3.1 INTRODUCTION TO LIMITED PARTNER ADVISORY COMMITTEES

As a reminder of the terminology we introduced in Chapter 1, a private equity fund is typically established under a legal structure known as a limited partnership and the investors in the fund are commonly referred to as limited partners (LPs), which can also be referred to simply as a private equity fund's investors. As with most investments, at its most basic level LPs in a fund provide money to a private equity fund, and by association the funds, with the hope of capital appreciation.

Throughout the course of their investing relationship LPs and general partners (GPs) interact in a number of ways. For example, the GP may send information regarding the performance of a particular LP account to the LP on a quarterly basis. On a practical basis this information may come directly from an LP herself or a third party known as an administrator. An administrator is a third-party firm that is responsible for performing a number of services for a fund, including fund accounting, calculating the net-asset-value (NAV) of a fund, and assisting in the oversight of shareholder services–related activities. Additionally, the LP may engage with the GP regarding questions she may have relating to the performance of a fund in which she is invested or relating to ongoing fund operational due diligence.

In some cases, a select group of investors in a private equity fund may participate in what is known as a limited partner advisory committee (LPAC), which is also sometimes simply referred to as an advisory committee. An LPAC is a committee of fund investors that typically maintain the right to be notified of certain fund-level activities as well as the power of approval over certain proposed actions of a fund. The responsibilities and roles played by LPACs can directly influence fund-level compliance, a topic that was discussed in the previous two chapters. This chapter will explore the role of LPACs as well as other fund boards.

3.2 SOURCE OF LPAC RESPONSIBILITIES: THE PPM AND LPA

As part of the compliance and legal obligations of a private equity fund investing relationship both LPs and the GP have certain rights and responsibilities. The bulk of these are governed by two key related documents. The first document is what is known as a private placement memorandum (PPM). A PPM may sometimes be referred to as an offering memorandum. The other key document is a limited partnership agreement (LPA). The PPM and LPA provide an overview of the key terms of the fund offering. Terms covered in a PPM and LPA typically include a wide variety of items such as the fees to be charged by the fund, the permitted expenses of the fund, and the fund's investment mandate. The PPM and LPA also outline the assignment of the responsibilities of the GP and related service providers.

Due to the fact that both documents outline essential fund terms the pair of documents is often referred to as the fund formation documents. In practice PPMs and LPAs are often thought of as two separate documents that are linked together. As evidence of this, both documents often reference each other. Therefore, when analyzing the rights of the GP and LPs, both documents are typically reviewed in conjunction with one another and may in practice reference each other.

The bulk of LP rights and responsibilities are typically outlined primarily in the LPA; however, the PPM may also contain information relevant to the LPAC. For the purposes of our discussion here, we will not delineate the source of the language outlining these rights but rather the substance of the LPAC's role.

3.3 THERE IS TYPICALLY NO REQUIREMENT FOR AN LPAC TO EXIST

Before proceeding any further with our discussion of LPACs, it is important to highlight that there is typically no regulatory requirement for an LPAC to exist. The decision by the GP to form one is often voluntary and not required by law or financial regulators. Why, then, would a GP go through the extra effort to install an LPAC?

Different LPs will often commit different amounts of capital to a private equity fund. Those who pledge to commit more capital, which can be ultimately called down by the GP, often expect to have more oversight and rights as compared to other, smaller LPs who contribute less capital. In order to keep these investors happy, GPs therefore have obliged larger LPs' desires for more input and oversight into the management of the fund in which they are invested.

That being said, the GP wants to maintain the flexibility to manage the fund in their own discretion, subject to a predetermined investment mandate without too much interference from LPs. LPACs are the modern evolution of the governance and compliance mechanism that is the result of this compromise.

Historically, when an LPAC may not have been in place, the roles performed by the LPAC were typically performed directly by the GP. In practice so as not to surprise large LPs with significant fund changes, the private equity fund manager would likely have reached out to these larger fund holders to solicit feedback prior to implementing any changes. However, technically, according to the PPM and LPA the right to make changes or approve transactions that an LPAC would have typically performed would have instead likely resided primarily in the realm of all LPs, and be subject to mechanisms such as a consent vote (i.e. majority or 2/3rd majority) from all LPs.

3.4 COMMON LPAC DUTIES

LPACs serve as an oversight and governance mechanism on the operations of a fund. They are meant to represent the interest of LPs and provide them with a voice in the management of the fund. While the specific duties of LPAC may differ across private equity funds, traditionally the core duties of an LPAC are often centered around the areas that may present the greatest risks to LPs. Specifically, key areas LPACs focus on include:

• Conflict of interest oversight. The LPAC may be responsible for overseeing a number of situations in which different conflicts of interest may arise between the actions of the GP, its employees, and the LP. Two of the more common conflicts that LPACs review include:

• 1. Related-party transactions oversight. These are investments where a fund may seek to enter into transaction with individuals or entities related to the GP. Two common related-party transactions for which LPACs provide oversight are:
     1. Approval of concurrent investments. A concurrent investment generally refers to a situation in which a fund purchases the securities of a portfolio company concurrently with another fund. In practice, the timing of the investments may not be simultaneous, and the two purchases could occur at slightly different times. In these situations, inherent conflicts may arise across a variety of areas, including the allocation of securities among the two affiliated funds. Therefore, most funds are structured to submit concurrent investments to the LPAC for review and approval.
     2. Approval of cross investments. A cross investment refers to a situation where a fund purchases the securities of a company that is a portfolio company of another fund managed by the GP. Due to the dual ownership of both affiliated funds of the investment, the potential for conflicts related to items such as the valuation of the investment may arise either at the time of the initial purchase, throughout the life of the investment, or upon sale. In order to provide additional oversight of such conflicts, LPACs typically are required to grant approval on any cross investments.
  2. LP transaction oversight. A fund may also seek to enter into a transaction directly with an LP in addition to their capital commitment to the fund. To oversee these conflicts, the LPAC therefore represents LPs in reviewing and ultimately deciding whether to approve or prevent such transactions.

• Valuation oversight. When disagreements arise between LPs and GPs over the valuation of an asset or group of assets held by a fund, the LPAC typically plays a role in working with the GP, and in some cases third-party appraisers, to determine a valuation. This process is discussed in more detail in Chapter 4, which focuses on valuation compliance.

The duties of LPACs are typically outlined specifically in the fund formation documents. Other common LPAC duties typically include:

• Approving capital calls from investors in certain situations. Approving the issuing of capital calls by the GP in certain instances where they would not otherwise normally be permitted is one common LPAC role. An example of a situation where this could occur would be if the commitment period for a fund had ended and the GP wanted to issue a special capital call to raise more funds for the purpose of enabling the fund to make additional opportunistic investments in portfolio companies. Typically, since the commitment period had already ended, the fund formation documents would outline that LPAC approval was required to issue these new capital calls.
• Approving tax distributions. Tax distributions are distributions of capital typically made to LPs in order to offset each individual LP's deemed tax liability with respect to his investment in the fund. To be clear, the purpose of these distributions is to provide the LP with money to pay taxes related to their investment in a fund, not to provide them with any sort of profits related to their investment in the fund. These tax distributions are typically paid by funds within 90 days after the end of the fiscal year of a fund. In some instances, a fund's formation documents may set a ceiling limit on the amount of total aggregate tax distributions the fund can pay out to LPs, such as US$500,000. If the aggregate contributions were to exceed this ceiling amount, then approval from the LPAC would typically be required to pay out a greater amount of tax distributions.
• Overriding investment limitations. At the time of formation of a private equity fund, there may be a variety of investment limitations placed on a fund. These are also sometimes referred to as investment restrictions. A common example of such a restriction would be a cap on the total investment that may be placed into a single portfolio company. For a variety of reasons, such as shifting market conditions, a GP may wish to override this cap once the fund actually starts investing capital. In order to breach this cap, LPAC approval would typically be required.
• Approving the advance of GP litigation defense costs. Under certain circumstances a fund may advance an LP money to fund his defense in litigation related to his duties on the LPAC. Similarly, in some cases a fund may advance the GP capital to fund their defense in a lawsuit brought from other LPs. The advance of capital in these situations typically requires LPAC approval prior to disbursement.
• Restricting fund principals' activities and new fund launches. Typically when a private equity fund is in the process of allocating capital, a restriction exists with regards to the principals of the fund (i.e. the portfolio managers) from working on the management of other funds. Similarly, in order to not cannibalize the opportunity set of the current fund, restrictions also exist on the launching and subsequent closing of new funds by the GP. Any decision to violate these restrictions would require approval from either the LPAC or the majority of interest holders of the fund in most instances.
• Ceasing limited operations mode related to key person events. A key person event refers to a situation that is triggered when a single individual, or multiple persons as the case may be, who are critical to the management of a fund are no longer able to perform their duties. Historically, these provisions were also referred to as key man events. An example of such an individual would be a portfolio manager of a fund. Specifically, the common occurrences that trigger a key person clause include the death of a key person, his incapacitation, if he takes bad actions that are determined to constitute items such as fraud or gross negligence, or if he is simply no longer involved in the day-to-day management of the fund for an extended period of time.

  While the specifics of key person clauses vary across private equity funds, once a key person clause is triggered, many private equity funds formation documents contain a provision that the LPs who hold that majority of the fund's interest can vote to place the fund into what is known as a limited operations mode. In this mode, the fund will not make any new investments and will generally only fulfill the funding of previous investment obligations and make follow-on investments into portfolio companies.

  Depending on the circumstances of the key persons involved in the fund, and the specific investment situation of the fund, its LPs may decide to pull the fund out of limited operations mode and continue normal investment activities. An example of such a situation would be if a portfolio manager of a fund suffered an illness that forced the fund into limited operations mode but the portfolio manager had then recovered from the sickness, and the LPs wanted to resume the normal fund operations. Typically, most funds are structured in such a way that in order to resume normal operations of the fund out of limited operations mode, either a majority-in-interest of the LPs of the fund or the LPAC must approve this transition back to normal fund operations.

• Service provider oversight. In certain instances the fund formation documents may outline that changes to material service providers relationships, such as the auditor of a fund, would require LPAC approval.
• Extensions of a fund's term. The term of a private equity fund refers to the entire period of the fund's existence through to the winding-up and liquidation of the fund. The term of a fund is also sometimes referred to as the life of a fund. A common fund term would be 10 years from the date of the initial fund closing; however, they may be longer or shorter. Generally, extensions of a fund's term require approval by the LPAC.
• Other matters the GP deems important. Many fund formation documents contain a provision such as “The General Partner may consult with, or seek the approval of the LPAC regarding any other matter determined by the GP for any other matter as determined by the GP in its sole and absolute discretion.” This means that there may be other situations or potential investments that were not specifically contemplated at the time the original fund formation documents were drafted that have subsequently arisen that the GP feels is a good idea to run past the LPAC.

However, as these clauses are typically written, the other types of items the GP brings to the LPAC are in the GP's complete discretion. So how should a GP, or an LPAC for that matter, determine what other items that should be raised to the LPACs attention? This determination is typically related to a concept known as a good-faith effort. The general standard outlined in fund formation documents is that the GP makes what is known as a good-faith effort to bring items to the LPAC's attention and provide them with enough material facts so that they can make an informed determination of the merits of the proposed GP action. This good-faith effort is also related to the issue of GP disclosures, that is discussed in more detail ahead.

3.5 LPAC FORMATION CONSIDERATIONS

Although not a technical requirement, due to the increased input and oversight it affords LPs, today most private equity funds maintain an LPAC. Once a decision has been made to implement an LPAC, there are a number of initial questions facing GPs regarding the structure, membership, and duties of the LPAC.

3.5.6 LPAC Joint Committees

In certain instances, a private equity fund's formation documents may contain a provision for the creation of a related group of funds that are called parallel funds. Parallel funds are generally managed in what is known as a pari-passu manner. This means that these parallel funds adhere to the same investment strategy of the fund and are managed in the same manner. The reason for the creation of these parallel funds is typically to facilitate certain legal and regulatory matters. A common example would be the creation of a separate parallel fund to exempt the fund from registration as an investment company under Section 3(c)(7) of the US Investment Company Act. Another type of parallel fund would be one created to facilitate advantaged tax treatment.

In the private equity industry, a catchall term that encompasses parallel funds that are created for legal, tax, and regulatory reasons is special requirements fund. This can be distinguished from another type of parallel fund known as a principals fund. The purpose of these funds is to carve out a separate structure to manage the capital of the GP and related person (i.e. the private equity fund's employees), as well as to facilitate their estate planning.

As part of their membership in the original fund, when these parallel funds are created, the LPAC typically transitions from a single-fund LPAC into what is known as a joint LPAC, or simply joint committee. This joint committee is responsible for not only the original fund but also the newly formed parallel funds. In practice, the duties of the LPAC are effectively the same as they were before the formation of the new parallel funds with the added complication that the responsibilities are now applicable across both the original and parallel funds. This relationship is summarized in Exhibit  3.1.

3.6 ARGUMENTS IN FAVOR AND AGAINST LPACS

As outlined above, LPACs can play an important role in providing LP representation in the management of the fund and overseeing the actions of the GP. In summary, the two key arguments in favor of LPACs are:

1. Enhanced oversight of important GP actions by key LPs in areas including valuation and conflicts of interest
2. Facilitation of communication between LPs and GPs

On the other hand, objections can be made as to the structure of LPACs. A primary objection of LPACs is that they give larger investors more of a voice to the exclusion of smaller LPs. The argument could be made that larger investors in a fund are even more incentivized than smaller LPs to ensure actions are taken in the best interest of the fund; however, conversely, situations could arise where the interests of all LPs are not similarly aligned. This could result from differences in the various LP investment requirements and risk tolerances. For example, one LP may have a preference or need for liquidity ahead of other LPs. These types of differences could represent different motivations for investors who may act in their own interests as opposed to the interest of all fund investors.

Let us consider a smaller LP who is not an LPAC member but wants more liquidity, and would want a private equity fund to wind down operations and be paid out rather than extend the fund term. This could be contrasted with a larger investor on the LPAC who could vote to extend the fund term, because the individual larger LPs on this committee do not have immediate liquidity needs; then such a difference could arise. In this example, we do not know which action would be in the best interest of the fund itself, but the point is that conflicts among larger LPs sitting on an LPAC and smaller non-LPAC LPs could arise, leading to calls for enhanced inclusiveness of LPACs.

In much the same vein, differences could arise among the actual members of the LPAC as well. However, if an LPAC has too many members, it may become inefficient and difficulties may arise with regard to making decisions. As such, a compromise is often made between LPs and GPs to limit the size of LPACs to larger LPs, and smaller LPs put their faith in larger LPs to act in the best interests of all fund investors.

3.7 SUMMARY

This chapter provided an overview of the roles of LPACs. We began by defining what an LPAC is. Next, we outlined how the source of LPAC responsibilities can be found primarily in two key fund formation documents, the PPM and the LPA. The lack of a technical requirement for LPACs to exist was then addressed. We then provided an overview of common LPAC duties, including oversight of conflicts of interest of both related-party transactions (i.e. concurrent and cross investments) and direct LP transactions, service provider oversight, as well as key person event oversight. Considerations surrounding the completeness of GP disclosures to LPACs as well as LPAC formation considerations were next discussed. The importance of unaffiliated LPAC members and the role of LPAC advisory boards was also covered. In this chapter we also introduced the fact that LPACs can play an oversight role in determining the value of a private equity fund's positions. With this background in place, in the next chapter we will address the issue of valuation compliance in more detail.