Dissolution of Guernsey Limited Partnerships: Are the Limited Partners Sufficiently Protected in the Current Environment? (Part 2/4)

Last week, I introduced the first instalment 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 suppose I should start with 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. Moreover, I am not a lawyer nor ever intending to be a lawyer. I am just an engineer with a passion for projects and who ended up in finance. The LLM is just another in a long list of mid-life crises.

This week, lets start by looking deeper into Limited Partnerships. As I mentioned last week, a limited partnership is managed by one or more General Partners (GP) under a limited partnership agreement (“LPA”) and Limited Partners (LPs) sign subscription agreements committing funds to the partnership. The fund’s LPA contains the terms and conditions of the partnership specifically including investor protection around the investment criteria specifying the number and types of investments, and the formation of an investment committee to approve all investments. Other investor protections in the LPA include the requirement for the GP to co-invest alongside the LPs and the right of the LPs to dismiss the GP, either unilaterally or in certain specified circumstances although not without cost for both options, especially for unilateral termination without cause. Limited partners do not have the right to demand the early return of their capital but they do have the right to transfer their interest in a partnership to a third party which allows them to exit a fund should they choose to.

The LPA will also include the fee arrangements with the GP. The fund management industry does its best to adhere to the “2 and 20” fee model; in a survey of 837 private equity (“PE”) funds, the authors found that ‘the typical fund follows a "2/20/1" rule: a management fee of 2% per year, carried interest (carry) of 20%, and GP ownership of 1% of the total fund size’.[1] There are many variations on fund fee structures however the overall package is intended to ensure that the interests of the GP and LPs are aligned. In particular, the GP’s carried interest is typically subject to first delivering an IRR-based hurdle return to the LPs (say 8%), hence the GP is heavily incentivised to deploy the fund’s capital and return it to investors in the shortest possible time so as to maximise its own returns.

A 10-year limited partnership typically comprises an initial five years available for investing followed by the remaining five years for realising investments, often with the option of two or three single year extensions. According to Fraidin and Foster, ‘the average number of years from investment to exit historically has been around three to five’, the expectation being that the GP would fully invest the fund’s committed capital across a series of investments which would all be realised well before the ten-year term was reached.[2] This meant that 10-year closed ended limited partnerships were deemed attractive to investors who typically had a six to eight year investment horizon. Once the GP has sold all the fund’s assets and returned the capital to the limited partners (less its own compensation, assuming the hurdle return to investors has been achieved), the fund can be wound up and dissolved. With the management fee expiring at the end of the 10-year term, the GP is clearly incentivised to complete the investment and divestment phases and fully wind up and dissolve the fund within this time limit.

Returning to Guernsey limited partnerships, there was a marked increase in both the number of funds and net assets under management in Guernsey in the run-up to the global financial crisis with both peaking in 2008/09. At the same time, other industries were also enjoying buoyant times. In the European wind energy sector, the industry was fuelled by the 2007 announcement by the European Council for all EU members to increase their supply of renewable energy to ‘a binding target of 20% by 2020’ which was subsequently legislated for in Directive 2009/28/EC.[3] Correspondingly, significant demand for wind turbines saw prices peak in 2009 as shown by the Wind Turbine Index published by Bloomberg New Energy Finance (see below).[4] As the turbine price makes up some 64% of the total windfarm construction costs, the higher turbine prices led to more expensive windfarms which will ultimately be less competitive against later projects with lower construction costs and lower debt burdens.[5]

At the same time, private equity and institutional investors discovered the renewable energy sector and piled in. According to Hart, ‘between 2006 and mid-2011, private equity and venture capital firms invested almost $50bn in renewable or clean energy.[6] Whilst many commentators thought that acceptance of climate change was the driver for PE interest, more likely it was the relative simplicity of renewable energy projects and the government-backed revenue stream that was considered low risk and “bankable”. Moreover the supply chain industries for the wind and solar technologies together with the service companies managing the long-term operations of projects were traditional sectors for private equity funds and offered another investment dimension beyond the electricity generating infrastructure.

However, by 2009/2010, the financial crisis was starting to bite, particularly with EU members who saw attractive tariff schemes lead to the deployment of more renewable energy projects than was forecast. As Iliopoulos says ‘the cost of overproduction becomes unaffordable for a State in recession and deficit’.[7] EU members including Spain, Czech Republic, Poland and Romania went on to reduce the regulatory support level and/or the applicable support period that hereto the project owners thought they were legally entitled to and had “banked”. As a result, many renewable energy projects, having successfully been constructed and actively contributing to the host country’s 2020 EU target were left facing much reduced cashflows to service debt and equity.

Within the European renewable energy sector, and as a result of retrospective tariff adjustments by certain governments, many projects were left over-leveraged and unable to service debt without a restructuring. This essentially meant an extension of the debt repayment period often beyond the regulated tariff period. Lenders, however, prefer to avoid relying on cashflows beyond the tariff period as the widespread introduction of renewable energy projects into the post-tariff wholesale electricity markets is relatively untested. It is feared that future projects, which were cheaper to build, will undercut older projects built with more expensive and less efficient technology. To ensure debt providers were repaid within the tariff period, there would be cash sweeping towards debt prepayment again taking cash away from the equity providers. This leaves many project owners facing a back-ended cashflow profile whereby returns would be much deferred and exposed to the project’s performance in a future and uncertain electricity market.

Next week I will look at the options a GP faces with distressed assets within the Fund and then delve into the dissolution phase of Guernsey limited partnerships, and what it means to be entering dissolution whilst still holding material assets. Thanks for reading.

[1] David T. Robinson & Berk A. Sensoy, ‘Do Private Equity Fund Managers Earn Their Fees? Compensation, Ownership, and CashFlow Performance’ (2013) 26/11 The Review of Financial Studies 2760

[2] Stephen Fraidin & Meredith Foster, ‘The Evolution of Private Equity and the Change in General Partner Compensation Terms in the 1980s’ (2019) XXIV Fordham Journal of Corporate and Financial Law 321

[3] European Commission, ‘Presidency Conclusions - Spring European Council, 8-9 March 2007’ < https://ec.europa.eu/growth/content/presidency-conclusions-spring-european-council-8-9-march-2007-0_en> accessed 14 January 2020

[4] BloombergNEF, ‘2H 2017 Wind Turbine Index’ <https://about.bnef.com/blog/2h-2017-wind-turbine-price-index/> accessed 14 January 2020

[5] IRENA, ‘Renewable Energy Technologies: Cost Analysis Series’ (Vol 1 Issue 5/5 Wind Power, 2012) < https://www.irena.org/-/media/Files/IRENA/Agency/Publication/2012/RE_Technologies_Cost_Analysis-WIND_POWER.pdf> accessed 14 January 2020

[6] Joanna Hart, ‘Environment: Renewable Energy - Private Equity - The Private Rise of Renewables’ (2011) Nov The Banker

[7] Theodoros Iliopoulos, ‘Renewable Energy Regulation: Feed-in Tariff Schemes under Recession’ (2016) 4/2 European Networks Law and Regulation Quarterly 110