On January 11, 2011 the Institutional Limited Partners Association ("ILPA") released an updated version of its Private Equity Principles (the "Principles").^[1] The updated Principles maintain the three original guiding tenets of "Alignment of Interest," "Governance," and "Transparency," while incorporating feedback solicited throughout 2010 from general partners, limited partners and industry third parties to increase focus, clarity, practicality and adoption. The following summary highlights some of the more notable Principles.

Alignment of Interest

• Significant cash contributions by the General Partner are strongly preferred to fee waivers.
• European-style waterfalls (i.e., all contributions plus preferred return back first) are preferred to American-style waterfalls (i.e., deal-by-deal), but with certain safeguards an American-style waterfall may be acceptable, some of which include: (i) return of all realized costs, (ii) make-ups for partial impairments and write-offs, (iii) return of all fees and expenses to date, (iv) valuing all unrealized investments at the lower of cost or fair market value, (v) carry escrow accounts of 30% or more of carry distributions, and (vi) no carry being paid on recapitalizations until the full amount of invested capital is returned to the limited partners.
• With respect to general partner clawbacks:
  • When American-style waterfalls are used, clawbacks should be supported by NAV coverage tests (125%) before paying carry on distributions and/or there should be interim clawbacks triggered at defined intervals and upon the occurrence of specified trigger events, e.g. a key person event.
  • Joint and several liability of individual general partner members is preferred, but a joint and several guaranty from a substantial parent company or an individual general partner member (or subset of general partner members) is considered a possible alternative.
  • Clawbacks should not be reduced by an assumed tax rate but rather the actual tax liability of the carry recipient (i.e., actual tax liability net of loss carry forwards and gain offsets); a change from the prior version of the Principles, which argued for the clawback to be gross of taxes.
  • Annual disclosure of actual and potential clawback liabilities and a plan to resolve them (as opposed to the prior version's push for every reporting period).

Governance

• All-partner clawbacks to satisfy indemnification obligations should be capped at no more than 25% of the aggregate fund commitments and limited to a reasonable duration like two years following the date of distribution.
• Limited partners should be able to remove a general partner before there is irreparable damage to their interest (as opposed to the prior version's more concrete but perhaps too rigid requirement of an initial court determination), subject to mitigating factors.
• No fault termination thresholds were increased: 2/3 in interest for termination/suspension of the commitment period (as opposed to simple majority in interest); 3/4 in interest for removal of a general partner and dissolution of the fund (as opposed to 2/3).
• The principle stating that the external auditor should not perform other services for the GP and/or its affiliates was deleted in favor of a disclosure obligation.
• Ratification by limited partners of a change in the fund auditor was also deleted in favor of a disclosure obligation.
• Where the interests of the general partner and the limited partners might not be aligned, at the request of a reasonable minority of the members of an Advisory Committee, independent counsel should be provided to the Advisory Committee at the expense of the fund.
• Auditors should be present and available to meet with an Advisory Committee (without the general partner present) to discuss valuations at least annually.
• The updated Principles provide greater flexibility with respect to amendments and state that certain changes may require either a majority or supermajority; however, the updated Principles are firm in stating that amendments that negatively affect the economics of a particular limited partner should require that limited partner's consent.

Transparency

• The periodic introduction of various standardized reporting packages, the first of which is the standardized form of capital call and distribution notice template available on ILPA's website.
• The laundry list of information that should be provided during due diligence was deleted from the Principles.

Advisory Committee Responsibilities and Best Practices

• An Advisory Committee's formal responsibilities should be defined in the applicable fund governing document, and are generally to be limited to reviewing and approving conflicts of interests, valuation methodologies, and certain other consents.
• After the initial constitution of an Advisory Committee, the addition or deletion of Advisory Committee seats should be subject to the mutual consent of the general partner and a majority of the sitting Advisory Committee members.
• Any three members of an Advisory Committee should be able to call for a vote of the Advisory Committee, in concert with consultation with the general partner.
• Background information regarding a vote should be provided to Advisory Committee members at least 10 days prior to the date of a meeting on a best efforts basis.
• The review of partnership expenses as a key duty of an Advisory Committee was deleted in the updated version of the Principles.
• The right of an Advisory Committee to require an Advisory Committee matter to be submitted to a limited partner vote was deleted in the updated version of the Principles.

This client memorandum is only a highlight of certain key items enumerated in the updated Principles.

This article was prepared by Forrest Brumbaugh, Phil Svahn and Scott Cheskiewicz from Fulbright's Private Equity Practice Group. For more information on the ILPA Principles and matters affecting private equity partnerships, their general partners, and their investors, contact Forrest Brumbaugh (fbrumbaugh@fulbright.com or 214 855 7177), Philip C. Svahn (psvahn@fulbright.com or 512 536 5669), or Scott D. Cheskiewicz.