By Beth Young and Kimberly Gladman
Companies whose initial public offerings (IPOs) take the form of limited partnerships (LPs) rather than corporations, may pose special risks to investors. LP owners do not have the same legal rights as corporate shareholders, and standards of director independence and fiduciary duty do not protect investors' interests to the same degree. The governance disadvantages of LPs may not be reflected in IPO prices, but could lead to price declines if they are subsequently recognized by the market.
The Carlyle Controversy
U.S. alternative asset manager Carlyle Group (CARL) stirred controversy recently when it announced it would go public as a limited partnership with very limited rights for public investors. Most strikingly, the company's IPO documents initially contained a provision that would have forced investors who wanted to sue the company for any reason to resolve their disputes through private arbitration. Investors would have been barred from using the courts even for securities class actions alleging stock price manipulation and fraud. However, the mandatory arbitration provision did not pass muster with the Securities and Exchange Commission (SEC), which required its removal in order for the offering to proceed. Without that provision, Carlyle's governance looks a lot like that of Fortress (FIG), Blackstone (BX), KKR (KKR), Kinder Morgan Energy Partners (KMP), and other companies that have gone public in the last few years as LPs rather than corporations. So can Carlyle's would-be investors set their minds at ease?
The Conundrum of Non-Corporate Governance
We're not so sure. Using the LP form to go public is a recent innovation, and it fundamentally alters the traditional relationship between the investing public and the newly-listed firm. Going public has always been viewed as a trade-off-owners take capital from the public in exchange for giving up some amount of control over the company and allowing the company to serve the interests of a broader, more diverse group of investors. This is what happens when a firm goes public as a corporation, whose governance-as mandated in every state in the U.S.-requires a certain level of transparency and accountability to shareholders. State fiduciary law standards require corporate boards to make decisions in the interests of all shareholders (and corporate governance research firms like GMI Ratings exist to research and rate them on the degree to which they do so).
At LPs, in contrast, investors (who are known as "unit holders" because they technically buy units rather than shares) lack many of the rights enjoyed by corporate shareholders. For example:
- LPs are managed by a general partner (itself usually a corporation or limited liability company), rather than a board of directors, and unit holders have no say over who sits on the general partner's board, absent special circumstances. As a result, LPs are exempt from the stock exchange listing standards requiring independent director oversight.
- LPs are not required to hold annual meetings.
- Unit holders may replace the general partner of an LP only under very limited circumstances.
In addition, LPs can cut back on fiduciary duties owed by the general partner to unit holders. Carlyle, for one, has done so: its registration statement warns that its "general partner may favor its own interests and the interests of its affiliates over the interests of [unit holders]."
Because LPs have such different structures from corporations, GMI Ratings does not currently assign them ESG ratings. We also have no opinion, pro or con, about the LP structure in and of itself, when it is used, as it typically is, by private firms with a small group of investors. However, we know from our research that despite their legal rights and directors' legal duties, shareholders in corporations sometimes see their interests neglected or abused. We wonder whether public investors in non-corporate forms, which afford them far fewer rights, may be at even greater risk.
So Why the LP?
Given these concerns, how are LP IPOs able to attract any investors at all? There are several reasons we can think of. First, companies organized in this form have certain tax advantages which typically keep the aggregate tax burden on the company and its investors lower than for a corporation. For one, if a company is organized as a corporation, it pays taxes on its income; its shareholders also pay capital gains tax on the profits from their investment in it. If the same company is organized as an LP, however, investors simply pay tax on their share of the LP's income, a method which may be preferable for some investors. In addition, LPs make quarterly distributions to their unit holders, which are not always taxable and which may appeal to income-oriented investors.
Furthermore, the IPOs of alternative asset managers like Carlyle may be attractive, regardless of the form they take, because they allow investors to gain exposure to alternative asset classes, even if their net worth does not qualify them to invest in buyout or hedge funds.
Finally, another reason these IPOs may find buyers is that no one seems to care, at least initially, about the loss of control and accountability the LP form represents. If this were true, it would fit with an established body of academic work noting that investors seem to accept, at the IPO stage, governance features such as classified boards that they widely oppose as value-destroying when they are given the opportunity to vote on them later on. While this seems puzzling, we think the contradiction may disappear when one realizes that the "investors" who fail to discount IPOs with bad governance are not the same as the "investors" who vote against poor governance features. In our experience, the employees at an investment manager or mutual fund company who make buy and sell decisions are very often different from the employees who make decisions about proxy voting and corporate governance engagement (indeed, in some cases, the two are separated by a firewall). If governance data are often not thoroughly considered or understood by investment personnel, it would make sense that governance features are not fully reflected in IPO prices. If this information later is recognized by the market, however, the value of the investment could decline.
Financial Innovation Alert
There are also other reasons to be cautious about the recent raft of LP IPOs. One is that, in many cases, the companies choosing to make their public-market debut in this form operate in businesses that are by their nature complex and opaque. Carlyle's business of alternative asset management is one example. As Carlyle states in its registration statement, "There are often no readily ascertainable market prices for a substantial majority of illiquid investments of our investment funds. . . . [Valuation methodologies for these assets] involve a significant degree of management judgment." Investors should be cautious, we think, about investing in a difficult-to-understand business in which management has a great deal of discretion and in which accountability to investors is lacking.
Yet another red flag, in our view, is the fact that a number of the companies that have gone public as LPs in recent years have been assisted by the same corporate services firms,who seem to be seizing upon this as a profitable niche. (For example, law firm Simpson Thacher and Bartlett has worked on the IPOs of Blackstone, KKR, and Carlyle.)While we're all for creativity and profit-making, we note that in several cases in recent history, when a small group of highly-paid professionals developed a new financial vehicle and benefited handsomely from it, the investing public later wound up paying the price. (Think of the credit-default swap or the collateralized debt obligation - both of which, remember, were supposed to be good for investors.) To be sure, there is no evidence that LPs are a ticking time bomb of that scale, but there is certainly enough evidence to advise: "buyer beware."