We’ve pointed out that private equity investors, known in the trade as limited partners, enter into agreements with private equity firms that do a terrible job of protecting the investors’ interests. That sad reality is contrary to the urban legend propagated by the general partners, that the agreements are negotiated, that the limited partners are sophisticated and understand full well what they are getting into.
The evidence on the ground strongly suggests otherwise. Sophisticated parties who used their bargaining power, for instance, would not enter into contracts where the other party controls the money flows and they lack audit rights, which are standard provisions in adequately negotiated licensing agreements, vastly simpler relationships than private equity funds. While the limited partners can indeed see the books and records of the fund (but even then with some inconvenience), they have no right to see the financial records of the companies that the fund has purchased. And that’s where the real opportunity lies for chicanery, since the general partners control the management of those firms and can impose all sorts of self-serving contracts on them. Perversely, the limited partners know about and accept monitoring fee agreements that Oxford professor Ludovic Phalippou has described as “money for nothing“; even worse from a legal perspective are undisclosed fees and expenses that general partners charge to the investee businesses.
In keeping, the SEC’s head of examinations, Andrew Bowden, pointed out in a widely publicized speech last May that private equity agreements did a poor job of protecting investors, and were unduly vague on far too many key points. That’s the big reason that general partners have huffed and puffed that they are within their rights to be extracting as much as they do from the portfolio companies. The tricky, ambiguously drafted agreements give them broad discretion and contain multiple waivers of fiduciary duty.
The logical question then becomes: how do supposedly sophisticated investors sign up for such one-sided deals? One part is the idea that these agreements are negotiated in any normal sense is a myth. For instance, the core contract, the limited partnership agreement, is presented to the investors only three weeks prior to closing. They are told to have their comments in ten days later. Ten days is not remotely enough time for limited partners to coordinate their objections and present a unified front in insisting on changes. Thus any fights usually boil down to a few headline items, such as the percentage of fees to be rebated to the limited partners and key man provisions, with the general partner making an art form of agreeing to relatively inconsequential change requests so as to look like he has given ground, while keeping the contract almost entirely intact.
Another looming issue is that the limited partners do not have attorneys representing them that are aggressive advocates. One can argue that the problem ultimately rests with the clients, since most lawyers that do contract negotiations regard their role as being deal makers rather than deal breakers. But most of the investors are fiduciaries and therefore are held to high standards of accountability. Their legal representatives should be cognizant of that and mindful that they meet their duty of care.
The real issues are twofold. First, the private equity firms command the attention of the top lawyers at the best law firms. Any firm that does not do a lot of private equity work aspires to. The general partners create massive amounts of legal work. The lawyers on the other side of the table don’t have strong incentives to cross them, since it’s an uphill battle to begin with, and many of the law firms representing limited partners also do work for the general partners. Getting in better graces with the limited partners is a vastly better business strategy than doing a bang-up job for the limited partner.
The document below illustrates the magnitude of this problem. It was presented last June, meaning a month after the Andrew Bowden speech describing in usually vivid terms how more than half the private equity industry was engaged in serious misconduct. The venue was a conference organized by the National Association of Public Pension Attorneys. We have all the presentations from this conference. The one we’ve embedded at the end of this post, despite its short length, is meaty enough that we’ll spend more than one post on it. But it is also written in a sufficiently user-friendy way that you’ll learn quite a lot simply by reading it yourself.
Note first who the authors are. The lead is Dulcie Brand, a partner at Pillsbury Winthrop and a board member of the NAPPA. She regularly negotiates (if you can call it negotiation) private equity agreements. Her clients have included CalPERS, the Los Angeles County Employees Retirement Association, and the New York State Common Retirement Fund.
What is disconcerting about this presentation is that it was made at all. Here, a month after Bowden tells the world that limited parters have done a terrible job of protecting their interests, a top outside attorney makes a presentation to the general counsels of the biggest and supposedly most sophisticated fiduciaries and says, “The agreements are even worse than you thought.” What does this say about her culpability and that of everyone in the room in allowing that to happen?
While one can’t know what Brand said in addition to the material on her slides, they present evidence that the general partners continue to move the terms of the governing agreements, which were already skewed in their favor, even more in their direction. If you’ve followed our posts on private equity, including our releases of limited partnership agreements, you’ll recall that we’ve already flagged some remarkable lapses from an investor protection standpoint, including clawback language that does not work as advertised, advisory boards that provide Potemkin oversight, and sweeping indemnifications and clever conflicts of interest language through which the general partners try to waive their fiduciary duties.*
Here are a few of the striking that Brand flagged:
Consent terms designed to make it remarkably easy for general partners to push through amendments, including allowing for numerous instances where no consent is needed
An affirmation by ERISA investors that their investment will not make the private equity fund subject to ERISA**
A waiver of fiduciary duty hidden in the subscription agreement
Other critical terms sunk into the subscription agreement, like waiver of the right to trial by jury and stunningly, a waiver of the right to make any claims with respect to conflicts of interest, when you’d expect to find terms like that in the limited partnership agreement
It’s already hard to fathom how investors accept the basic terms of a private equity fund: the general partners get to call the funds on a five to ten day notice, have near-complete investment discretion, subject only to very broad investment parameters, with inadequate oversight and reporting, and return the money pretty much when it suits them. The fact that the detailed terms are so one-sided should lead anyone with commercial sense to run for the hills. Yet the limited partners aren’t merely intellectually captured by the private equity kingpins; worse, they actually trust them and are afraid to rock the boat.
And since no one wants to look like a dupe, the reflex of the limited partners has been to circle the wagons with the general partners or simply remain silent. But investors are going to find themselves caught between professing they didn’t know how bad things were, which is tantamount to admitting that their due diligence and oversight was lax or trying to cop that the revelations are no surprise. And it’s even harder to defend the role of hired guns like Dulcie Brand who have clearly failed abjectly in making sure private equity agreements served their clients, as opposed to the interests of voracious private equity overlords.
*Notice this issue is not clear cut. The SEC in presentations takes the position that general partners are fiduciaries under the Investment Act of 1940.
** This is a belt and suspenders provision. Private equity funds are not subject to ERISA if less than 25% of the fund’s assets come from ERISA investors. Needless to say, general partners are very mindful of this limit and exercise great care to stay below it.