Alignment of General and Limited Partner Interests in PE Funds

There are arguably two broad objectives to the governance of any entity including private equity (PE) funds: i) effective and accountable decision-making and ii) aligning interests of different stakeholders. This article focuses on the second of these objectives describing in more detail the difficulties in aligning interests between a general partner (GP) and a limited partner (LP) in a PE fund.

The governance of PE funds is increasingly coming into the spotlight. The Institutional Limited Partners Association (ILPA) revised its Private Equity Principles in 2011 to establish a set of best practices to govern the relationship between GPs and LPs. Also, the UNEP Finance Initiative for Responsible Investment (UNPRI) issued a second version of its guide for LPs in 2011. There are contributions from the European Private Equity and Venture Capital Association (EVCA), the Australian Private Equity & Venture Capital Association Limited (AVCAL), as well as most recently from the International Corporate Governance Network (ICGN)—all on the same topic.

PE fund governance differs from conventional corporate governance in that investors, as LPs, engage the GP or fund manager to achieve a specific investment purpose over a defined period of time. The relationship between the LP and the GP mainly relies on explicit contractual measures, which are entered into at the outset of the partnership. Fund governance also features another layer, which focuses on the governance—and the PE fund’s influence—on portfolio companies. Proponents of PE would argue that the governance of their portfolio companies is superior because of a better alignment of interests between themselves and their portfolio companies. This alignment, however, seems to be achieved at the detriment of the alignment of interests between the GP and the LP. Many LPs complain that governance structures that supervise the relation between GP and LP do not provide them with sufficient control mechanisms over the ultimate users of their funds. One could thus argue that the PE industry hasn’t actually solved the principal-agent problem that exists in public companies but rather shifted it up the investment chain.

Conceptually, the LP is a passive partner in the management of a fund. Investment and risk management considerations, for example, are entirely delegated to the GP. In most jurisdictions—and this is a major obstacle in enhancing the governance role of the LP—the LP will lose the limitation of liability if it interferes in management. As a consequence, LPs have limited rights to participate in day-to-day operations, challenge decisions of fund managers, or approve major transactions as board members in a publicly listed company would do.

Since GPs act as agents for external investors who choose to invest in publicly-held or closely-held firms through an intermediary, rather than directly, the agency problem not only still exists, but is likely to be difficult and intractable. One can observe a high degree of information asymmetry between the GP who may play an active role in the portfolio company, and the LP, who is not able to monitor the prospects of each individual investment closely.

While in such a set up the need for aligning interests can hardly be disputed, the question remains whether covenants and schemes that align the incentives of GPs with those of outside investors are sufficient and adequately reduce agency costs. The success of the limited partnership model ultimately relies on the interests of both parties being adequately taken into account. Events over the life of the fund may result in a change in how LP or GP interests are best being served. LPs do entrust their capital to a GP for up to 15 years based on the expectation that the investment thesis will remain valid over time and also that their interests will remain aligned. If one of these two assumptions does not hold true, there is immediately a problem with the relationship that remains unsolved unless both parties agree to change the underlying agreement, which is rarely the case.

This article will attempt to describe the most pressing problems around the alignment of interests between GPs and LPs in PE governance. We will make the argument that some of the best governance practices developed for publicly listed companies can indeed be ‘borrowed’ to improve the misalignment of interests between GP and LP. In an ultimate step this could also lead to exploring alternatives to the limited partnership model on which the establishment of most PE funds is currently based. In the relationship between GP and LP we do appreciate, though, that the latter stands to benefit from a specific skill of the former for which the latter should be willing to forgo certain control rights that it would otherwise have when investing directly or ensuring for co-investment rights.

The full article is available for download here.