Private Equity Corporate Governance: Rethinking A Faulty Model

• Transparency: investors have increased their requests for transparency in the PE industry, especially around fees, performance calculations, and co-investment arrangements.
• Limited Partner Advisory Committees (LPACs): investors are searching for more governance oversight around their PE investments – but the LPAC is an imperfect tool. We discuss this finding in more detail below.
• Co-investment: Co-investment structures are becoming ever more popular, both as a mechanism to reduce the aggregate fees paid by investors across their PE programs and (especially for larger investors) as capacity access tools. However, co-investments can create a range of conflicts of interest: one panelist, for example, asked why potential co-investors frequently do not bear their pro rata share of broken deal costs. Under current PE “this is the way we have always done it” practice, it is typical for the primary pooled fund to bear all broken deal expenses – which can run into millions of dollars - even if co-investors would have allocated if a deal had been consummated.
• Outsourcing: Investors continue to be strongly in favor of outsourcing to third party fund administrators – in fact, every investor surveyed by IFI and Vistra indicated that they supported outsourced fund admin. This finding highlights, however, quite an exceptional expectations gap, given that the majority of US based PE managers have not appointed a third party administrator -  just as many larger US based hedge funds were self–administered pre-Madoff. Separately, the survey noted that cybersecurity risk was the most important concern for both investors and managers when considering the suitability of outsourcing providers.
• Fund structures and domiciles: Despite Brexit, AIFMD and a proliferation of new fund structures in jurisdictions such as Ireland and Luxembourg, there is no particular trend towards looking at new types of fund entity in the PE space. 

Our thanks to both Vistra and IFI for preparing this very informative survey.

Rethinking the LPAC
 
To focus on one topic discussed, the sense of both the survey and panelist comments was that the LPAC, as a governance model, is faulty. Indeed, while 100% of the investors surveyed require an LPAC – 100% of investors also stated that they are “not satisfied” with the governance structures employed in the private equity industry. That is a pretty damning statement as to the current status quo.
Among topics discussed:

1. Membership criteria for each LPAC is not standardized and selection criteria can be opaque. While LPACs may focus on larger investors, membership criteria may not be uniformly applied: legal panelists reminded investors that the manager typically has “complete discretion” as to LPAC membership. The “bigger investor” approach can also create an LPAC perspective which is skewed, with less attention given to matters of concern to smaller investors. 
2. LPAC minutes may not be available to all investors, creating unequal disclosure and a sense of “two classes” of investor.
3. Panelists spent considerable time on the inherent incompatibility of, on the one hand, investors’ desire to be more involved in governance oversight and have “control” with – on the other hand – investors’ emphatic desire to not acquire any liability. There was a sense that, if a contentious issue arises four years into a fund, investors may retreat from decision making due to liability concerns. The paradox of investors who seek only “observer” status on LPACs – again, to avoid liability – was also discussed. What happens if the investor observes something they don’t like – but has no ability to do anything about it?
4. The terms of reference and responsibilities of each LPAC are contractual, not defined by law or regulation. As a result, the scope of LPAC oversight can differ greatly. Castle Hall’s favorite is when the manager (GP) retains the ability to selectively consult the LPAC when a situation arises which – in the opinion of the GP – could give rise to a conflict. Legal weaselwords and “broad and flexible” powers granted in fund documents can undermine effective LPAC oversight across many dimensions.
5. Key aspects of LPAC functional behavior are often not defined or can be inconsistent. Who can call an LPAC meeting? Who has the authority to add agenda items to an LPAC meeting? Can the LPAC engage legal counsel to provide its members with independent advice (and, if so, who pays for that advice)? Can the LPAC mandate an in camera session whereby LPAC members can discuss issues without the manager being present? 

Aside from the above, Castle Hall is also concerned when the same investors serve on the LPACs of different vintage funds. If Fund V sells an asset to Fund VII, there is a conflict and appearance of self-dealing if the same sub set of investors approve both sale and purchase across different fund entities (especially when LPAC meetings are, to all extents and purposes, held concurrently in a commingled, single forum). It is also notable that the investor appointed LPAC representatives approving both sale and purchase are typically front office investment professionals, compensated based on the performance of funds overseen. Looking forward, a pivot towards LPAC membership being staffed by investor compliance and governance specialists may bring greater objectivity to challenging governance questions.

All of the above raises a fundamental question – why are private equity funds structured as limited partnerships in the first place

It is pretty clear that the LPAC is a half-way house which – especially in contentious situations – may prove to be unfit for purpose. 
The answer to better corporate governance in the PE space is relatively obvious: structure all alternative asset vehicles, including PE (and real estate and infrastructure), as corporate entities, each with an active, independent board of directors. Under a corporate structure, PE would move out of the legacy contractual world of individually negotiated partnerships into a more clearly defined framework of board responsibilities and corporate law. And yes, it is possible to handle tax issues with a corporate rather than partnership fund entity for the significant majority of investors.
At present, the idea of a PE vehicle which is not a limited partnership seems to be a black swan for many PE industry participants. Given the evident weaknesses of the LPAC model, however, it may be time to challenge the status quo.