Private equity finance captures the regulator’s and politician’s attention. As the financial crisis tightens its grip, general regulatory action is urged to control the investment activities of funds. Closer inspection suggests that any regulatory policy on investment funds will have to address two problems, the maintenance of corporate governance standards within the funds and the capital market aspects of private investment. This paper focuses on the governance structures of private equity funds which are rarely scrutinised. It assesses the legal framework for private equity finance which takes place on a market for highly sophisticated investors. As 51 per cent of the European private equity investment is channelled through United Kingdom (UK) pri­vate eq­uity firms, the UK law on private equity finance has set the stan­dards for Europe’s capital markets. Therefore, the focus is on the UK law on limited partnerships and on private con­tracting mechanisms to contain opportunis­tic behaviour.

SOMMARIO:

I. Private Equity – Capital Market Relevance - 2. Limited Partnership Law - 3. Limited Partnerships – The Real World - NOTE

I. Private Equity – Capital Market Relevance

1. Statistics.– For many years, private equity has been a growth industry, employing 8 per cent of the British workforce [[1]]. In the first half of 2006, private equity fund managers in the United King­dom (UK) raised some £ 11.2. bn of capital, thereby outstripping the capital raised through initial public offers at the London Stock Exchange [[2]]. 51 per cent of the European private eq­uity invest­ment is chan­nelled through UK private equity firms [[3]]. The current private equity busi­ness focuses on cross-border operations. In fact, of the 20 largest private UK-based equity firms, 79 per cent of new funding in the 2004-2006 period originated outside Britain, and only 38 per cent of the investments were directed to UK investee companies [[4]]. Private equity is ‘pri­vate’ because it builds on equity financing in companies that are not listed at the stock exchange. It is also ‘private’ since investors invest in funds which are usu­ally not listed [[5]]. The funds, in turn, operate as intermediaries directing investors’ money to­wards portfo­lio and tar­get companies. The industry has devised a specific private investment vehicle which places investments in the market and oversees risk-spreading [[6]]. The private equity industry handles ‘venture capital’, invested in technologies, ‘growth capital’ for expanding companies, and ‘buy-outs’ [[7]]. Historically, the need for venture capital finance had been instrumental in promoting private equity funding mechanisms. In the mid-1980s, venture capital finance accounted for some 50 per cent of UK-managed private equity investment. By 1999, three quarters of British private equity were invested in buy-out trans­actions [[8]]. Over the years, the UK market for management buy-outs and management buy-ins has dominated the European private equity market, but marked differences between Britain and continental Europe persist [[9]]. Compared to the rest of the European Union, the UK per­forms relatively poor in venture capital. Early venture capital financing had led to insufficient re­turns, unleashing a move towards buy-out financing. Conversely, some continental Euro­pean countries appear to have benefited from early UK experiences, assuring higher re­turns [continua ..]

2. Limited Partnership Law

a. Basics.– Under s. 4 (2) of the Limited Partnerships Act 1907 a limited partnership shall consist of at least one general and one limited partner [[61]]. Limited partner­ships have no predecessors in com­mon law or at equity [[62]]. They were created by the 1907 Limited Partnerships Act and the statutory rules take precedence over the non-codified law of the land. Nonetheless, reference may be made to the 1890 Partnership Act, and to the rules of equity and common law applica­ble to partnerships [[63]]. There is, however, very little case law that would inform private practitio­ners on how to structure the relationship between managing general partners and the limited partners. A limited partner may not take part in the management of the partnership. If he does, he will be liable for the debts and obligations of the business, arising as long his par­ticipation in the management continues [[64]]. It is understood that a limited partner will not be exposed to liability if he makes use of his statutory informa­tion rights or participates in a de­cision on the terms or structure of the partnership (such as the nature of the business carried on, the admission of new partners and the profit sharing ra­tios) [[65]]. There are some company law cases on the disqualification of de facto directors and on undue restrictions which investment agreements might place on the board of directors of the investee company. Under the Company Directors’ Disqualification Act 1986 some active participation in the management of the company is required. To be disqualified, the de facto director would appear to have acted on equal footing with the duly appointed directors, mak­ing representations towards third parties [[66]]. In Russell v. Northern Bank Development Corpora­tion Ltd. [[67]] the House of Lords held that a shareholders’ agreement may not encroach upon the statutory rights of a company whether contained in a side-agreement or in the articles of association. Private practice has attempted to get around the narrow holding in the North­ern Bank case by strengthening procedural covenants and introducing severance clauses should provisions or covenants be declared invalid [[68]]. From a law and economics perspective, both, the case law on directors’ disqualifica­tion and on overly restrictive shareholders’ [continua ..]

3. Limited Partnerships – The Real World

Limited Partnership Agreements are concluded in private. They do not openly respond to the signals from the market place, nor are there capital market assessment mechanisms which would ascertain the value of a particular fund. However, in an indirect way, signals from the capital market may translate into the structure of the fund. Under market conditions where a venture capital firm experiences difficulties to raise sufficient capital for a new fund, poten­tial limited partners may use their bargaining power to restrain the discretion of the gen­eral part­ner to better protect their investment [[84]]. Conversely, abundant liquidity in the markets en­ables the (organising) private equity firm to propose a limited partnership agreement that al­lows for greater freedom for the managing general partner and his investment specialists. This will produce important repercussions as the covenants on managerial activities may be less re­strictive, thereby exposing the investors to greater risk [[85]]. a. Organisational Structures.– At the inception of a new private equity fund, the private placement memorandum or an infor­mation memorandum is circulated by a private equity firm, setting out the terms of the fund. If interest is shown, investors will then be provided with a draft of the limited partner­ship agreement and will be able to propose amendments to accommodate their particular needs, including tax considerations and certain US law restrictions on pension funds invest­ment ac­tivities [[86]]. Nonetheless, the contractual stipulations establishing a limited partnership are marked by a great degree of homogeneity in order to meet the tax law standards laid down in the Memorandum of Understanding between the British Venture Capital Association and the UK treasury [[87]]. The general scheme of the limited partnership agreement [[88]] specifies the initial contribu­tions to be made by the limited partners. In order to escape the verdict of untimely repayments of capital, limited partners will under UK law commit only a limited amount of cash. Their remaining contributions will be infused by way of loans. The limited partnership agreement will further specify the circumstances and procedure under which the managing general partner may call for another tranche in order to make an investment into a target com­pany. Draw down requests will preferably [continua ..]

NOTE