Private Equity Conflicts of Interest: A Delicate Balancing Act

An unsurprising consequence of the difficult market conditions that the private equity industry has endured over the past 18 months has been the call from limited partners for some significant changes to the rules of the game.

The Private Equity Principles published by the Institutional Limited Partners Association in September 2009 (the ILPA Principles) and the International Organisation of Securities Commissions’ consultation report on PE conflicts of interest published in November 2009 (the IOSCO Report) have highlighted the desire of investors for a better alignment of interest between the key players in the market, as well as for improved standards of governance and transparency. Conflicts of interest, and how they may be addressed, have increasingly come under the spotlight.

Conflicts of Interest

In the PE context, typical conflict situations include:

• where an investment manager manages multiple funds with similar or overlapping investment strategies, on both the acquisition and sale of investments by each such fund;
• the acquisition by the fund of securities of any entity in which the general partner or its managing members or their affiliates holds any direct or indirect interest;
• the sale by the fund of assets to any entity in which the general partner or its managing members or their affiliates hold any direct or indirect interest;
• the acquisition by the general partner and its managing members of securities of any entity in which the fund holds an investment or in which the fund has actively considered making an investment, other than certain publicly traded securities; and
• where an investment manager is fundraising for a successor fund in circumstances where the predecessor fund is not yet fully invested.

General Partner Fiduciary Duties

The fiduciary duties of general partners are particularly key to this discussion. With certain exceptions and modifications, the common law duties applying to partnerships are expressly incorporated in the Cayman Islands' Exempted Limited Partnership Law (2009 Revision) (the ELP Law). It is a well established principle at common law that all partners owe each other a duty of good faith in all partnership dealings.

Also relevant to the conflict of interest analysis is the common law duty not to take a secret profit in relation to the business of the partnership without the consent of the other partners.

Additionally, the common law duty to account for and pay over to the partnership all profits made by a partner in a business if such a partner, without the consent of the other partners, carries on any business of the same nature as and competing with that of the partnership.

The general partner is also under a statutory duty pursuant to Section 4(3) of the ELP Law to act at all times in good faith in the interests of the partnership. It is generally accepted that the statutory duty set out in this Law cannot be limited or excluded by the terms of the partnership agreement or with the consent of the partners.

Whilst there is no further guidance under the ELP Law or from the Cayman Courts as to the nature and extent of that duty, there are good grounds to extrapolate a meaning from the similar duties applicable to the directors of Cayman Islands companies.

Certain aspects of such duties, such as the prohibition against making secret profits, are likely to be inviolable. However, there are areas where the common law takes a less absolute approach, and of these the one that is perhaps most open to contractual determination is the obligation to avoid conflicts of interest.

It is well established in relation to company directors that where such directors address conflicts of interest in the manner contemplated by the constitutional documents of the company (usually involving an element of disclosure) then, absent bad faith, that is usually sufficient to discharge such directors of their duty in this regard. By analogy, it must therefore be available to parties to determine how conflict situations are to be resolved, and thereby to define the scope of any duty relating to conflict situations in the partnership agreement.

It is difficult to see how a general partner might be censured for a failure to discharge its fiduciary duty where it has sought to resolve a conflict situation in a manner expressly contemplated and permitted by the terms of the partnership agreement.

It is therefore important for the parties to clearly set out in the partnership agreement the manner in which conflict situations, that will inevitably arise, will be resolved. By acting in accordance with the clear requirements of the partnership agreement in that regard, the general partner should be able to rely on the agreement of limited partners to the resolution of the conflict situation and so have discharged its fiduciary duties under the ELP law and at common law.

Advisory Committee

PE funds will generally form an Advisory Committee comprising representatives of the key limited partners (the LPAC), unless there is a small number of investors. LPACs are created primarily to assist in the resolution of conflicts of interest, though they may also be used to review or to approve general partner valuation decisions, and to grant approvals or provide consents as are expressly required or permitted to be granted pursuant to the terms of the partnership agreement.

In some circumstances, the LPAC may be asked to lend their industry knowledge and experience in counselling the general partner on such fund matters and investments as may be requested by the general partner.

In terms of fund-related conflicts of interest, the ILPA Principles stipulate that, save when general topics are being discussed, LPAC meetings should not be combined across affiliated funds even where the membership of each LPAC is the same or similar. 

The ILPA Principles further include a recommendation that fund terms should require the general partner to present all conflicts of which it is aware to the LPAC for review and seek prior written approval of any material conflicts or non-arms' length transactions.

They also include a recommendation to avoid provisions in the partnership agreement which allow the general partner to exercise its sole discretion to weigh its own self-interest against the interest of the fund, or to waive broad categories of conflicts of interest.

Not all limited partners are anxious to participate in the deliberations of an LPAC and many prefer a passive investment, understandably concerned that with a more active role in the business of the fund comes greater responsibility. For those who are willing to participate, the partnership agreement will usually provide that LPAC members have no duty to the fund or the partners of a fund other than a duty to act in good faith.

This broadly echoes the sentiments of the common law which simply requires that limited partners act in good faith and otherwise in accordance with their obligations under the partnership agreement.

Furthermore, the partnership agreement will usually provide for an obligation on the fund to indemnify LPAC members unless such members fail to act in good faith. Provided then that a member of the LPAC acts within the four walls of the partnership agreement and does not seek to extend the scope of his role, he should be able to act in his own interest (and the interests of the limited partner that he represents) safe in the knowledge that he will not be in breach of his duties.

It is worthwhile mentioning that under the ELP law, a limited partner risks losing its limited liability status if it is involved in the conduct of the business of the partnership with third parties who believe it to be a general partner.

Following a recent amendment, the ELP Law now specifically provides that the appointment by a limited partner of a representative to an LPAC is expressly included in the safe harbours set out in s7(3) of the ELP Law whereby a limited partner will be deemed not to be taking part in the conduct of the business of the partnership.