Originally Published in Law 360.

Law360, New York (May 04, 2010) - Approximately six months ago, the Institutional Limited Partners Association (ILPA), a voluntary organization dedicated to the interests of institutional limited partners in private equity funds, released its Private Equity Principles. Since then, the Principles have received the endorsement of more than 100 of the largest and most influential institutional private equity investors.

The ILPA's effort to provide more standardized — and investor-friendly — terms, and the backing this effort has received from investors, has caught the attention of fund sponsors and others. What fund sponsors may have initially seen as mere "saber-rattling" has turned into a mobilization effort of the most influential investors and negotiators in the private equity space.

Of course, this effort is being made at a time when institutional investors have increased leverage in negotiating terms with fund sponsors as a result of the decrease in overall commitments by institutional investors to alternative investments caused by the economic downturn and the corresponding "denominator effect."

The ILPA maintains that the concepts contained in the Principles reflect its suggested best practices in the private equity fund space and are intended to serve as a basis for discussion among general partners and investors with an objective of strengthening the basic "alignment of interests" value proposition in private equity. Others suggest that the Principles represent a "wish-list" among the most significant private equity investors, and some private equity firms have retained outside counsel to examine whether the proposal raises antitrust issues.

The Principles sets out the ILPA's discussion of best practices for private equity funds and includes two appendices — one with preferred terms and the other with best practices for limited partner advisory committees. The Principles covers many of the significant deal terms and due diligence issues typically negotiated between a general partner and the potential investors in a fund. It also contains investor-friendly positions on terms investors once thought were non-negotiable.

We believe that many institutional investors will push for the recommendations outlined in the Principles when establishing a new relationship with a fund or negotiating a new investment with an existing fund. Both fund sponsors and investors will need to think carefully about these recommendations, however, since a "one-size-fits-all" response may not be appropriate in most cases. We look forward to discussing the Principles with our general partner and limited partner clients and considering which recommendations are appropriate under the circumstances.

Some of the more significant "Best Practices" offered by the ILPA include:

Distributions

Return of capital plus preferred return (calculated from when capital is contributed to the point of distribution) in an enhanced deal-bydeal model (e.g., continuous makeup of partial write-offs and return of all expenses to date) should be standard. Tighter distribution provisions should help avoid clawback situations. GP Clawback

Clawback should be gross of taxes paid and paid back no later than two years following recognition of the liability. Any clawback obligation should be determined and clearly disclosed at the end of every reporting period.

Carried Interest

The carry should be calculated on the basis of net profits (not gross profits) on an after-tax basis. Carry escrow accounts should be required. Effects of changes in the tax treatment of carried interest should not be a fund obligation.

Management Fee

The management fee should be based on and limited to reasonable operating expenses and reasonable salaries and should step down significantly following the close of the investment period. Management fee models should be provided to the investors at formation. The management fee should encompass all normal operations of the general partner to include, at a minimum, overhead, staff compensation, travel and other general administrative items, as well as interactions and meetings with limited partners. Placement agent fees and general partnership insurance should be an expense of the general partner. The limited partner advisory committee should review partnership expenses annually.

Fee Income Offsets

All transaction monitoring, director, advisory and exit fees charged by the general partner should accrue entirely to the benefit of the fund investors.

General Partner Investment

The general partner commitment should be significant with a "high" percentage of that amount being a cash investment, rather than being contributed through a waiver of management fees.

Other activities of the General Partner

Principals and key persons should devote substantially all their business time to the fund. No principal or key person should act as a general partner for another fund with substantially equivalent investment objectives and policies until the termination of the investment period or until the fund is fully invested or committed.

Fiduciary Duty

Liability for the General Partner's gross negligence, fraud and willful misconduct should be the baseline for duty of care standards. Recent efforts to reduce duties to the fullest extent permitted by law or to waive broad categories of conflicts of interest should be avoided. There should be full disclosure of conflicts and non-arm's length interactions and transactions.

General Partner Removal / Key Person Event

Supermajority "blow-up rights" and the right to remove the general partner without cause should be available. General partner removal for bad acts should be permitted upon a preliminary determination (i.e., a final court decision not subject to appeal should not be required). The occurrence of a key person or "for cause" event should result in an automatic suspension of the investment period.

Style Drift/Investment Purpose

The investment purpose should clearly and narrowly outline the investment strategy and program, and there should be strict adherence to the investment strategy outlined in the offering document. Any changes to this purpose or program should require supermajority approval. Limits and restrictions should be placed on: (i) percentage of commitments that can be called on an annual basis; and (ii) investments in debt instruments (in respect to buyout funds), publicly traded securities and pooled investment vehicles.

Transparency / Reporting

Fee and carried interest calculations should be transparent and subject to limited partner and independent auditor review and certification. Includes a best practices request for annual and detailed quarterly reports, which includes significantly more calculation and reporting than is typically offered (e.g., robust portfolio company reporting).

Due Diligence of Fund and General Partner

During due diligence prospective investors should be given: (i) valuation of unrealized investments of prior funds; (ii) IRR reporting on gross and net basis (and an explanation of the deviation of IRR); and (iii) disclosure of political campaign contributions. In addition, a schedule of existing limited partners should be provided. Investors should also have the opportunity to diligence the economic arrangements among the principals, including individual financial commitment, vesting schedules, carried interest sharing percentages and involvement in other funds dedicated to alternative strategies.

The Best Practices for Limited Partner Advisory Committees includes protocols for the formation of the committee, meeting protocols, duties and member responsibilities. Some of the notable duties include disclosure and discussion with the general partner regarding: the general partner's operating budget and financial statements; partnership compliance with the investment purpose and restrictions; costs expensed to the fund versus absorbed as part of the management fee; investments made by the general partner outside of the fund; fees and carried interest calculations; changes to the investment strategy; and valuations of portfolio companies no less frequently than quarterly.

While the ILPA focuses on private equity funds, whether institutional investors will push for similar types of principles in hedge funds is unclear.

The Institutional Limited Partners Association's Web site is ilpa.org.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.