Why Private Equity Agreements are One-Sided
Almost everyone agrees that private equity’s limited partnership agreements are extraordinarily one-sided. As I discussed yesterday, the SEC doesn’t have the authority to ban or modify the contractual terms between the general partner and its investors. It can only attempt to make sure the terms are clear and followed. Under the securities laws, it is assumed that sophisticated investors can fend for themselves.
Critics have charged that the LPs are simply overwhelmed by the sophistication and intellectual power of private equity executives and their lawyers. Detractors argue that institutional investors aren’t being rigorous in negotiating with private equity firms. While there’s some truth in these arguments, they don’t begin to explain why the private equity documents are so one-sided.
So why do so-called “sophisticated investors” routinely allow the general partner to engage in all sorts of conflicts of interest, limit the LPs legal remedies, and generally fail to constrain the GPs ability to do pretty much as it pleases? I think there are a series of factors that combine to produce one-sided legal documents.
Who controls the pen? When an institutional investor hires a conventional stock or bond manager, the investor provides the manager with the investment contract. While the money manager may ask to tweak an item or two, the contract is generally favorable to the institutional investor. In the case of private equity (and alternative investments generally), the money manager writes the contract (LPA) and related documents. Thus investors face the uphill battle of trying to negotiate over a host of terms that are highly favorable to the manager.
The decision to invest has already been made. By the time an institutional investor turns over the legal documents to its lawyer for review and negotiation, due diligence has been completed and the institution is inclined to make the commitment. Most institutions don’t have the time, resources, or money to begin negotiating terms before the due diligence is complete. Therefore, by the time the institution sits down to hammer out the LPA, the balance of power has shifted to the manager. He knows that this is an investment the institution is eager to commit to.
Greed trumps fear when investors make the commitment. When institutional investors commit to a private equity fund, they are mainly focused on the potential return of the investment. It’s the 20% or 25% payoff (greed) that has gotten the investors attention. While the investor will also pay some attention to the management fee, carry structure (bonus), and some of the investment risks, the legal terms are of tertiary interest. After all, most of the legal terms only come into play if something goes wrong.
At the outset most of those contingencies seem rather remote, so less attention is paid to those terms in the LPA. Obviously, if something goes wrong, the investors immediately turn to their legal documents and discover that they don’t have very many rights. Nonetheless at the outset of a relationship with a PE firm, the legal terms are not top most in the investor’s mind.
Conquer and divide. Typically a PE firm looks to corral a lead investor when it sets out to raise a fund. Being the first to commit to a PE fund, the lead investor will be given special favors, such as lower fees or carry, or superior co-investment terms (the right to invest in particular deals along side the fund at no fee). In exchange the anchor investor will agree to the LPA, along with its manager-friendly provisions. When subsequent investors come along and try to negotiate better terms, they’ll be told that the LPA has already been fully negotiated by the lead investor. If the terms were acceptable to a $200 or $300 million investor, what kind of leverage do you think a $50 million investor will have, if it tries to engage in detailed negotiations over legal terms? Not much.
The Institutional Limited Partnership Association (ILPA), which includes most major pensions, endowments, and sovereign wealth funds, has attempted to come up with uniform investment terms for limited partnership agreements. While they’ve issued guidelines and principles, they haven’t made a great deal of progress in achieving more favorable legal terms. In the end, the factors I cited above overwhelm the ability of institutional to band together.
The notion of exempting certain kinds of investments from the securities laws because sophisticated investors are making those decisions is flawed. It isn’t that institutional investors aren’t sophisticated. Rather, they playing a game in which private equity and other alternative managers have huge built-in advantages in negotiating deal terms.