GPs abusing ‘hedge clauses’ to dodge fiduciary duty: ILPA

An LP lobby group says a change in Delaware law and an SEC no-action letter unleashed a 'perfect storm' to the detriment of private fund investors.

General partners have been abusing so-called “hedge clauses” in limited partnership agreements to avoid their fiduciary duties – part of an “explosion of effort” to eliminate fiduciary duty entirely, according to the Institutional Limited Partners Association.

In its August 6 response to the Securities and Exchange Commission’s call for comment on interpreting the standard of conduct for investment advisors and enhancing regulation, industry group ILPA said that “hedge clauses” are being used by GPs in private equity funds to avoid legitimate fiduciary obligations. The creation of these clauses stems from relief granted by the SEC in a no-action letter issued to Heitman Capital Management in 2007, which enabled GPs to write these little-known clauses into LPAs to swerve fiduciary duty. They have since become a way for GPs to try disclaiming all fiduciary duty, according to ILPA.

“Change in Delaware law and the Commission no-action relief has resulted in an explosion of efforts to modify or eliminate fiduciary duties, to the disadvantage of LPs and in contravention of the aims of the [Investment] Advisers Act,” ILPA said in its response, which was signed by chief executive officer Steve Nelson.

Nelson pointed to state law changes in Delaware – the state where most US funds are domiciled – in 2004 as the beginning of these efforts; changes that he said “permitted GPs and LLC managing members to disclaim their fiduciary duties of care, loyalty and good faith owed to LPs and LLC members.”

The modification of state law and the use of hedge clauses “has significantly reduced the obligations of a manager to act in the best interests of its investors and has also driven up legal cost and uncertainty for investment advisers and LPs in the private fund marketplace,” Nelson wrote. ILPA said the two changes had unleashed a “perfect storm” of conditions that negatively impact investors in private funds.

ILPA pointed to 18 SEC enforcement actions since 2014 against private fund advisors that the group said were found to have breached their fiduciary duties.

“Most of these actions highlighted the breach of the duty of loyalty, and most significantly the failure to disclose either real or potential conflicts of interest or inappropriately charged fees & expenses,” according to Nelson’s letter.

US advisory firm Beach Street Legal said that a hedge clause “is one of those contractual provisions that is monumentally unimportant until a dispute arises between the client and the advisor, at which point it can become one of the most important legal nuances in the entire contract.”

ILPA also took aim at increasingly “complex and opaque” limited partnership agreements and private placement memorandums that leave LPs ill-informed about GP conflicts of interest, as well as the fees and expenses they charge. ILPA said that as a result of this opacity, it is often difficult for even sophisticated LPs to truly give informed consent when confronted with written LPA terms and PPM disclosures that are “broad, opaque, voluminous, inclusive of comprehensive possibilities or potential conflicts that are not thought to be relevant, complex, and sometimes contradicted by the oral statements of the investment adviser.”

ILPA said the SEC should rescind the 2007 no-action letter “to prevent the continued abuse of the objectives of the Advisers Act and ensure that the fiduciary duties owed to private fund investors are clear.” It said change was necessary to stop LPs from being “forced to accept these reductions in the applicability of basic duties of fairness, loyalty and good faith owed to them by the investment advisers they invest with.”

The industry group also said that the SEC should compel private funds to provide a detailed summary of conflicts of interest to their investors “to further address the requirement to have ‘informed consent.’”

ILPA says it represents more than 470 member institutions – including pension funds, university endowments and sovereign wealth funds – that have over $2 trillion in
private equity assets under management.