Private Investment Fund Terms and Conditions: The Relationship Between GPs and LPs

Striking a Balance in the Relationship Between GPs and LPs

The relationship between a General Partner (GP) and Limited Partners (LP) is a multi-trillion dollar industry. General Partners (GPs) sponsor and manage private investment funds. They need capital to invest but demand flexibility and discretion to get the deal done. Limited Partners (LPs) are the investors committing capital to those funds.

There are two types of LPs:

• Institutional LPs (pensions, foundations and endowments)
• Wealthy individuals and families

The relationship between GPs and LPs requires a careful balance of caution and trust. Navigating this relationship requires evaluating both sides’ perspectives, motivations and sensitivities. Closing a private investment fund is the beginning of the relationship between GPs and LPs. The limited partnership agreement governing the fund must provide a commercial relationship that will last for at least ten-plus-two years.

How the Relationship Between GPs and LPs is Governed

The basic principles governing private investment funds haven’t changed in twenty years. The Institutional Limited Partners Association (ILPA) outlines the three guiding principles on the relationship between GPs and LPs:

1. Alignment of economic interests

• Management fees
• Fee income offsets
• Organizational
• Operating expenses
• Carried interest

2. Governance

• Management team responsibility and accountability
• Investment strategy
• Fiduciary duties
• LP Advisory Committee oversight

3. Transparency

• Financial reporting
• Risk and conflict disclosure
• Capital call and distribution notices

The terms and conditions underlying these fundamental principles remain consistent. But, the scope of these terms fluctuates over time, and ILPA continues to publish additional guidance under these principles. ILPA Principles 3.0, published in 2019, discusses more on the topics of fund term and structure, financial disclosures, key persons and more. As the financial market’s pendulum swings, so too does the negotiating leverage between GP and LP.

Market Swings Affect the Negotiating Relationship

During the record fundraising levels of the early- to mid-2000s, General Partners enjoyed easier access to capital. The GP dictated favorable terms and raised oversubscribed funds during condensed marketing periods.

Following the 2008 financial crisis, the relationship between GPs and LPs changed. GPs struggled to invest dry powder in their existing funds. Institutional investors were hesitant to commit new capital to blind pool funds. As a result, GPs trying to raise capital found that LPs perceived they had much stronger negotiating leverage.

This led to more LP-favorable terms:

• “No-fault divorce” provisions
• 100% fee income offsets
• Heightened reporting obligations

The market for private investment funds has returned to those pre-2007 record-breaking levels. For nearly a decade, GPs have enjoyed the improvements in private investment fund terms and conditions and a renewed robust fundraising market. For example, LP Advisory Committee consent rights are steadily replacing veto rights. Portfolio Company fee income still offsets management fees on a dollar-for-dollar basis. But more categories of fee income are being excluded from the offset. Basic financial statement reporting packages are still available to LPs. But supplemental reporting and enhanced information rights come from most-favored nations clauses.

There are those who believe that the market pendulum has reached its apex and is beginning its downward swing. We saw 2017 have near-historic private equity fundraising levels. Now there are some signs that the capital-raising frenzy is slowing down. Fundraising levels remain robust. But institutional investors appear to be consolidating their holdings with fewer, established managers. Marketing periods are getting longer. Blue-chip, top-quartile performing managers are still raising new funds effortlessly. But smaller managers and first-time managers are struggling to get to initial closing.

It remains to be seen if these indicators are predictions of a market correction. But General Partners and Limited Partners alike should be alert to potential shifts in their dynamic. Ever-changing market conditions may once again sharpen their perspectives vis-à-vis the private investment funds that they sponsor and shift the negotiating leverage between GPs and LPs.

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[Editors’ Note: To learn more about this and related topics, you may want to attend the following webinars: What is a “Private Fund?” and Basics of Fund Formation.]

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