Common pitfalls when drafting an LPA
Raising a fund and making investments is hard enough; don’t let these common mistakes see you erode hard won returns, alienate investors or breach company law.
1) Investors paying different amounts of fees
There are several reasons why different investors might not be charged fees at the same rate. For example, cornerstone or ‘early bird’ investors are often charged no fees or fees at a reduced rate, while those committing to the fund at a later date pay the full amount.
Despite this being a common occurrence, it’s important the fund caters to the impact of the varying fee payments in its operational mechanics to avoid ending up with partially excused investors, unused commitments or waived management fees. For example, there are two investors in the fund who both commit £10m. One is paying fees and the other isn’t. If a capital call is made, plus fees, the fee paying investor is left with less capital in the fund compared with the non-fee paying investor.
According to Ken Ritchie, head of fund administration at Highvern, this kind of oversight can leave GPs in an ugly situation. “Eventually, the GP will issue a call and the one paying management fees will have nothing left to pay. Then what do they do? Stop making calls? Then they’re left with committed capital left on the table, which is no good. Or even worse, the fee-payer stops participating in capital calls and is constantly getting watered down.”
To avoid this, Ritchie suggests structuring management fees outside of the commitment, and ensuring this is catered for in the LPA.
2) Fee exemption for the advisor
A common oversight where only the tax man wins. When members of the private equity firm put skin in the game and invest in the fund, they shouldn’t be paying fees. If overlooked, their post-tax money will be paid up to the advisor, before being distributed in the form of salary or bonus and taxed again.
3) Feeder funds and fund-of-funds with matching capital call periods
This can create a big operational headache. Here, a capital call is made at the main underlying fund level, but the feeder fund or fund-of-fund LPs have the same turnaround time for delivering the capital. Says Ritchie, “If you don’t make the capital call to the feeder fund on the same day, you’re essentially forcing the investors to default.”
The situation is the same for fund-of-fund LPs, where the capital call requirements need to be factored into the LPA to provide enough time for them to call the capital from their investors.
4) Non-material variation clauses
LPAs are by design difficult to change; they are in place to protect investors. However, these contracts exist for a long time, typically more than 12 years. During that time, it is likely that non-material adverse impact or regulatory changes will need to be made to the document, where there is no impact to the investors. However, to make changes to the LPA, majority consent from the LP base is required. Says Ritchie, “It’s a huge job to make non-material changes if the LPA doesn’t contain the wording in its variation clause. Where there is no impact to the investors, it should be possible to amend the LPA.”
5) Realisations prior to fund close
This one might seem to jumble up the natural order of raising a fund, deploying the capital and then realising assets, but it is possible for an investment to be made and exited while the fund is still being raised. The problem this causes is in how the realisation of those gains are treated when accepting new investors. Ritchie says that investors coming into the fund at a later date typically pay an equalisation fee. However this fee seldom factors in the impact of realisations prior to fund close.
6) Forgetting the equalisation clause
The point above highlights one example of why an equalisation clause is important. If an equalisation isn’t included in the LPA then investors coming into the fund on subsequent closes should have their capital committed to separate vehicles, rather than the main fund.
According to Ritchie, if all commitments go into the main fund, “You’re essentially creating separate share classes, which are tricky to manage. Normally, when an investor comes into a fund, it is equalised by paying back-dated operational expenses and management fees. If this doesn’t happen the GP is losing out on fees it is entitled to and new investors are getting a free ride off of the setup fees paid by the existing LPs.” While the prospect of GPs not collecting fees seems highly unlikely, Ritchie and his colleagues have seen this particular case surprisingly often.
7) Funding ongoing expenses
If a fund runs longer than initially planned, or it requires additional cash for administrative or legal fees that weren’t factored in at the beginning of its life - how is that additional cash treated? “Is it capital, or is it a loan?” asks Ritchie. “This is important because it always needs to be paid back in a waterfall structure, which is designed to work out how carried interest works, which then raises the question of whether or not it collects a hurdle.” To overcome this (pun intended) the LPA should include a paragraph to address how the capital will be treated.
8) Forgetting subsequent investor clauses
This is most likely to happen when a fund has a limited number of investors and there is a clear plan of the assets the vehicle will acquire, and so a subsequent investor clause isn’t included in the LPA. However, as Ritchie points out, no one knows what will happen in the future. “If the asset(s) does really well and attracts more capital, but there isn’t a subsequent investor clause, then how do you bring in that investment?” Similarly, if the asset(s) doesn’t perform as expected and requires further investment. One solution would be to create an entirely new fund, or much easier - remember to include a subsequent investor clause in the LPA. Says Ritchie, “It’s always best to assume you might need more capital in the future and to add in the subsequent investor clause.”
9) Corporate benefit
This one could see GPs breaking the law, so needs careful attention. Where the GP is a company (or where a company acts for and on behalf of a GP), company law requires the directors to only enter into transactions where the company will receive a corporate benefit (i.e. in the best interest of the company). Remember that acting as a GP carries unlimited liability and a certain degree of risk, which the GP needs to be remunerated for.
In most circumstances the GP’s corporate benefit comes in the form of management fees or carried interest, however it is common to see situations where management fees bypass the GP and are paid direct to the advisor, or where a separate LP receives the carried interest, or even situations where the GP enters an agreement to push all of its fees up to the advisor, leaving the GP with no corporate benefit.
Directors must act in the best interest of the company, meaning the GP could end up acting as the GP for free, which breaches company law. Says Ritchie, “Every GP should have certain ongoing expenses paid by the partnership, however it’s surprisingly common to forget to pay for director / administration fees.”