Crossing the Line: Why LPACs Need Full Transparency in Principal Trades
>> Cross-trades can benefit funds and shareholders through more efficient portfolio management but can also pose significant conflicts of interest. As a result, cross-trades trigger a variety of legal obligations under the U.S. Investment Advisers Act of 1940 (the “Advisers Act”), particularly concerning the adviser’s fiduciary duty.1 Principal cross-trades—where the adviser arranges for an asset to be purchased from or sold to a client from its own account—require explicit written disclosure and client consent under Section 206(3) of the Advisers Act.
In private equity funds, it is common for Limited Partnership Agreements (“LPAs”) to delegate approval of principal cross-trades to the Limited Partner Advisory Committee (“LPAC”). However, there are critical disclosures that investors should ensure the General Partner (“GP”) is required to provide to the LPAC. This guide will highlight the key information you need to look for to protect your interests.
Simple Cross-Trade or Principal Trade? Know the Difference
In the context of private equity funds, a cross-trade occurs when a manager decides to sell or transfer an asset from one fund to another, both of which they manage. It’s like trading within your own team. Sounds efficient, right? Sure, it can be. After all, keeping things in-house can save the fund the transaction costs and settlement risk of transacting on the open market.
But it’s also a ripe area for conflicts of interest. The manager’s making the deal on both sides—so how do you know if the deal is truly in your best interest? The potential for conflicted transactions explains why the Advisers Act imposes strong fiduciary duties on managers in such trades.
Unsurprisingly, the responsibility of the manager is heightened in principal trades, where the manager not only acts on both sides of the deal but also acts for its own account. In principal trades, Section 206(3) of the Advisers Act obligates the manager to disclose in writing to the client that it is acting as principal and obtain the client’s consent.
But hold on, if an adviser causes one fund it manages to transfer an asset to another fund it manages, isn’t that just a simple cross-trade? It turns out that the answer is no, because the SEC has clarified that if the manager or its principals own a substantial interest in a fund (generally more than 25%) that is a party to a cross-trade, then the adviser is considered to be acting for its own account.2
The LPAC: Your Gatekeeper (But Also the Manager’s Friend?)
In a principal trade, the Advisers Act affords you more protection as an investor. But most LPAs delegate to the LPAC your right of approval for principal cross-trades requiring Advisers Act consent:
“The LPAC is authorized to give any approval or consent required under the Advisers Act on behalf of the Partnership and the Limited Partners, including under Section 206(3) of the Advisers Act.”3
Is that favorable to investors? Not exactly. As an LP, you’d prefer to retain your right under 206(3) to approve any principal cross-trade in which you’re implicated. Moreover, the LPAC members are generally drawn from a select set of key institutional investors whose interests might be more aligned with the GP than yours are. In consequence, the LPAC might have a cozier relationship with the manager, which means it could greenlight a deal that not all investors would love.
If LPAC approval is more favorable to the manager, why is it generally accepted by LPs in the market? Well, it’s thought that getting all LPs’ consent is comparable to herding cats—time-consuming and unrealistic. In practice, it’s simply too cumbersome for managers to get every LP to sign off. Limiting approval to the LPAC body is thus an acceptable compromise to streamline the process of obtaining consents.
Still, this doesn’t mean you’re powerless.
In the rest of our writeup, we look at:
What to focus on for the GP's provision of LPAC information
Valuation Timing: A Procedural Safeguard
Final Thoughts
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1 SEC Risk Alert: Observations Regarding Fixed Income Principal and Cross Trades by Investment Advisers from An Examination Initiative (July 21, 2021).2 SEC No-Action Letter: Gardner Russo & Gardner (June 7, 2006).3 Drawn from the LPA of a large well-established fund.
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