As most in the private equity industry know, in January the Institutional Limited Partners Association released an updated and revised version of its private equity principles. Like the original principles, which were published in September 2009, version 2.0 states that three guiding principles form the essence of an effective private equity partnership: (1) alignment of interests between investors and fund sponsors; (2) good fund governance; and (3) appropriate transparency. Version 2.0 of the principles then describes in great detail ILPA's "preferred private equity fund terms and best practices" in each of these three areas, noting that version 2.0 was developed after "reflecting on the extensive input" that ILPA received from GPs as well as LPs in 2010.

Overall, the principles seem to be an attempt to move the market in a more "LP-friendly" direction. Although described by ILPA as "best practices," the fund terms listed in version 2.0 continue to be seen by some GPs as essentially a long LP "wish list" of terms. While the three general principles around which ILPA proposes that GP and LP discussions be organized are not controversial, many of the specific "preferred" fund terms advanced in version 2.0 as furthering these principles are controversial. Vigorous discussion and debate between GPs and LPs over these terms can be expected to continue as private equity fund agreements are negotiated in the years ahead.

GPs are not the only market participants who may take issue with certain preferred terms included in version 2.0. Not surprisingly, different LPs have different views on the importance and desirability of certain of these terms. For example, version 2.0 proposes a prominent role for the LP advisory committee, which is described as a "sounding board" for the GP and also as a "voice" for LPs. Yet, some LPs that are not represented on LP advisory committees may prefer to rely on the judgment of the GP, or may want controversial matters to be put to a vote of all LPs. They may feel that an overly strong and active advisory committee could exert disproportionate influence on the GP, to the potential detriment of the fund as a whole. Even some LPs who do hold seats on LP advisory committees may not wish to assume all of the responsibilities described in the principles, such as approving valuations or valuation methodologies or reviewing allocation of investment opportunities.

Another example of a "preferred" term that might not always be in the best interest of LPs is the statement in version 2.0 that LPs and GPs "must" recognize as a "best practice" a distribution waterfall that returns to investors all capital contributions, plus a preferred return, before any carried interest is paid to the fund's GP. This approach, which is quite common in Europe, reduces the likelihood that the GP will be required to make clawback payments. On the other hand, this approach (as compared to the "deal by deal" distribution model that has been the market standard in the U.S. for more than three decades) delays distributions of carried interest to GPs, often for many years. Such a delay affects GP incentives and could adversely impact the ability of some private equity firms -- particularly small and midsized firms that do not have multiple products or lines of business -- to attract and retain the most talented investment professionals. It also could, perversely, encourage a more rapid disposition of investments than is appropriate. Some LPs and many GPs could well take the view that, at least for certain firms, the model that ILPA describes as "best practice" is not necessarily consistent with the goal of maximizing investment returns.

Version 2.0 recasts some of the terms included in the original principles to be more GP-friendly, but also adds new pro-LP terms. Set out below are some of the notable changes proposed in version 2.0 as compared to the original principles:

After-tax GP clawbacks. The original version of the principles stated that the GP clawback (that is, the GP's obligation to return overdistributions of carried interest) should be gross of tax. ILPA now states that an after-tax GP clawback is acceptable, but proposes a complex calculation to determine the after-tax amount. Even the revised ILPA clawback calculation is more aggressive than the approach agreed to by a majority of LPs in the past decade.

Guarantees of the GP's clawback obligation. The original version of the principles took the off-market view that individual GP members must guarantee the GP clawback obligation on a joint and several basis. Version 2.0 acknowledges that a creditworthy backstop (such as a substantial parent company guarantee or guarantees by a subset of GP members) may be an acceptable substitute for joint and several guarantees, but does not go so far as to accept the market practice of GP members guaranteeing only their pro-rata shares of the GP's clawback obligation.

Interim GP clawbacks. Version 2.0 recommends that, if a "deal by deal" carried interest distribution waterfall is used in a new fund, then the GP should be subject to interim clawbacks (as compared with a clawback obligation that only applies at the end of the term of the fund), triggered both at defined intervals and upon specific events, such as a key person event or in the event that a fund's net asset value is less than 125% of cost (NAV coverage itself being a new concept for the principles, and not one generally used for private equity funds other than some venture funds). Interim clawbacks were not discussed in the original principles and are not customary in today's market.

Limits on all-partner clawbacks. Version 2.0 states that so-called all-partner clawbacks (that is, the obligation of all partners to return distributions to indemnify the GP) should be limited so that the amount subject to clawback does not exceed 25% of committed capital and so that only amounts distributed to LPs in the preceding two years (or some other "reasonable period") may be clawed back by the fund. Such limitations have been frequently requested by LPs over the years. However, these terms have been vigorously (and often successfully) resisted by many GPs, who argue that such restrictions make it much less likely that the all-partner clawback will work as designed (that is, to protect the GP from bearing more than its share of fund liabilities). Instead, GPs have frequently obtained agreement to higher caps on amounts subject to clawback (for example, up to 50% of distributions) and to longer periods during which such amounts are subject to clawback (for example, until the second or third anniversary of the end of the fund's term). All-partner clawbacks were not discussed in the original version of the principles.

GP contribution to be in cash. Version 2.0 states that the GP's commitment to a fund should consist entirely of cash, as opposed to being contributed in whole or in part through a management fee offset mechanism. The original version of the principles required a "high percentage" of the GP commitment to be in cash.

Required vote for "no fault" suspension of investment period or GP removal. Version 2.0 proposes that the investment period of a fund may be suspended or terminated on a "no fault" basis following a vote by two-thirds in interest of LPs, compared with the majority in interest vote in the original version of the principles. Version 2.0 also proposes that the GP may be removed or the fund may be dissolved on a "no fault" basis following a vote by three-quarters in interest of LPs, compared with the two-thirds in interest vote in the original version of the principles. We expect these pro-GP changes to be welcomed by some LPs, on the grounds that such extraordinary and disruptive actions should only be taken with a strong mandate from LPs.

GP removal, or fund termination, for cause. Version 2.0 provides that a majority in interest of LPs should have the ability to vote to remove the GP, or terminate the fund, for cause. This issue was not addressed in the original version of the principles, although such provisions are standard.

Disclosure of certain LP conflicts. Version 2.0 states that if a member of the LP advisory committee has a conflict of interest (for example, the LP that such member represents is co-investing with the fund or has obtained more favorably economic terms), that conflict should be disclosed to the other members of the advisory committee. This issue was not addressed in the original version of the principles.

Notice of liabilities, breach. Version 2.0 states that the GP should immediately notify the LPs if there is a breach of the fund's limited partnership agreement, or if any material contingency or liability arises. It appears that the principles are referring to fund-level liabilities or contingencies, although this is not explicitly stated. Version 2.0 does not address situations where such disclosure would be contrary to the best interest of the fund, nor does it address the potential liability of the GP to the LPs if the GP's judgment as to materiality or the existence of the breach, contingency or liability is made in good faith but proves to be incorrect. This is a new term.

Annual reports, focus on risk management. Version 2.0 states that annual reports should be provided to LPs within 90 days after the end of the relevant annual period, rather than within 75 days as provided in the original principles. Version 2.0 also adds a new reporting requirement: Annual reports should include information on material risks and how they are managed, at both the fund and portfolio company level.

Quarterly projections. Version 2.0 states that the GP should provide estimated quarterly projections for capital calls and distributions. This is new.

Liquidation timing. Version 2.0 provides that a fund must be fully liquidated within a year after the fund's term has ended, unless LPs otherwise consent. This is a new term, and addresses LP concerns that dispositions are too often delayed and/or that management fees are charged during the extended liquidation period. However, this requirement also could require GPs to dispose of assets more quickly than they believe is prudent.

The principles have been the subject of much discussion in the industry and are often mentioned in the context of GP/LP negotiations of fund terms. Some of the terms that the original principles advance (for example, the requirement that all transaction fee income received by the GP be shared with the LPs, and proposed changes concerning the role of the advisory committee) have been adopted by a number of GPs. We expect that certain of the version 2.0 proposals concerning clawbacks (for example, the use of interim clawbacks) and fund reporting will also be adopted (or increasingly adopted) by GPs. We also expect, however, that GPs will continue to resist strongly a number of the ILPA preferred terms, and that LPs will continue to hold differing views on the relative importance of certain of the preferred terms and their impact on fund performance and governance.

Michael P. Harrell is a partner and Gavin Anderson is an associate in the New York office of Debevoise & Plimpton LLP. A version of this article originally appeared in the winter issue of the Debevoise & Plimpton Private Equity Report.