LPACs: Conflicts and complexity

Navis Capital Partners exited Hong Kong-headquartered garment label manufacturer Trimco in 2012 with a 10x return. But it could have been more. The firm’s plan to retain the asset, selling it from one fund to another, required approval from the LP advisory committees (LPACs) of both funds involved. One LPAC member objected, citing a blanket protocol against cross-fund transactions, and the deal foundered.

Trimco was sold to Partners Group, which exited in 2018 with a 3.4x return. Affinity Equity Partners picked up the baton and held the business for another four years, nearly tripling its investment. If the situation emerged 10 years later, Navis would almost certainly have explored transferring Trimco into a single-asset continuation fund, but at the time these structures had yet to take root in Asia.

“We felt there was more mileage in it, and we told LPs that. We didn’t know about continuation funds. Today, it would be relatively easy to say, ‘You’ve made 10x, but if you want to roll over for the next chapter, we think there’s another 3.5x on top of that,’” said Nick Bloy, a managing partner at Navis.

“There is a lot more slicing and dicing of cash flows nowadays. People are more comfortable with the prospect – whether it is a cross-fund transaction or a continuation fund – and they just want to make sure the process is balanced and reasonable.”

This oversight role is distilled into assessing potential conflicts of interest, specifically whether a manager has done enough to mitigate them for a transaction to proceed without risk of harming the interests of the LP base. The challenge for Asian private equity is that the slicing and dicing has become a lot more complex, leading some industry participants to question whether LPACs are fit for purpose.

Conflicts that used to be largely restricted to cross-fund deals now also encompass situations where a single firm might have exposure to the same asset across multiple strategies and secondary transactions with layers of structuring that send distributions in different directions. Indeed, certain LPs may struggle to reconcile their own interests with those of the broader investor base.

“The Asia Pacific private equity environment is more mature and increasingly complex compared to 10 years ago. When you overlap conflicts of interest with the makeup of the LPAC and how voting procedures work, you might have members who are not properly placed to address those conflicts,” said Wen Tan, founder and CEO of Azimuth Asset Consulting, an advisor to asset owners and asset managers.

“For some LPs, compensation is largely linked to generating co-investments and secondaries, and if the primary and secondary teams are not separate, the LPAC might exacerbate conflicts of interest.”

Asian nuance

The function and powers of an LPAC are defined by the fund documents. Even in situations like no-fault GP removal that may require support from three-quarters of the entire investor base, action would likely be driven by the LPAC because it tends to comprise the largest LPs.

Asia complies with global norms to the extent that funds are domiciled in recognised jurisdictions such as the Cayman Islands. However, there are examples of managers that do not have an LPAC at all. Australia-based Quadrant Private Equity and Mercury Capital fit this profile, as do Sequoia Capital’s China and India affiliates, now independent and known as HongShan and Peak XV Partners, respectively.

This doesn’t necessarily signify a lack of transparency – where a fund has no LPAC, the manager might seek approval from all LPs on potentially divisive issues. VIG Partners is a case in point. The Korean manager runs two funds that invest in parallel, one for domestic LPs and the other for international players. There is no LPAC on the domestic vehicle because managers are expected to consult all LPs.

“We have a relatively large number of Korean LPs, and we chose to operate in this way,” said Jason Shin, a managing partner at VIG. “For secondaries, though, local regulations mandate that you get consent from every LP. From the perspective of Korean authorities, continuation funds are self-deal transactions, and they are very strict where there could be conflicts of interest or room for manipulation.”

VIG, which recently launched its fifth fund, accommodated overseas LPs from Fund III onwards. Participants were few compared to the Korean investor base, so they all got seats on the LPAC for the international vehicle. That largely remains the case. Of the 13 LPs in Fund IV, 12 make up the LPAC.

This is relatively large by Asian standards; most LPACs attached to funds raised by Asia-based GPs have between seven and nine members. Size and composition evolve over time. ChrysCapital Partners had five LPAC members through Fund V and increased it to seven over the next three vintages, restricting itself to a small contingent even as the corpus grew from USD 510m in Fund VI to USD 1.4bn in Fund IX.

“It gets challenging when you have an LP that has been with you for several cycles and has a lot of exposure, and then a new LP writes a very large cheque but it’s the only fund they are in,” said a source close to the India-focused private equity firm. “And when you start raising money from US state pensions, they might require an LPAC seat. One solution is to add more non-voting observer seats.”

Hahn & Company is at the other end of the spectrum, having grown its LPAC from 10 to 15, but the expansion rationale is similar. For example, Pennsylvania State Employees' Retirement System (PennSERS) invested in Fund I through fund-of-funds Asia Alternatives but went into Funds II and III directly. Asia Alternatives, a longstanding backer of Hahn, was already on the LPAC; PennSERS joined the roster.

Giving potential reasons for the large committee size, a source close to Hahn & Company stressed the importance of quality information. First, LPACs for country funds tend to spend more time discussing the deal dynamics of their market, which gives LPs insights that can be cross-referenced against other parts of the portfolio. Second, the GP values a broad range of perspectives from its investor base.

“It’s not just about having the 15 largest investors,” the source said. “You want a wide representation in terms of geography and investor type. Funds-of-funds, sovereign wealth funds, foundations, and public pensions have very different views. A fund-of-funds might want you to take more risk because they have an additional layer of fees to overcome, but they sit on a lot of LPACs, so they bring that experience.”

Exchange of information

Tapping into the collective expertise of an investor group away from the large format of an annual general meeting (AGM) is mentioned time and again. Agenda items extend beyond conflicts of interest to valuations, distributions, and addressing problem portfolio companies as well as strategic issues such as structuring an AGM, developing talent, building internal capabilities, and expansion.

“On a broad level, the more LPs on the LPAC, the better,” added Bloy of Navis. “It becomes difficult when a voting LPAC member has a complicated internal process and must go back and consult a board that meets only once every three months. You would be thoughtful about renewing that LPAC member. Maybe you suggest they become an observer instead.”

LP feedback on LPACs in Asia is varied and case-specific. One family office LP described being the sole foreign member of an LPAC for a Japanese fund where their primary role is to interject when proposals veer too far from international norms. The process is complicated by simultaneous translation and consensus decision-making that takes place elsewhere and is presented to the committee.

This LP does not insist on LPAC representation; being one of the 15 largest investors in a fund is enough because that tends to be the threshold for direct consultation on key issues. In contrast, fund-of-funds often regard LPAC seats as a badge of honour – a way of demonstrating value-add to their own investors – and a fast track to information and insights regarding the manager.

“It’s one thing to get an LPAC presentation that’s detailed and may or may not be the same as what is presented at the AGM,” said one fund-of-funds LP. “More important are the informal discussions around the table. You might get some information or just some additional colour around an upcoming exit, which can be very helpful if you are trying to price a secondary.”

Asked about the contributions of LPAC members, Tan of Azimuth references a wide range of behaviour: investors who ring around to canvas opinion about opportunities or challenges emerging at the GP level; investors whose limited bandwidth is an obstacle to deep involvement; and investors who don’t cast a vote – or even say a word – at meetings on the advice of their compliance departments.

The liability issue is real. LPs in the US have been subject to legal action for allegedly overstepping the bounds of their remit and essentially behaving as a GP. Penalties, in theory, can be severe: GPs are structured to minimise the impact of unlimited liability but LPs, as limited partners, are not.

One longstanding industry participant recalls frequent warnings about behaviour on LPACs for fear of being accused of interfering in the management of the fund and potentially facing litigation. That was early in his career. Nowadays, he believes the nuances of the LPAC role are increasingly overlooked.

“For a lot of LPs, fund investment is no longer the primary focus. They use it to get co-investment and secondaries, and so LPAC membership is seen in that context,” said the industry participant.

“This becomes a problem if it undermines the purpose of the LPAC, which is to decide whether a GP has done enough to address the conflicts of interest around a transaction, not whether the transaction represents a good deal. LPs must be aware of the responsibilities – and the risks – of their role.”

Best practice vacuum?

The rise of secondary continuation funds has given these issues renewed focus. Situations are often fraught with ambiguity. Chinese venture capital firm Legend Capital, for example, has completed three GP-led transactions in the past three years, but a fourth was recently nixed by the LPAC.

It was a staple with preferred equity, so incoming investors would commit to Legend’s new fund and receive distributions from an existing fund ahead of other LPs subject to a minimum return threshold, according to sources familiar with the situation. Was the LPAC view shaped by an unresolved conflict or unhappiness with the terms? Is it possible to know either way, regardless of any official record?

In situations where an LPAC member has an interest in a secondary transaction as a potential buyer, they would typically recuse themselves from discussions, even if the limited partnership agreement (LPA) doesn’t require it. Additional complications may come if an LPAC member who is not selected as the preferred bidder on a transaction tries to undermine the deal with a view to finding a way in.

Seeking to address a perceived vacuum in best practice, the Institutional Limited Partners Association (ILPA) issued guidelines for continuation funds earlier this year. These include recommendations on process and timing and terms and documentation, as well as instructions regarding the LPAC role.

The committee should have 10 business days to review a transaction and consider conflicts – the crystallisation of carried interest, the method of soliciting bids on the selected assets, and any economic incentive accruing to the GP like stapled financing and changes to preferred returns – and then provide guidance to the GP throughout to ensure the process is transparent and fair.

In addition, pricing for the secondary should be established through a competitive process that includes third-party validation. The US Securities and Exchange Commission (SEC) addressed this in private fund advisor rules adopted in August, stipulating that an independent financial advisor must provide an opinion that the transaction is fair or an opinion as to the value of the assets being sold.

“The ILPA guidance goes too far in some respects,” said Damian Jacobs, a partner at Kirkland & Ellis. “There is a distinction between waiving a conflict of interest and approving the terms of a transaction. The LPAC should be involved in the former, but members can be uncomfortable doing the latter.”

Even though many Asia-based managers are not registered as investment advisors in the US and therefore out of the SEC’s orbit, fairness opinions are expected to become an LPAC requirement. Their utility is debatable amid suspicions that managers just go “opinion shopping” for the required outcome. Full pricing discovery, involving genuinely interested parties, is preferable though not always feasible.

“These are mechanical steps that extend the timetable required and extend the cost,” said Azimuth’s Tan. “Will it make any difference in terms of how people behave? Maybe at the margins. But on balance, secondary deals will still be better for GPs than for LPs.”

Shaping the narrative

On a broader level, LPAC behaviour is qualitative rather than quantitative. The debate can be shaped using guidelines; implementing rules is harder. ILPA accepts that LPAC members will act in their own interests and have no fiduciary duty to the fund. It asks that they consider continuation fund proposals with a view to maximising value for existing LPs, yet perceptions of value will inevitably vary.

A continuation fund might be seen as an investment opportunity, a much-needed source of liquidity, or a transaction priced at an impossible-to-justify discount. The fund-of-funds LP recalled a recent LPAC in-camera session spent discussing whether an asset should be sold or rolled into a continuation fund. Though the objective was to establish the best outcome for the fund, individual priorities were apparent.

“The duty of care is with the GP and the LPs individually; there is no concept of joint responsibility. This makes any discussion of what is fair or unfair tricky because you will appeal to the legal construct first,” said Jason Sambanju, a partner and CEO at secondaries specialist Foundation Private Equity.

Confronted by a mixture of interests that may cloud objectivity, private equity firms are advised to communicate their plans early and openly to the LPAC. The ILPA guidelines state that GPs should engage the LPAC “at the earliest opportunity” to ensure proposals are met with full consideration. Several managers advocate one-on-one discussions with influential LPs as a consensus-building tactic.

“If you are walking into an LPAC meeting looking for a conflict waiver and you don’t have a pretty good idea of what the outcome will be, you probably haven’t prepared yourself well. You need to talk to people, check the temperature,” said Kirkland’s Jacobs. “Going too early is as bad as arriving late. Things tend to go wrong when the sponsor asks for a conflict waiver almost as a first point of contact.”

Bloy of Navis also stresses the importance of preparing the ground ahead of a meeting, but he notes that the optimal course of action is ensuring there is no point of contention – continuation vehicle, cross-fund transaction or otherwise – in the first place. Well-worded fund documentation that considers different conflicts and eventualities can remove the need for a vote.

The example given is a continuation fund that has some dry powder for follow-on investments and must exist alongside the main fund. To avoid conflicts of interest that may arise should both funds pursue the same asset, the limited partnership agreement for the continuation fund would include clear language as to the kind of deals for which it has precedence and how long this arrangement lasts.

“LPAC issues are increasingly complicated, which can create ambiguity for less experienced LPAC members who don’t know what to do and want to consult their legal departments,” Bloy said. “The more you can find a legal solution in the documentation instead of proceeding to a vote, the better.”

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• Topics
• GPs
• LPs
• Fundraising
• Funds
• Regulation
• Secondaries
• Asia
• regulation
• Fundraising
• Navis Management
• VIG Partners
• Hahn & Co
• ChrysCapital Management
• Azimuth Asset Consulting
• Foundation Private Equity
• Secondaries