Professional services businesses have historically been considered as ‘people’ business, whose value attached to the participants and as such unattractive to an investor. This can no longer be assumed. Brand loyalty is often bigger than individual reputation, work is increasingly commoditised, and many businesses have invested in valuable fintec, lawtec or investec products. In addition, these businesses have a recent track record of weathering an economic storm well. Whereas the markets for traditional investors look increasingly fragile, investors in non-traditional asset sectors may well be looking to professional services firms as alternative investments.
For many professionals and other service-led businesses, the vehicle of choice has for many years been a limited liability partnership (LLP). For many external corporate investors, however, an LLP is an unfamiliar vehicle; to maximise the benefits of investing in an LLP, specialist financial, tax and constitutional advice should be sought. An LLP is a corporate entity, but it is not a company. The rights and obligations of its members are far more complex than for their counterparts in the company sector, and LLPs lack the layer of statutory protection for its participants.
Profit and capital structure
One sector where external investment is already commonplace is the fund management sector. There are several reasons why a firm may be looking at selling part of the equity in the business, driven largely by either an exit strategy for the existing individual members or as an alternative to loan finance. For an investor, the profit and capital structure must facilitate a return on their investment and/or an increase in capital value. This approach is a significant departure from the typical profit and capital model in LLPs, broadly consisting of a defined proportional share of profits (with some variation or subtleties) and a ‘capital in equals capital out’ entitlement.
On its admission to the LLP, a corporate member would contribute capital to the LLP. There would typically be no sale of ‘LLP interests’ from the existing individual members, although their proportional share of the capital would be reduced as a result. The flexibility inherent in an LLP allows for capital to be invested in full or in tranches perhaps, for example, by reference to performance criteria or pre-determined capital requirements. Often investors do not consider these more creative options for their investment, and do not appreciate that their proportional equity stake can be secured at the outset notwithstanding these arrangements.
An investor will be looking for a return on its capital. The profit-sharing waterfall is inevitably one of the most complex of provisions in an LLP agreement, especially in the fund management sector where synthetic vesting arrangements (complex in themselves) for the individual fund managers will be required, or where there are different classes of individual members. The investor return can be structured in a number of ways, a fixed sum, by reference to capital invested or through a formula based on profit. The equity members and the corporate member usually sharing any residual profits according to their proportional equity stakes in the LLP.
The investor will need to provide for an exit strategy in the LLP agreement, even where a defined exit is not envisaged. An investor can also embed exit rights or options in the case of a loss-making or underperforming business, as an alternative to (or as well as) serving notice of retirement, which tend to require six or twelve-months’ notice.
The ‘capital in equals capital out’ model is unlikely to be suitable for a corporate investor. In addition to the capital invested, a corporate investor will typically be looking for a synthetic goodwill or exit payment on retirement from the firm. The difficulty with making these payments to the exiting corporate member is that, in the absence of capital reserves, the continuing partners’ capital interests are devaluated possibly to an unacceptable extent.
Particularly in fund management LLPs, a model where a retiring member’s interest ‘vests’ over a period of years is preferred. Often amounts payable under a vesting model will be based on an annual ‘goodwill’ valuation. Outstanding vesting payments are crystallised on a sale. The complexity of these clauses is compounded by the fact that no amount is ascribed to the value of the goodwill of a partnership or LLP in the statutory accounts. Instead, the post-retirement payments tend to be based on a pre-determined formula, often linked to profitability and other conditions.
On the sale of a business, an investor would be well advised to require appropriate anti-embarrassment provisions in the LLP agreement, a concept most unusual in traditional professional services business. The former investor would have a contractual entitlement to share in the value of the business, where the business is sold within, for example, three years of the retirement. These clauses can become extremely cumbersome, particularly those containing tapering payment and conditional entitlement structures.
The flexibility afforded to participants in an LLP cannot be easily replicated in a company. The de-linkage of capital, profit and voting rights allows for a more complex but bespoke investment arrangement. As an investment vehicle, an LLP, however unfamiliar, is always worth considering.