All-terrain vehicles

Challenging market conditions look set to force a rethink on the terms of investment partnerships, says Iain Redford

Limited partnerships (LPs) and limited-liability partnerships (LLPs) have been the vehicle of choice for many investors in real estate and in private equity funds – the reason, of course, being tax efficiency.

However, given the difficult challenges facing the commercial real estate sector and the private equity industry in 2008, are these investment partnerships likely to be the latest casualty of the financial crisis?The inherent advantages of LPs and LLPs are now so well established that they are here to stay. However, the next 12 months will see lawyers in this field taking a long hard look at the terms on which their clients have invested and the protection afforded to their clients if all is not going well.

Those of us who are working on new investment deals may well be revisiting some of the more standardised terms to test whether these provisions still work in a harsher economic climate. This will impact on partnership agreements in a variety of ways.

Partnership capital and financing

The signs are that for the foreseeable future it will be difficult to raise bank debt and any debt raised will be on more stringent terms. For example, there is downward pressure on loan-to-value covenants – that is, the ratio of borrowings to partnership assets – due to a general desire on the part of banks to take on less risk and a drop in the value of assets. This will inevitably impact on partnership agreements.

First, in times of trouble cash is king, so partners may be required to inject more equity capital. In respect of limited partnerships, the tried and tested approach is that only a nominal amount of cash is injected as a capital contribution, as the liability of the limited partner investors is then limited to this nominal amount, with most of the equity being lent interest-free to the partnership. In the case of LLPs, members’ capital tends to be substantial but is often borrowed and possibly secured against a member’s own assets.

The issue will be whether the partners or members are required to advance more money under the partnership agreement. If they are then all is well unless a partner or member is unable to provide the cash – in which case they will usually be penalised for such failure. If, however, certain partners do default, or partners are already fully committed, the partnership will need to refinance.

What we are likely to see, therefore, is a return to partners providing mezzanine finance. This usually takes the form of interest-bearing loans that rank behind the bank but ahead of partner distributions. If only some of the partners or members provide such finance, this will inevitably alter the relative returns that partners receive.

Second, partnership agreements often include provisions on ‘gearing’ – with a limit on the amount of external borrowing that the partnership can take on. In real estate investment partnerships, for example, it is common for external borrowing to be capped at a percentage of gross asset or market value of the properties it owns and/or total development costs if it is a development project. These limits may well be under pressure if valuations are falling and ways will need to be found to relieve the pressure. One obvious way is to inject more cash, but if this is not possible or desirable an alternative would be to allow the partnership to reinvest capital that arises from the disposal of its assets.

This may well require an amendment of the partnership agreement, as it is not uncommon for the agreement to require all capital – and certainly capital gains – to be distributed.

Investment strategy

It is common practice for partnership agreements to include an investment strategy or investment policy. When the partnership is established there is inevitably a tension between the investors and the general partner – commonly referred to as the sponsor or manager – running the partnership or fund.

The investors, and their lawyers, like to see a clearly defined strategy with obvious parameters, while the sponsor likes to retain as much flexibility as possible (within reason) and so pushes for a more generic principles-based strategy. This can often lead to drafting compromises and it is, alas, only when things get tougher that people revisit, and potentially call into question, what has been done.

Going forward, we can expect to see strategies and policies defined in very precise terms.

Profit shares and carried interests

Often the investment strategy will include projected rate(s) of return. Depending on the nature of the partnership, these can vary greatly in length and complexity from very detailed IRR (internal rate of return) calculations to more simple yield projections.

Crucially, these are likely to be linked to the profit share entitlement of the sponsor/manager who will receive extra money if it exceeds certain performance hurdles. In the case of LPs, this additional (priority) profit share is often called a carried interest.

The sixty-four-thousand-dollar question in times of falling values will, of course, be: are these returns being achieved? And who is entitled to what (if anything)?A less obvious question, perhaps, will relate to how the strategy has been drafted in the first place. Does it refer to projected returns in a purely aspirational way – eg “it is the intention of the parties that…” – or is the wording more absolute? If it is the latter, this could have serious consequences for the sponsor/manager, and this is certainly an area in which we can expect more thought and discussion in future.


The natural desire for investors if the partnership is not performing as hoped may be to exit or retire. Sounds simple, but chances are it will not be, particularly if it is a partnership that has been established as a bespoke fund for a few investors, as it is likely that any partner wishing to exit will have to offer their interest first to the other partners.

In any event, there may well be financial disincentives to early exit or retirement. There is little lawyers can do to change the dynamics of this situation because it is, as I have heard many a person say, “the nature of the beast”.

It is still too early to say with certainty what will happen in 2008, though we may well see fewer new partnerships set up. What is clear is that for lawyers practising in this field the coming year promises to be an interesting, and hopefully not nervous, time.

Iain Redford is a partner at Bristows