Dissolution of Guernsey Limited Partnerships: Are the Limited Partners Sufficiently Protected in the Current Environment? (Part 4/4)

Over the previous three weeks, I introduced excerpts of a research piece that I did as part of my ongoing LLM in International Financial Law at Sussex University. My hypothesis when I started out was that the global financial crisis has led to a set of circumstances that were most likely not envisaged when the Limited Partnerships (Guernsey) Law, 1995 (the “LP Law”) was drafted. In particular, the fund dissolution provisions in the LP Law are limited in scope, and as an increasing number of funds hit the dissolution phase holding material assets, the dissolution clauses have become more relevant than ever.

I will repeat the usual caveats: the views expressed by me in these articles are my own personal views and observations and do not reflect those of my company or Sussex University. This week is also the final excerpt.

Previously I had introduced Guernsey Limited Partnerships and the growth of funds under management that peaked around the same time as the financial crisis of 2007/08. I also introduced closed-ended funds and some of the basic terms between the General Partner (GP) and the Limited Partners (LPs), all of which are detailed in a Limited Partnership Agreement. I also described the typical 5-year investment period followed by 5-years for divesting the Fund’s assets. Additionally, I described the situation in the European renewable sector where, following retrospective regulatory amendments, PE Funds were left holding impaired and under-performing assets. Finally I introduced the dissolution of Limited Partnerships and looked at the provisions within the LP Law and their provenance, particularly coming from similar Guernsey Company Law provisions.

So, at this point, it is worth further comparing a fund to a company which is likely to be actively trading with suppliers, customers and finance providers. A fund is more akin to a holding company owning a portfolio of investee companies with no third-party debt at the fund level. Indeed, the limited partners are both the fund’s members and creditors having provided their commitments by way of capital contribution and (majority) loan. Liquidation is a mechanism to protect creditors first and foremost allowing them a first call on the company’s residual cash from the realisation of all remaining assets. In the case of a fund with no third-party debts, there would not seem to be a need for protection against creditors which is what a company benefits most from after appointment of a liquidator.

So if the fund does not need protection from its creditors through appointment of a formal liquidator, this leaves the remaining task of realising the last of the fund’s investments. Returning to an example of a fund owning impaired renewable energy investments, the GP’s day job pertains to managing or overseeing the day-to-day operations of these companies whilst restructuring the debt. Once the debt has been rescheduled, the GP then retains the decision of whether to put the asset up for sale or to wait out for better times, usually driven by what maximises the GP’s total returns. Therefore, and if relations between the GP and the majority of LPs remains solid, it is likely that the optimal route forward is for the GP and LPs to agree new commercial terms for the dissolution phase which might also include new incentive payments to achieve the LPs’ desire strategy. If the GP-LP relationships are fraught, or the LPs disagree with a GP’s long-term ambitions, then their only route is to petition the Royal Court to replace the GP with an independent liquidator and/or to invoke any LPA provisions that still legitimately allow removal of the GP.

From a review of all available reported and unreported cases of the Royal Court, the author can find no evidence of LPs seeking to have a GP replaced. If this is not a route pursued by LPs, then either the existing law is working satisfactorily or perhaps LPs have lost interest at this point, or as a group are pushing in different directions. Considering the LP group further, it may well comprise private investors with “skin in the game” either personally or through remuneration or incentive structures, and salaried employees representing large institutional LPs who may be personally unaffected by the overall performance of the fund. Also, some of the LP representatives may have been in place since the fund’s constitution and be somewhat “battle-weary”, whilst some of the larger LPs may have regularly rotated their representatives and hence the current incumbent may have “fresh legs”. From this backdrop, it can be assumed that there is a range of disparate views and enthusiasm levels amongst the LP group as to how the fund should proceed with any remaining assets.

Looking more broadly for industry-wide best practice on the dissolution process, the guidelines issued by InvestEurope, formerly the European Private Equity and Venture Capital Association (EVCA), are informative. In the 2014 version of its handbook, these is a clear recommendation that the LPA should contain provisions on ‘the period in which liquidation should be effected’.[1] However, in InvestEurope’s 2018 handbook, this recommendation has been deleted.[2] One possible conclusion is that in the face of lengthening fund lives and/or the difficulty of forecasting the time taken for problematic assets to be sold, consultation by InvestEurope with GPs had led to this recommendation being dropped from the handbook.

Moreover, there are other externalities to be considered depending on if the GP is managing its first fund or has a broad range of fund mandates. As Figge et al observed in their 2012 paper:

if a PE firm is preparing for fundraising or, as a GP in an existing PE fund, has distributed relatively little capital to its LPs, this has a strong impact on his exit choice, i.e. the choice of how to exit a specific portfolio company or the choice of which portfolio company to exit.[3]

Thus if a GP is fundraising for a new venture and the existing end-of-life fund represents a small portion of its overall portfolio of incomes, then it will have less incentive, perhaps other than a moral commitment, in spending any significant time to eke out any last returns for the LPs. Conversely, a first time GP will be driven to maximise the returns for the LPs and the overall fund returns which would support any future fundraisings.

There has been much written about shareholder-director agency issues which was beyond the scope (and my word limitation!) of my original research piece. However as Paterson notes, ‘shareholders should think about corporate governance issues not only for good times, but also to protect themselves against a flight of loyalty if the business becomes distressed’ and this would apply equally for LPs.[4] It is clear that in a Guernsey fund’s dissolution process, the GP retains absolute control throughout and its behaviour at this point will largely be driven by the fund’s performance to date, legacy incentive arrangements under the LPA and the GP’s future fund management aspirations. I therefore conclude that the LPs are controlling a fund’s dissolution through re-incentivising the GP with new fee terms but ultimately, if the GP is pursuing its own strategy with regards any remaining assets, then the LPs are simply embracing this.

In conclusion, and having established the current trend of more funds entering dissolution whilst holding material portfolios, over the last few weeks I have focused on the relevant provisions from the LP Law and looked at the balance of power between LPs and the GP which has shifted towards the latter. In the research piece for my LLM I ultimately concluded that in the absence of evidence that GPs are being replaced, strategies for selling the remaining portfolio assets during a fund’s dissolution are agreed upon by new commercial arrangements that re-incentivise the GP towards an outcome preferred by the LPs. Notwithstanding that the dissolution provisions contained within the LP Law are relatively thin and give complete discretion to the GP, this paper concludes that to date, the market is seemingly accommodating, and new or revised financial incentives from LPs are prevailing and on this basis there is no obvious need for more intrusive and directive dissolution provisions within Guernsey’s law for limited partnerships.

[1] EVCA, ‘Professional Standards for the Private Equity and Venture Capital Industry’ 2014 < https://www.ikinvest.com/globalassets/files/evca_interactive-handbook.pdf> accessed 14 January 2020

[2] InvestEurope, ‘Professional Standards Handbook’ 2018 < https://www.investeurope.eu/industry-standards/professional-standards/> accessed on 14 January 2020

[3] Christian Figge et al, ‘The GP-LP conflict in private equity funds revisited: The impact of fund-level considerations on the divestment decision’ (2012) SSRN < https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2051441> accessed 14 January 2020

[4] Sarah Paterson, ‘The Paradox of Alignment: Agency Problems and Debt Restructuring’ (2016) 17 European Business Organisation Law Review 497