There has been discussion in the private equity community both in the United States and abroad about the need for more common or standard language and structure in limited partnership agreements (LPAs). As with any discussion, lots of questions have been raised. How broadly and strongly is the view held that such model LPA language would benefit the industry? Is a model LPA useful in helping new funds complete their initial fundraising? Would a model LPA improve the liquidity of the secondary market in partnership interests? If seen as useful, what would be the key sections of an LPA that, if standardized, would add the most value? Finally, beside economic terms, do general partners and limited partners view key sections of the LPA differently?
To answer the questions surrounding LPAs, the Center for Private Equity and Entrepreneurship at Dartmouth's Tuck School of Business conducted an online survey over the past several weeks. It is important to note that the focus of the survey was on the nature of key clauses of the LPA rather than on opinions about the appropriate balance of economic interests, such as levels of management fee and carried interest, which are the subject of negotiation between GPs and LPs.
We were very pleased with the number of survey respondents: 122 GPs and 95 LPs completed the survey. Those numbers take on even more significance when you consider that each respondent had to answer 75 questions.
Of the general partners who participated, 73% were primarily venture capital investors, while 21% were buyout investors. As seen in the "GP Respondent Demogrphics" on page tk, 70% of GPs had up to three funds under management. Five percent of GP respondents had more than 10 funds under management and 5% of respondents raised more than $1 billion in their most recent fund.
Of the LPs who participated-see "LP Respondent Demographics, page tk-more than 88% managed $1 billion or more, and 13% managed total assets greater than $75 billion. Smaller institutions (those with total assets less than $500 million) accounted for 7% of the total. The majority of LPs were pension plans (44%), followed by endowments (23%) and insurance companies (7%).
Importance of a Model
As shown in Figure 1 (next page), more than half of GPs and nearly 80% of LPs said that a model or guideline LPA would be useful as a starting point in negotiating private equity investments. While a standard, "one size fits all" agreement cannot possibly meet the needs of all venture and buyout funds and public and private LPs, there appears to be industry-wide agreement that LPAs could use some level of standardization. The opinion about the usefulness of a model LPA was held across a broad spectrum of industry participants with diverse characteristics. These characteristics ranged from capital under management to investment focus to total amount of assets to percentage allocation to private equity.
The concept of normalized legal agreements has already been adopted by the National Venture Capital Association, which earlier this year posted model documents for venture funding of portfolio companies. These documents include a term sheet, stock purchase agreement, investor rights agreement and voting agreement, among others. As stated on the NVCA Web site (see www.nvca.org), the model documents aim to "be fair, biased toward neither the VC nor the entrepreneur, consistent with industry norms" and "include explanatory commentary where necessary or helpful." As described on the NVCA Web site, a large number of experienced law firms developed the model agreements with the help of other industry players.
Where's the Value?
The survey showed that in assessing the multiple potential benefits of a model LPA, LPs generally viewed it as more valuable than GPs. The characteristic of a model LPA for which GPs and LPs agreed was most valuable was in helping identify alternative solutions to a particular issue and providing specific language for alternatives. Ninety-six percent of LPs and 86% of GPs ranked this as having at least some value. However, as noted before, they differed in their strength of opinion. Forty six percent of LPs viewed this characteristic as either "very valuable" or "extremely valuable," while just 27% of GPs felt that way. A substantial minority of GPs (14%) said that the alternative solutions had "no value," while just 4% of LPs held that opinion.
Also of note, LPs viewed reduced transaction negotiation time and cost as particularly useful-47% described it as either "very valuable" or "extremely valuable." In contrast, 40% of GPs characterized it as having little or no value and just 21% said it was very valuable or extremely valuable.
GPs and LPs were in closest agreement that a model LPA could facilitate dispute resolution, identify alternative solutions to a particular issue and minimize the likelihood of litigation.
The survey sought opinions of GPs and LPs regarding 27 different types of LPA clauses. As with value assessments, LPs generally gave greater importance to individual clauses than GPs. There was substantial agreement on what was most important. Six of the top 10 clauses were the same and the No. 1 for both GPs and LPs is the clause that addresses waterfall structure and carry calculations (see Table 1, previous page).
There were five key issues that GPs and LPs disagreed on. These were portfolio company fee offsets and allocations; GP conflict issues, including allocation of opportunities and non-competition; escrow account provisions; side letters including most-favored-nation status; and key man provisions.
Of the 27 clauses that GPs were asked to assess, only two proved to be of greater importance to them than to LPs. Those were ERISA exemptions, which neither group viewed as particularly important, and confidentiality provisions, which both viewed as relatively important.
As shown in Figure 2 (below), LPs clearly prefer that the LPA be a governance tool for valuation policy but GPs are divided on this issue. Furthermore, the survey confirmed some contentious aspects of GP/LP relationships that are commonly understood by the industry. For example, LPs were far less satisfied than GPs with the detail of reporting prescribed by LPAs. LPs also placed a higher level of importance than GPs on the specificity of valuation methodologies. Similarly, LPs expressed greater dissatisfaction with the performance of governance mechanisms such as advisory boards and valuation committees.
Some survey respondents viewed LPAs that are now used by law firms as de facto templates. However, survey data indicated that among GPs, who are largely responsible for initiating drafts and overwhelmingly use outside counsel, the average amount spent on legal fees for negotiating an LPA was over $210,000. A number of GP respondents paid more than $1 million. LPs, on average, reported spending one-tenth as much on outside counsel, slightly more than $20,000 per LPA. However, since the average GP reported having 72 LPs, the aggregate legal cost for LPs to negotiate an LPA are on par with costs of GPs.
The development and wide adoption of a model LPA may prove to be a long and difficult process. Certainly some respondents expressed skepticism. GPs and LPs generally agreed that top-tier GP resistance would be a "significant challenge" to the adoption of a model, and GPs in particular said that differences among types of funds would represent a meaningful challenge. Thus, separate model documents will have to be created for venture, buyout and mezzanine funds. The models will have to be "living documents" subject to revision, as hidden issues are uncovered and industry players attempt to use the model LPAs. Furthermore, both LPs and GPs agreed that annotations and illustrative numerical examples would be useful in model LPAs. In spite of the challenges outlined above, 60% of LPs and 38% of GPs expressed an interest in participating in working conferences to develop a model LPA.
In summary, as the survey results proved, there would be economic value to the industry by using a model LPA, and both GPs and LPs view a model LPA as potentially useful.
Colin Blaydon is the William and Josephine Buchanan Professor of Management at the Tuck School of Business at Dartmouth. Fred Wainwright is Adjunct Assistant Professor of Business Administration at the Tuck School of Business. The authors are principals at the Center for Private Equity and Entrepreneurship at Tuck. This article was developed with the assistance of Erick DeOliveira, Research Fellow of the Center. Web site: www.tuck.dartmouth.edu/pecenter.
This article originally appeared in the July 2004 issue of the Venture Capital Journal.