs), or other investment management legal issues, contact Deven S. Kane, Of Counsel, at KPPB LAW.
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