cross border transactions

 

Posted By: Moty Ben Yona

 

The recent financial crises, on one hand, and the growth of private funds, on the other hand, have raised numerous calls for reduction of management fees and more efficient investor protection. Moreover, in order to reach such objectives there have been recently discussions in the U.S and in Europe about the need for regulation of private funds, primarily hedge funds.

Without addressing the question whether regulation of private funds is indeed necessary, it is obvious that a more efficient protection for the interests of the Limited Partners can be achieved by incorporating certain terms and conditions to the limited partnership agreements and the ancillary documents, which govern the relationships of the Limited Partners, the General Partner and the fund managers.

While the typical limited partnership agreements tend to be very long and contain hundreds of clauses, it is important to make sure that these agreements include certain terms and conditions, which are designated to align the interests of the Limited Partners and the General Partner. It is also important to make sure that the fund provides the Limited Partners with adequate transparency.

Below is a short outline of some of the issues required to be addressed prior to executing a subscription agreement by which a Limited Partner will make a solid commitment to invest in a private equity fund:

What is the term of the Fund?
It should be confirmed what is the term of the fund, as throughout such term management fees will be paid to the General Partner (subject to certain adjustments within such term). It is also advisable to take into account that the General partner is usually entitled to extend the fund for additional 1-2 years, at its sole discretion. Also, in most cases the term of the fund may be further extended with the consent of a majority in interest of the Limited Partners. In addition, it is advisable to confirm what is the duration of liquidation and whether the General Partner or the liquidator of the fund will be entitled to fees throughout such period of liquidation.  

What is the Capital Commitment provided by the General Partner?
It is recommended that the General Partner of the Fund will have a substantial capital commitment and a substantial equity interest in the fund. Naturally, while the General Partner invests its own money in the fund a strong alignment of interest with the Limited Partners can be reached. It is also suggested that such investment shall be made by the General Partner in cash rather than by means of waiver on management fees.

What is the method of the calculation of the Carried Interest?
Carried Interest is the share of profits that the General Partner receives as compensation. Traditionally, the amount of Carried Interest is set at around 20-25% of the fund’s annual profit. However, it is necessary to confirm how the Carried Interest is calculated. For instance, it is advisable to confirm whether the Carried Interest is calculated based on net profits or gross profits and whether the carried interest is calculated on an after tax basis.

What is the Structure of Management Fees?
It is advisable to ensure that the Management Fees are not excessive and that they are based on reasonable operating expenses. Also, it should be confirmed whether the management fees cover all the overhead and staff compensation as well as travel and other administrative expenses. It should be confirmed which expenses are not covered by the management fees and whether such expenses should be borne by the Partnership or by the General Partner. For instance, it should be discussed whether the general partner’s insurance will be borne by the Partnership or the General Partner itself. In this context it should be also confirmed whether the Limited Partners’ Advisory Committee has any rights to review the Partnership’s expenses on a periodic basis. It is also advisable to confirm whether the Management Fees are decreased significantly once the investment period is over.

Is there a Clawback Obligation?
A clawback obligation of the General Partner ensures that the General Partner will not keep distributions in excess of a certain percentage which was agreed upon in the Limited Partnership Agreement. The clawback provision will require the General Partner to repay the Limited Partners such amounts which were distributed in excess. To secure the clawback repayment by the General Partner, it is possible to require that the General Partner will maintain a “carry escrow account” with significant reserves to cover potential clawbacks.  

Are there any “No Fault” Clauses?
No fault clauses provide the Limited Partners with the right to demand changes in the operation of the fund upon majority in interest vote. “No Fault Divorce Clause”, for instance, provides the Limited Partners with the right to remove the General Partner of the fund and either terminate the fund or otherwise appoint a new General Partner. Such clause can be activated even if the General Partner is not in breach of the Limited Partnership Agreement, provided that the resolution for the removal of the General Partner was adopted by a special majority of the Limited Partners. Other “No Fault Clauses” provide the Limited Partners with the right to demand the suspension or the termination of the “Investment Period”, during which the General Partner invest the fund’s commitments.

This entry was posted on Monday, March 22nd, 2010 at 3:49 pm and is filed under Venture Capital Industry Trends. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.