The purpose of this article is to bring forward some ideas for limited partners on how to improve governance, protections and controls for emerging private equity managers and smaller GPs.
Ultimately, private equity is in the “trust business”, where LPs are expected to give money to a GP for 10 years and trust that the GP invests it wisely and returns it with profits, but certain controls and measures can help improve oversight and protections for LPs.
I suspect the LP community is currently debating some of these measures and controls, and it would be interesting to see the outcome in future limited partnership agreements. As any experienced financial controller or internal audit professional will tell you, it’s all about people, systems, and controls. However, below are some suggestions that hopefully will add an extra layer of protection to limited partners.
Much has been said about the importance of externalised fund administration, whether for corporate services or fund bank account control. However, it is critical that the external administrator questions the GP’s instructions and makes sure they are comfortable with these, rather than taking blind instructions, lest it become a rubber stamp.
In addition, I believe it is good practice to have regular third-party review of fund admin work, as not all fund administrators are equal. Having observed different types of fund administration providers, from in-house to external, a key element that adds more “safety” is if the fund administrator bears the legal liability as directors in the GP, as this increases the focus and attention to detail. I have also seen this in action when the fund administrator appoints professional independent directors to the GP board, as these add an extra layer of overall scrutiny.
“A key element of diligence is maintaining scepticism until the very end.”
Drawdown requests are the first line of defence from a cash controls perspective. What is critical is that LPs understand the purpose of the drawdowns and are able to audit cashflow from the fund to the bidco SPV and what happens to the cash after that.
Access rights to information for audit purposes are critical. Furthermore, funds shouldn’t have large positive cash balances and alarms should go off if there are drawdown requests from funds that already have large cash balances.
A recent case involved a fund that had externalised fund administration, but where drawdowns were made despite that fund having large cash balances. Monies ultimately went to a bidco SPV where the bank accounts and SPV were controlled by the GP without external oversight from independent directors or a fund administrator (despite the actual fund having fully externalised its fund administration).
Funds should not have large cash balances for multiple quarters, especially given the risk of fund bank account balances with “quarter end window dressing”, where the cash balances of a fund can temporarily be shored up from external funding sources, which can be difficult to detect, resulting in reported cash in the GP reports not actually existing for the reporting period.
“[LPAs] are likely only to get more complex and convoluted given recent events in the private equity industry.”
The core of any investment relationship between the LPs and GP is the limited partnership agreement. These documents are likely only to get more complex and convoluted given recent events in the private equity industry. In my opinion, the basic elements to review and potentially revamp are:
- Defining the powers of the Limited Partners Advisory Council (LPAC), and ensuring that one is formed and exists at all times, is a key responsibility of LPs.
- Conflicts of interest or related party arrangements may arise from time to time. How these are dealt with in the LPA, and making it mandatory to refer all conflicts without discretion to the LPAC and potentially an independent conflicts director, is critical.
- The LPAC needs to have the ability to demand a fund forensic audit and access to fund bank statements.
- Generally, LPAs tend to refer to the general partner managing the fund when it comes to undertakings and insolvency/bankruptcy. Given the various complex structures in place for certain GPs, a look through to the parent company of the GP will likely be standard going forward.
- Heavily negotiated clauses, such as right of LPs to divorce a GP for fault or no fault have proven to be theoretical and not actionable in practice. In addition, divorce allows for a lower LP vote threshold to break away from a GP, but given unanimous consent is required to make material amendments to the LPA, it is unclear in practice how anything other than mutual consent or GP resignation will work if LPs want to part ways with the GP.
- Limited partnership agreements have in them definitions of what constitutes financial institutions, and the ability to park fund cash in related party treasury accounts is a thing of the past.
Fund valuations of portfolio companies and investment positions are a key topic, more so in the past year. The key message on valuations is that it is an art not a science. But there is a certain sense check that can be done – potentially as simple as requiring valuation EV/EBITDA v comparables, disclosed as part of the fund reporting table. It need not be complex.
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External third-party review of valuations is also critical, and ideally should not be the same as the auditor of the fund given potential mandate conflicts. While realised track record should be straightforward to review, it is almost always accompanied by adjustments to the track record. As valuations play a key factor in GP fundraisings, especially unrealised valuations, these are likely to remain a hot focus point for years to come.
Flushing out inconsistencies from one-on-one interviews, historic churn of GP professionals and interviewing the internal auditor (including specifically what has been excluded from the internal audit cycle) are some of the approaches. Bottom line here is: slides may be perfect, but it can’t be all rosy. Fund manager due diligence is key in any LP investment decision process. Some LPs outsource this to gatekeepers, and others insource the diligence process. It is very difficult to detect “sharp” practices from the vantage point of the diligence process, but a key element of diligence is maintaining scepticism until the very end. This is very difficult to do, especially in many LPs where the journey from initial GP approach to final LP approvals is a six- to 12-month process or more. Emotional investment potentially gets in the way, similar to any deal environment psychology.
Another area of due diligence LPs rely on is the financial strength of the GP. One observation is where there is substantial leverage or complex structures in place, it becomes imperative to do a more thorough review.
To conclude, I am certain some of the above thoughts on incremental protections will make their way into future LPAs for emerging GPs. However, you can have all the processes and systems in place, but in the end it’s all about the people implementing these and the appropriate third-party checks to make sure what is being preached is being practised.
Ahmed Badreldin was until recently a partner at the Abraaj Group, where he headed investments for the Middle East and North Africa region.