Structure for LP Control: An Alternative to Divorce

Joseph W. Bartlett, Founder of VC

4 minutes to read

Herewith a possible a solution to the problem limited partners in private equity funds face when it becomes apparent that investor values will be negatively impacted until and unless the proprietors (the limited partners) are able to make their voices felt the way shareholders do these days in general business corporations . by disciplining and/or making changes in the management of the assets.

Traditionally, this has been difficult for limited partners... particularly those which are super sensitive and averse to becoming involved in a controversy (the "shrinking violets"). First, prior to adoption of the Revised Uniform Limited Partnership Act, the notion was that limited partners might wind up crossing the line if they took a pro-active role, exposing themselves to liability as general partners. That concern has now been put to rest; but, nonetheless, the possibility remains that, if the general partners resist, the affairs of the partnership could wind up in court; and the old adage applies. an exploding hand grenade usually wounds or kills everybody in the vicinity, the just and the unjust alike. Moreover, the typical partnership agreement historically imposed high significant obstacles in the way of limited partner activism, the general partners for years having enjoyed the upper hand on that issue.

Based on my most recent assignment as a "divorce lawyer" (meaning the most recent of six assignments in which I have been employed to figure out a way to mollify the GPs and LPs in a fund in which the LPs were justifiably unhappy), let me recommend a provision along the following lines:

The typical partnership agreement contains conventional 'no fault divorce' clause, meaning that a given percentage of the limited partners (usually somewhere around two-thirds) may either shut down the investment process and require the GPs to run out the string or remove and replace the GP; the latter is (or at least has been up until now) less common than the former... unless the GP and/or its members have committed an egregious act amounting to "Cause."

The above provision is necessary but not sufficient for the shrinking violets' purposes, particularly if Cause is (as is almost always the case) narrowly defined and if the percentage required for removal is quite high. Thus, the further possibility is a provision which organizes, as of the closing of the fund, a committee ("Committee") of limited partners . an advisory committee, if you like, but with a very specialized function.

The Committee should be broadly based in the sense that it represents limited partners of various sizes, shapes and descriptions (from individuals to, say, large pension funds) but should number no more than, say, five members because anything over five runs the risk of inertia and unwieldiness. The agreement then provides that any limited partner (or group of the same) with, say, more than five percent of the profits interests may convene the first meeting of the Committee. Note that the convening limited partner, which in this case could be a shrinking violet, need not be a member of the Committee.

The Committee then would meet and be charged (indeed, it would be its only purpose) with examining the performance of the general partner and reporting back to the limited partner group as a whole. The members would be indemnified by the fund.

The Committee would have, in effect, subpoena power in the sense that it could require that any and all financial records of the fund be presented to it and that the general partners appear before the Committee and, in effect, testify. The Committee would have the power to hire counsel and other consultants. While its recommendations would not be binding on the limited partners as a whole (the limited partners still having the right to vote by whatever the required percentage might be), the very fact that Committee makes a specific recommendation will, in my judgment and recent experience, carry the day. The existence of a Committee composed (with the agreement of the general partner in advance) of willing limited partner representatives (and a limited partner could appoint anybody, including its counsel, as its representative) should shield a limited partner, particularly non-members (like the shrinking violet), from the possibility that it will be named as a party if the situation turns ugly. The Committee then is the moving force, acting as shrinking violet's proxy as it were. And, given the natural inclination of GPs to protect their reputation, it is likely that a very high percentage of the disputes will be settled without resort to courtroom proceedings.