Memo-Limited-Liability-For-Investors-In
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eo me lly o eo e euy u Memo, 6 July 2020 Peter aer Partner Jonathan Uggedal, Senior Associate Advokatfirmaet BAHR AS e uos Limited liability for investors in private equity funds 1. Introduction Limited liability is a commonly accepted legal concept and is one of the key characteristics of several different types of legal entities, such as limited companies and limited partnerships. The Norwegian AS and the limited liability enjoyed by its shareholders is one familiar example. Limited liability is also a material point for investors in private equity funds. It is market standard that private equity funds are set up so that the limited liability of its investors is ensured. The British Private Equity & Venture Capital Association (BVCA) summarises this as follows in a technical briefing from 2018 (attached as appendix 1): The limited partnership has, for the past thirty years, been the vehicle of choice for fund managers across private equity and venture capital (PE/VC) to aggregate and put to work the capital of their investors […] Limiting liability for limited partners is a key reason investors prefer limited partnerships for structuring PE/VC funds. PE/VC investors are passive investors with very little control, who are investing in a relatively illiquid but high performing asset class and do not want to monetarily risk more than that which they have committed to the fund.1 Below we further discuss the topic of limited liability and consider the following points: Section 2 – How is a private equity fund typically set up? Section 3 – What is meant by limited liability in this context? Section 4 – Why is limited liability for the investors important? Section 5 – How is limited liability typically regulated? Section 6 – The implications of limited liability in deal structuring Section 7 – Key takeaways The discussions assume that the fund is structured in accordance with a limited partnership model, but the main principles should also apply for funds set up as for instance a Norwegian AS. 1 BVCA - The importance of UK Limited Partnerships for Private Equity & Venture Capital (Technical Briefing August 2018), page 1 and 4 (https://www.bvca.co.uk/LinkClick.aspx?fileticket=dWRGpm3xElY%3d&portalid=0×tamp=1534942822184). 4 2. How is a private equity fund typically set up? Private equity funds in Europe that target investors from several jurisdictions are often established as limited partnerships in one of the usual fund jurisdictions (e.g. Jersey, Guernsey, Luxembourg). Invest Europe provides the following definitions of “limited partnership” and “limited partner” in its Professional Standards Handbook (the IE Handbook, attached as appendix 2): Limited Partnership - A legal structure commonly used by many private equity funds. It is used especially when catering for broad categories of international investors looking to make cross-border investments. The partnership is usually a fixed-life investment vehicle, and consists of a general partner (the GP/manager of the fund which has unlimited liability) and limited partners (the LPs which have limited liability and are not involved with the day-to-day operations of the fund). LP - A Limited Partner (LP) is an investor in a fund. More specifically, it means the limited partner in a Limited Partnership. LPs in a fund include sophisticated investors, such as pension funds/retirement systems, insurance companies, experienced high-net-worth individuals and entrepreneurs, sovereign wealth funds, endowment funds, foundations and family offices.2 3 The structure of a private equity fund set up as a limited partnership can be illustrated as follows: 2 Invest Europe - Professional Standards Handbook (April 2018), page 63 (https://investeurope.eu/media/1022/ie_professional-standards-handbook-2018.pdf) 3 Please refer to page 1 of the BVCA technical briefing attached as appendix 1 for an additional example. In the illustration above, the limited partners have undertaken capital commitments to the fund in line with the typical model for private equity funds. “Capital commitment” is defined as follows on page 61 of the IE Handbook: An LP’s contractual commitment to provide capital to a fund up to the amount subscribed by the LP and recorded in the fund documents, also known as such LP’s fund interest. This is periodically drawn down by the GP in order to make investments in portfolio companies and to cover the fees and expenses of the fund. 3. What is meant by limited liability in this context? For private equity funds, there will be specific provisions in the limited partnership agreement (the LPA) which deal with how the liability of the limited partners shall be limited. The Institutional Limited Partners Association (ILPA) is an association representing limited partners in private equity and has more than 500 member institutions representing more than USD 2 trillion of private equity assets under management. Examples of Nordic members of ILPA include the Swedish AP fonden (AP 1 – AP 4), PensionDanmark, Danica Pension, Industriens Pension, Varma Mutual Pension Insurance Company, Fonden Realdania, GjensidigeStiftelsen, Nordea, Skandia Mutual Life Insurance Company, Storebrand, and KIRKBI A/S.4 ILPA’s initiatives include work with industry affairs and standards. As part of this work, ILPA released its “ILPA Model Limited Partnership Agreement” in October 2019 (the ILPA LPA, attached as appendix 3). We can use the ILPA LPA to illustrate how the liability of Limited Partners will typically be limited. Section 3.2.2 of the ILPA LPA provides that: No Limited Partner shall be liable for the debts and obligations of the Fund; provided, however, that each Limited Partner shall be required to pay to the Fund amounts up to its Remaining Commitment pursuant to this Agreement. If we look further at the ILPA LPA, we will see that it limits the liability to the remaining part of the limited partner’s capital commitments, and states that the limited partners will only be liable to return distributions in limited circumstances. We will comment further upon this in section 5 below. The point here is that the detailed limitation of liability is typically regulated by the LPA and that this limited liability ensures predictability for the limited partners in the fund. Therefore, when referring to the limited liability of the limited partners in a private equity fund, this should normally be understood as the limited liability of such limited partners, as set forth in the LPA for that specific fund. It is the LPA that the investors have accepted and which is therefore important for the investors to be able to trust. 4. Why is limited liability for the investors important? The BVCA briefing attached as appendix 1 emphasizes on page 4 that investors in private equity are “passive investors” that “do not want to monetarily risk more than that which they have 4 Please refer to ilpa.org for further details. 6 committed to the fund”. This is comparable to a shareholder who subscribes shares in a Norwegian AS, and which thereafter has no further obligation to contribute funds to the company and which can normally expect to be able to keep distributions received. The need for predictability also exists for private equity fund investors and is the underlying rationale for why the LPA for a fund will contain finely drafted provisions limiting the liability of the limited partners / fund investors. This is illustrated by Invest Europe’s report on “Private Equity Activity in 2019”5 (attached as appendix 4), which on page 21 shows that much of the funds in 2019 were raised from investors such as pension funds (29%), fund of funds (13%), insurance companies (11%), government agencies (6 %), other asset managers (6%), etc. All of these investors will normally have a number of investments and other liabilities at any given time that they need to be able to cover, which both means that they need to know how much they as a maximum have to contribute to each single investment and when they can utilise distributions from an investment for other purposes. As other capital investors, investors in private equity funds thus have a need for predictability. It would for instance be challenging for the investors if they could be found liable to return distributions to a fund, without any limitations in amounts or time, based on it later being discovered for instance that there was fraud in a portfolio company of the fund. This is not very different from the situation where a listed company pays out distributions to its shareholders. If the fund investors cannot trust that their liability will be limited in accordance with the LPA, they will not be able to calculate how much funding should be reserved for each fund investment or liability and this could ultimately reduce their willingness and ability to invest in the asset class. 5. How is limited liability typically regulated? 5.1 Overview The limited liability for limited partners is typically ensured at two levels, both through legislation in the country where the fund is established and in the LPA. 5.2 Legislation The normal fund jurisdictions in Europe have legislation that limit the liability of the limited partners. The UK can be used as an example, although other jurisdictions have grown in popularity due to Brexit. In the UK, limited partnerships are governed by the Limited Partnerships Act of 1907 (the Act).6 Section 4(2A) of the Act has a general limitation of liability that applies for limited partners in traditional limited partnerships and which states that they shall “at the time of entering into the partnership, contribute to the partnership a sum or sums as capital or property valued at a stated amount, and shall not be liable for the debts or obligations of the firm beyond the amount so contributed”.