Alternative Insight – June 2019

Top tips for negotiating the LPA

 

Negotiating a private equity fund’s LPA can be a difficult, intricate process. If not managed properly, fund organisational expenses and LP due diligence costs will be higher than expected, and closing deadlines may slip. Here are seven top tips to speed managers and investors through a successful LPA negotiation.

Be a frontrunner

A strong first closing lends credibility to the management team and acts as a signal to the broader market, potentially unlocking additional capital commitments from other investors. GPs can incentivise early closers with management fee discounts, either systematically (via the LPA) or on an ad hoc basis (via side letters), although, in order to make the incentive stick, the GP must then be prepared to refuse late-closers’ requests for such discounts. If the fund has a tiered MFN right (i.e., an investor’s MFN rights are limited according to when it subscribed to the fund and/or how big its commitment is), that acts as another ‘early bird’ closing incentive, and ensures that investor-specific deals are only offered to other investors in the same position.

From an LP’s perspective, it is more likely to obtain its full desired allocation in the fund and to exert greater sway over the LPA’s terms when it participates in the first (rather than the final) closing. ‘Off-market’ terms are more difficult to dislodge once they have already been passed as acceptable by dint of the early-closing LPs having signed up to them.

GPs should note that EU and U.S. regulations mean that it is now either obligatory or strongly advisable that early bird incentives, which by definition treat investors differentially, be disclosed to all investors before admission.

Learn the ‘market’ 

Market practice and standards exert a powerful influence on LPA terms. It is important to understand what is currently ‘market’ on any given issue, if only to inform each side’s negotiating strategy and avoid battles of attrition. Of course, market practice shifts over time, pendulum-like, influenced by many variables, from regulatory and political scrutiny to the state of the broader economy. Every year MJ Hudson publishes a broad-based analysis of current trends in private fund terms, which makes a great starting point.

Start early

The GP should sound out big investors in its current fund at an early stage about whether they are looking to re-up and solicit their views on any modifications to terms which the GP wishes to propose. Ideally, key changes should be agreed in principle between the GP and its core investors before the GP’s lawyers circulate the new draft LPA. The LPA should be accompanied by a memo identifying what the key changes are from the last fund and explaining why they are being made.
Managers and investors alike should allow time for full consideration of issues with their respective counsel. Be forewarned: fund documentation is voluminous. The typical legal pack will include, among others, the LPA, the private placement memorandum, subscription and management agreements, carry and GP commitment vehicle documentation, legal opinions, contracts with the administrator, depositary and other service providers, fund policy documents, and investor side letters.
GP counsel will need adequate time to draft and agree the documents with its own client, and ultimately to negotiate final documents with prospective investors and their lawyers. Similarly, the legals are only one part of an LP’s fund due diligence, alongside commercial and operational DD. Starting early gives each side the space to get things right for what will be a long term relationship.

Take care with process 

The timeframes for LP comment, negotiation, KYC and closing should be reasonable, so that LPs aren’t forced to drop out for lack of time to complete their own DD and internal approvals. Investors should bear in mind that a manager is more likely to accommodate special requests where submitted ahead of deadlines (or at the very least on time).

Where timing is tight and the group of serious potential investors is not too large, consider following up the submission of comments with an all-parties call, with the key decision-makers dialled in. This will help to avoid the GP having to run (and eventually harmonise) multiple parallel negotiations . Headline commercial terms are often most speedily settled by discussions between the principals, whereas GP and LP lawyers can be relied on to negotiate the more ‘legal’ terms separately.
Side letters can be a better venue for resolving smaller or awkward points, which allows the main LPA negotiation to focus on ‘big ticket’ items.

What’s past is prologue, but…           

Arrangements that have worked well between a GPs and its LPs in prior funds should justifiably be preserved in the next fund, but neither side should become captive to the old terms and simply reproduce them in the next fund without due consideration for changes in law, circumstances or risks.

This isn’t merely a question of one side negotiating a ‘better’ deal for itself, but of both sides wanting to ensure that the new LPA deals with new, foreseeable challenges – a kind of future-proofing. For example, does the GP have a coherent succession plan in place for key executives? Has it built that into the LPA? Are the right people for the next fund listed as key persons? Is there any need to retain historical ‘super key man’ protection for founders who are gradually pulling back from the coalface? Are rising stars properly incentivised via carried interest?

Be pragmatic

For both GPs and LPs, what’s realistically achievable at the negotiating table will to some degree depend on market demand for the fund in question. For example, a prestigious PE firm marketing the latest in a long line of high-performing funds will, in today’s booming fundraising market, likely be oversubscribed, which will give it an excellent chance of obtaining commercial terms at least as good as its last fund. By contrast, a new manager raising a first-time fund will need to find ways to stand out in a crowded marketplace, which should motivate it to offer LPs a comparatively favourable deal.
If an LP isn’t going to rank among the fund’s biggest investors, or it’s applying for entry in a later closing, at which point the LPA is already largely set, it would be sensible to confine itself to the principal commercial concerns identified during its investment and legal due diligence.

Knowledge is king

Investors should hoover up as much information as possible about the manager and its business and funds through their initial due diligence before entering the formal LPA negotiation process. This enables them to ask more incisive questions, identify material risks, and aim for protective LPA provisions in the right areas.