The private equity (PE) industry has seen significant growth in the past decade, and with an increased number of market participants has come a heightened level of expectation and scrutiny on General Partners (GPs) to adopt best practices.
Evolution of the Principles
The Institutional Limited Partners Association (ILPA) Private Equity Principles, first released in September 2009, were developed to encourage discussions between Limited Partners (LPs) and GPs regarding the operation of fund partnerships in PE.
Following feedback from LP and GP communities, an updated version was released in January 2011 to address certain issues requiring additional focus, clarification or consideration of practical implications.
The third edition of the Principles, released in June 2019, builds on previous versions, taking into consideration the evolving industry demands while continuing to assert that three guiding principles – alignment of interest, governance and transparency – form the essence of an effective PE partnership.
Key insights of the latest edition include:
- Preferred return
The previous version of the Principles stated that preferred return should be calculated from the day capital is contributed to the point of distribution. The new Principles build on this by recommending that, in cases where capital is drawn from a bridging or other short-term financing facility collateralised by uncalled LP capital commitments, the preferred return should be calculated from the date capital is at risk (i.e. the date on which the facility is drawn) rather than the date at which the capital is ultimately called from LPs. Such a recommendation is likely to be controversial among GPs but should not come as a surprise as it is reflective of guidance released by ILPA in 2017 and is accompanied by recommendations to report on performance with and without the use of such facilities.
ILPA has also recommended that, to foster greater alignment of GP and LP interests, carried interest calculations should utilise a “hard hurdle” whereby the GP’s carried interest is based only on the portion of profits that exceed the LPs’ preferred return. However, in our experience this is not line with common practice, as most carried interest calculations incorporate a catch-up step to the GP, taking into account the profits paid to LPs as preferred return.
Another possibly debatable change focuses on clawback amounts; ILPA has reverted to the first version of the Principles by recommending that “all clawback amounts should be gross of taxes paid”. Standard industry practice is that clawback is paid net of any unrecovered taxes suffered by the carry recipient, and this recommendation represents a change in position by ILPA as the previous version of the Principles state that “after extensive discussions with GPs, we believe that it would be impractical to ask them to bear the cost.” The Principles do however recognise that in some cases it may be excessively burdensome or impractical to require clawback gross of taxes incurred.
- ESG policies and reporting
ILPA has included guidance on environmental, social and governance (ESG) policies and reporting, stating that “GPs should consider maintaining and periodically updating an ESG policy, provided to all LPs or to potential LPs on request.” The Principles also recommend how GPs can demonstrate their commitment to ESG and identify reporting frameworks to help LPs understand, verify and assess GP processes for ESG integration.
ILPA recommends that consultant costs related to ESG due diligence, management and reporting should be regarded the same as general due diligence costs and be borne out of management fee or charged to portfolio companies, unless requested by a specific LP (in which case it may be appropriate that the LP bear the cost).
Other issues classified as new and emerging include:
- Guidance relating to the communication surrounding, and allocation of co-investments
- Non-financial disclosures: incident reporting and regulatory compliance
- Policies for, and communication of, changes in GP ownership and succession planning
- Processes and approval for GP-led secondaries transactions
The Principles also re-emphasise the importance of providing LPs with clear information on the key components of their investments. By following the range of templates available e.g. the Fee Reporting template, GPs will be well placed to meet such requirements. The new Principles also contain extended guidance on various areas of GP and fund economics, particularly the calculation of fees. While no direct reference is made, indications are that the latest Principles are reflective of the findings of recent SEC led inspections and investigations during which a series of shortcomings were identified.
The full version of the Principles 3.0 can be found on the ILPA website.
Speak to IQ-EQ
For new funds, or those about to launch, the impact of the latest ILPA developments could be significant. They may also serve as a timely reminder for GPs of existing funds to consider the advantages of enhancing their current reports. To discuss the implications of the latest ILPA developments and how IQ-EQ can assist, please get in touch with our expert technical team.
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The information contained in this article has been compiled by IQ EQ Administration Services (UK) Ltd and/or its affiliates from sources believed to be reliable, but no representation or warranty, express or implied is made to its accuracy, completeness or correctness. All opinions and estimates contained in this article are judgements as of the date of publication, and are provided in good faith but without legal responsibility.