Legal and travel expense drafting in LPAs

In recent years management fee rates for institutional limited partners (LPs) have markedly decreased.[1] At the same time, General partners (GPs) have tended to include legal and travel related items in the limited partnership agreement (LPA) that historically would have been payable under the management fee as partnership expenses.[2] While potentially reducing management fees, the reclassification of these expenses could have significant economic consequences for LPs. They may also feel the consequences of a lack of standardization in LPA terms relating to legal and travel expenses, despite the provision of model form LPAs and guidance by the Institutional Limited Partners Association (ILPA). Accordingly, the drafting of LPAs around legal and travel expenses typically remains vague, with a seeming unwillingness to drill down into how such expenses will be allocated.

General reporting of expenses also remains opaque, and there is an apparent reluctance to adopt the ILPA Fee Reporting Template. Data from the ILPA SEC Survey 2022 shows that only 25% of respondents agreed or strongly agreed that reporting by GPs across fees, expenses, and performance provided the necessary transparency.[3] ILPA goes on to report that only 8% of LPs had a commitment from GPs to provide the ILPA Fee Reporting Template in the LPA, with 75% observing that a commitment to adopt the Template was made either via side letter or informally and not reflected in fund documents.[4]

Travel expenses

The ILPA Principles[5] advocate that travel expenses should only be allocated to the partnership once the investment passes the initial term sheet stage. In a review of recent-vintage LPAs, only 7% specifically excluded deal sourcing and due diligence travel expenses from partnership expenses (Figure 1). In addition, the LPAs referred to ‘travel expenses’ as an umbrella term for expenses with certain limited qualifiers relating to investment opportunities and dispositions, as well as standards of travel included in the drafting.

Whereas the ILPA Principles[6] recommend that travel expenses relating to deal-sourcing, networking, and preliminary due diligence should be borne by the GP under the management fee, the LPAs we reviewed typically stated that ‘any travel . . . including in connection with consummated and unconsummated investment and disposition opportunities’ should be allocated to the partnership.

ILPA also advocates LP awareness of the GP’s travel policy, particularly regarding parameters for the use of non-commercial air travel. The ILPA Model LPA goes on to recommend that, while certain travel expenses should be allocated to the partnership, this should exclude the ‘costs of private air travel.’[7]

For the majority of the LPAs we reviewed, funds were silent on private air travel, leaving LPs potentially exposed to excessive expense obligations of this nature (Figure 2). Of the 7% of LPAs that permitted expenses for non-commercial travel to be charged via partnership expenses, 2% permitted travel expenses up to the value of a commercial airfare, while 5% of the LPAs permitted full pass through of travel expenses for private jets. Only 5% of LPAs specifically excluded expenses ‘incurred in connection with air travel that exceed an amount equal to comparable commercial air travel’ or those ‘in excess of that applicable to business class air travel.’ It remains the case, therefore, that LPAs that satisfy all ILPA recommendations in respect of travel expenses are rare.

Legal expenses

The ILPA Principles allow third-party legal expenses incurred in the course of fund business to be allocated to the partnership. If the GP elects to use in-house legal staff, however, this should only be allocated to the partnership if the:

• market basis for calculating the cost thereof, and
• a rationale for using in-house as opposed to external legal services,

are communicated clearly to the LPs.

The ILPA Model includes legal fees among those to be allocated to the partnership, but confirms that expenses for ‘legal … services … performed by employees of the General Partner’ will be borne by the GP.[8]  In practice, however, the vast majority of LPAs do not go to this level of detail, referring simply to legal expenses, and indicating that they should all be borne by the partnership. Some LPAs refer to expenses of ‘third-party lawyers’, while failing to reference the use of in-house legal services.

Unclear drafting in the LPA could have an economic impact on LPs. If, for example, an LPA requires the salaries of GP employees (including in-house legal staff) to be paid by the GP under the management fee, the allocation to the partnership of expenses for work performed by in-house legal teams will, in effect, mean that LPs are being charged twice for the same service. According to Colmore’s analysis, 93% of funds are at risk of this, with an additional 6% lacking clear language (Figure 3).

Supporting best practice

Recent moves to increase transparency in LPA expense terms include the ILPA-led initiatives, as well as the Securities and Exchange Commission’s (SEC) proposed rule to enhance transparency for investors in respect of the cost of investing in private funds.[9] Nonetheless, significant ambiguity remains in an LPA for LPs in respect of their travel and legal expense liabilities. This is largely due to a lack of standardization in expense terms, vague drafting, poor transparency in the reporting of expenses more generally, and an apparent reluctance to adopt the ILPA Fee Reporting Template. It is imperative that LPs fully understand from the outset which travel and legal expenses they are liable for, as this will enable more accurate financial planning, as well as reducing the risk of unwanted surprises down the line. This becomes especially pressing given the recent tendency to shift certain legal and travel related items to partnership expenses, when they historically have been payable under the management fee.

To mitigate against significant travel and legal expense liabilities in a fund, LPs should consider the following when negotiating the LPA:

• Avoiding the use of umbrella terms such as ‘travel expenses’ and ‘legal expenses’.
• Clearly defining the parameters around: when and what travel expenses should be allocated to the partnership, including the use of non-commercial air travel, and which legal expenses should be allocated to the partnership, including those relating to external and in-house counsel.
• Adopting the ILPA Fee Reporting Template as standard.
• Requiring quarterly reporting from the GP of all fees and expenses payable by investors.

[1] Based on Colmore’s analysis of over 800 funds of vintage 2010 and later. See graphs published in ILPA Private Fund Advisers Data Packet (from ILPA LCON 2022). https://ilpa.org/wp-content/uploads/2023/03/ILPA-Private-Fund-Advisers-Data-Packet-March-2023-Final.pdf

[2] ILPA Principles 3.0. https://ilpa.org/ilpa-principles/

[3]–ILPA: The Future of Private Equity Regulation – Insight Into the Limited Partner Experience & the SEC’s Proposed Private Fund Advisers Rule, 2023. https://www.sec.gov/comments/s7-03-22/s70322-20158927-326926.pdf

[4]  ILPA: The Future of Private Equity Regulation – Insight Into the Limited Partner Experience & the SEC’s Proposed Private Fund Advisers Rule, 2023. https://www.sec.gov/comments/s7-03-22/s70322-20158927-326926.pdf

[5] ILPA Principles 3.0: Fostering transparency, Governance and Alignment of Interests for General and Limited Partners, June 2019

[6] ILPA Principles 3.0: Fostering transparency, Governance and Alignment of Interests for General and Limited Partners, June 2019

[7] The ILPA Model Limited Partnership Agreement (Whole-of-Fund Waterfall), July 2020, Section 2.5.1.7

[8] The ILPA Model Limited Partnership Agreement (Whole-of-Fund Waterfall), July 2020, Section 2.6.2

[9] Private Fund Advisers; Document of Registered Investment Adviser Compliance Reviews. A Proposed Rule by the Securities and Exchange Commission on 03/24/2022