My Notes from ILPA's 2020 Member Conference - Scrutinizing Terms in a Down Market
/Overall approach
· Are we getting the transparency we need?
· What do we need to be proactive about?
· Are there adjustments to be made with new commitments?
· What have we learned through the COVID experience?
Do we have confidence GP's are using the following tools in the best interests of LPs?
Current Tools at GP’s Disposal:
· Sub Lines
· Additional Borrowing Outside of Sub Lines
· Recycling Capital
· Relaxing Limitations on follow on investments
· Greater use of Affiliate service providers - are GPs using these providers more
· Fund mergers
· GP led restructurings
· Cross fund investments
· These are occurring although not widespread
· Term extensions
Most popular tools used: sub lines, other borrowings, and recycling of capital
Subscription Lines
· Some lenders are increasing the cost of facilities
· Often times sub facilities can be converted into an asset-based facilities
· Need to be mindful of requests to extend sub facility term
Risks with Subscription Lines
· Can see portfolio concentration risk
o What is the calculation of the test? Does it include use of sub facility?
o Test may use just equity investment without incorporating leverage investments
· Increases LP giveback risk
· Most LPAs now provide ability to force LP to return distributions not just for indemnification but for any fund liability
· Mindful of return of distribution to back sub facility liability
· Cross-collateralization Risk
o If there is a problem, all portfolio companies can be a source to repay
Other Fund Leverage Concerns
· Does the LPA allow fund leverage or guarantees of portfolio company obligations?
o Understand how these limits work
· Should borrowing be permitted to pay management fees?
o Many conversations on this
o Saw this in 2009 GFC, make GP defer fees
Recycling
· Cheap and easy for the sponsor
· Quick capital
· Consider raising limits only for new investments, not for expenses
· LPs should be cynical when GP downplays recycling amendment
o Example – amendment changed “return of capital” to “return of proceeds”
o Added 2.5x ability to recall funds
· Ask what they want to do with recycling
· Check consent and amendment rights as an LP
o Check required majority or if LPAC can approve
· Because it changes fund's exposure to liabilities, a change may require supermajority approval
Affiliated Service Providers
· Even if pricing offsets the management fees, it still results in current income being paid
· Get full transparency
· If LPA provide flexibility to use affiliated providers, monitor how they are using them
o Used to offset revenue decline
Fund Mergers
· GP tries to solve issues by using capital to support other funds
· Look at valuation issues - how do you value something with little revenue in today’s environment?
· Under certain statues may be able to merge without supermajority consent or without complying with LPA
· Under Delaware law, if 2 funds merge you comply with the surviving entity LPA; the LPA of fund going away disappears
o Understand which fund is surviving
GP led restructuring
· Will see big increases
Cross Fund Investments - Rescue Finance
· Role of LPAC – be cautious because approval here can absolve GP of conflicts
· LPAC needs access to financial and legal advisors
· Do you have clear information?
Term Extensions
· GP unilateral extension right
Current Fund Considerations
· Valuations
o Watch for changes in valuation process
o Any outliers
o Focus on what your LPA and Side Letters provide for information access
o GP wants to control content and discussion
· Port Construction
o Will concentration increase if new deals slow?
o Will GP deploy capital simply to build fee base?
o Will GP use COVID-19 as an excuse for performance and start to focus on the next fund?
o LPAC Role
o Conflicts are high and LPA terms give GP ability to create value for themselves at the possible expense of LPs
· Clawbacks
o Many GP are over distributed
o GP are incentivized to not mark down assets
o Increased LP Giveback risk
o With use of sub facility, if assets stand behind obligation to repay (if uncalled capital is not sufficient), there is a greater likelihood of distributions being recalled
o Greater giveback risk with leverage portfolio companies that distributed distributions
What should LPs be asking for when GP requests modifications/amendments?
Management Fees
· Focus on:
o Fee terminates after extension
o Exclude new capital for recycling from management fee - why pay for giving GP flexibility
· Ask for but less critical:
o Make sure fee base is determined just on equity invested
o Possible GP deferment of fees if liquidity is stretched
LP Giveback
· Focus on:
o GP must participate with LP
o Adjust so net of tax construct is removed or only applies if giveback exceeds tax carry
§ You net on a global basis; many funds fail to cover this term
o Ensure recycled amounts are no longer considered distributions that can be required to return
· Ask for but less critical:
o Deferred carry should not be considered a fund liability
GP Led Merger/Secondaries
· Focus on:
o Require high vote threshold - 75-80%, not just majority
o Have LPAC get financial advisor
o Try to get LPAC approval first before going to all LPs
Increased Clawback protection
· Ensure that when you run it that you protect for the preferred return
· Revisit clawback guarantee and collateral behind it
· Be aware that GP guarantee that will fall away upon fund dissolution, but LP liability extends far beyond fund life
Distribution Limitations
· Prohibit borrowing to make distributions
· Make it subject to LPAC consent; make GP explain why it's in LP interest to do this
New Fund Considerations:
· Haven't seen major changes in terms for new funds
· See an evolutionary, not revolutionary change in agreement terms
o More 1st close discounts coming back
Advice
· Ensure strong no-fault protection
· Be wary of deemed voting provisions (abstentions, non-response)
· Make sure you can access list of fellow LPs
· LPAC - have in camera meetings
· Expenses - push back on GP shifting overhead to fund
· GP Capital Funding - make GP fund pro rata share as they raise capital, not just at final close
· Transfer provisions
o Cap on fees for transfers