By Vittorio Lavioso and Alexandre Burtonboy
Disclaimer: the purpose of this article is to provide the reader with a basic framework to understand what a LPA is and how it works. This article is in no way to be considered as a legal opinion on the matter.
As with many things in life, the underlying structures of entities, whether it be the foundation of a building or the skeletal apparatus for humans and animals, often pass unnoticed, yet they nevertheless constitute an essential element for the very existence of whatever leans upon them. The same is true for the legal structures underlying Private Equity and Venture Capital funds.
First, let’s consider that in the Anglo-Saxon world the most widely used corporate vehicle to set up and operate a Private Equity fund is the Limited Partnership (LP). For its formation, the LP requires two or more partners, which are divided into two different categories: the Limited Partners (LPs) on one side and the General Partners (GPs) on the other, where the former have limited liability extending only to the amount of the committed investment whereas the latter are unlimitedly liable for the partnership’s obligations. The clear division of roles and competencies between LPs and GPs and the simplicity of the structure and fiscal transparency granted in many jurisdictions make the Limited Partnership an ideal vehicle to undertake Private Equity and Venture Capital activities.
Put simply, LPs are the investors, playing a purely passive role and not having a say on the management of the partnership, and GPs are the managers of the partnership – the decision-makers and the ones who make investments. Given their full personal liability for the partnership’s debts, it is very common for GPs to operate as limited partners of an LLP (Limited Liability Partnership), which plays the role of an advisory company and thereby shields GPs of personal liability. In such case, the LLP is fully liable for the partnership’s obligations, meaning that its assets will be used as collateral of the LP.
The LLP is formed when the two categories of partners have negotiated and signed the LPA (Limited Partnership Agreement), which is the agreement containing the terms that will govern the relationship between them. Such agreements are governed by the law of the jurisdiction in which the partnership is incorporated (e.g. the law of the State of Delaware in the US). In Europe, Private Equity and Venture Capital funds are regulated as a financial activity at the EU level (of paramount importance is Directive 2011/61/EU on Alternative Investment Fund Managers), and the most common vehicle used to invest is the Closed-end fund (CeF), which differs in nature and structure from the LP. Unlike the LPA, the relationship between investors and managers in a CeF is governed by the internal code of activity, which cannot be considered purely as a contract between the parties since it must be submitted to and approved by the supervising entity. On the other hand, in the US, Private Equity and Venture Capital are considered as an entrepreneurial activity and are mostly unsupervised. This means that the LPA can truly be defined as a contract between the parties, and therefore it must be drafted and negotiated with great attention (in certain jurisdictions, such as in the State of Delaware, default provision will govern the relationships within the LPA in case of absence of express or implied agreement to the contrary between LPs and GPs, but most funds do not desire such outcome and therefore provide for their internal governance to the smallest detail). Let’s now deep dive in more detail into some of the key areas addressed in the LPA.
The Limited Partnership Agreement defines and encompasses every specificity, stakeholder and rule related to the fund. Even though the length and complexity of the LPA might vary on a case-by-case basis, the general structure of the document is nowadays fairly standardized. The LPA begins with a broad, detailed set of definitions which explains in depth the meaning of all relevant words used in the document, both technical and non-technical. Moreover, the focus is given to certain other fundamental aspects such as the liability of Partners, Name, Purpose, Commencement and Duration, and the Principal place of Business.
After clarifying the extent of the Agreement, the second part sheds light on financing. This includes Capital Contributions and Loans. The former identifies all possibilities investors could encounter such as the maximum number of days to perform the required actions, the rights of the GPs regarding the increase in capital and all the actions needed to be taken for the closing adjustments. For example, loans may only be required to be advanced by Limited Partners. The failure by LPs to comply with such requirement (the so-called “drawdown notice”) could lead to the cancellation of the Limited Partner’s capital contribution. Finally, all technicalities regarding the end of the commitment period are thoroughly addressed.
What is important to remember and is largely explained in the ‘Rights and Duties of the General Partner’ section is that the GPs shall have full license and authority on behalf of the Partnership. Furthermore, the LPs shall not take part in the management or control of the business. Therefore, a major focus is devoted to the authorities and powers of the GPs. Nonetheless, clauses regarding the replacement of the GPs, the powers and duties of the GPs, the fees and the suspension of Investment Powers are also considered. Moreover, GPs have to comply with some investment policy guidelines, clearly stated in the so-called chapter. This chapter might include a set of provisions, the most common being the prohibition to invest in certain industries such as gambling or tobacco, the prohibition to concentrate more than a certain fixed percentage of the total committed capital into a single investment or even the prohibition to invest in any pooled investment fund.
The next two clauses are of pivotal importance and relate to the allocation of liabilities, profits and losses, and the distributions. The former lists the priority of allocation, the existence or not of personal obligation for the debts or liabilities and explains the apportionment of carried interest. The distribution section describes the timings of distributions, their nature, limitations and any other specificities. The agreement then outlines the Termination and Liquidation of the fund. The termination (or dissolution) can either happen after the provided life period of the fund has expired or before such date upon the occurrence of certain events. Similarly, it is in this passage that any possible extension of the fund’s life is disclosed.
The remaining sections are devoted to the accounts, reporting and auditors and the meeting of LPs and the advisory board. Lastly, the miscellaneous section outlines all the points that were not included by the previous chapters, such as the investment opportunities, the indemnification, the confidentiality and the governing law.
As we hope to have shown, the LPA plays a fundamental role in establishing the rules to which partners shall abide, thus establishing a contractual framework that governs the life of the fund itself. Its content might be dense, its clauses articulated and complex, but a well-written, well-negotiated LPA is inarguably the first step towards successful investing.
Editor: Eric Peghini
Authors: Alexandre Burtonboy, Vittorio Lavioso