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Developments in Private Equity Fund Terms Since the 2007-08 Financial Crisis (Part 2 of 2): Realignment of Fund Governance Terms

In this month’s President’s Corner, Quinn Moss, Esq. and Dolph Hellman, Esq. of Orrick, Herrington & Sutcliffe LLP (and Co-Chairs of their firm’s Private Investment Funds Group) discuss how fund governance terms set forth in limited partnership agreements have become subject to higher scrutiny by institutional investors since the 2007-08 financial crisis.

As we mentioned in our first installment, since 2008 the dialogue between GPs and LPs regarding fund terms and strengthening the alignment of interests among the parties as partners has been reinvigorated. In addition to a renewed focus on alignment of economic interests (as discussed in the prior President’s Corner), limited partner investors are scrutinizing more carefully the fund’s governance terms, in particular key person provisions and other limited partner remedies.

In the area of key person provisions, during the “boom boom” days of the mid-2000’s many sponsors sought to become more institutional, global and less tied to specific teams. However, with the slowdown in fundraising that occurred during and after the 2007-08 financial crisis, fund investors have paid greater attention to identifying the individuals who will be actually managing the fund’s portfolio, the skill sets of those individuals (for example, whether such managers are primarily deal makers, operational managers, financial engineers and/or value creators), and whether those managers were properly incentivized to stay with the fund, be it through their own “skin in the game” in the form of the “GP commitment,” the GP carry or other incentives. As part of the fund-raising discussion, most sponsors now understand that the key members of their team will need to make a commitment to spend all of their business time on sponsor-related business, and at a minimum the time necessary and appropriate to the business of the particular investment fund being raised. As such, fund terms now most frequently include, in the event of a key person trigger, an automatic suspension of the investment period and any investment activity other than those pursuant to binding commitments or follow-on investments for existing investments. A key person trigger typically occurs if a combination of specified key persons are not spending the time and attention required by the limited partnership agreement. Although these “key person” provisions now frequently allow for reinstatement of the investment period based on various cures such as satisfactory replacement of departing key persons, the cures are also often subject to limited partner oversight. In sum, the partners have come to agree that composition of the sponsor team is a fundamental building block of the fund and that any significant changes to the team need to involve input from the investors.

Likewise, since 2008 investors have frequently sought a more robust set of other limited partner remedies, including other triggers to suspend the investment period, rights to remove the general partner or rights to dissolve the fund. While “for cause” remedies had previously been the norm, one of the most significant developments in fund terms since 2008 (as also reflected in the ILPA guidelines mentioned in the prior President’s Corner) has been the addition of various “no fault” remedies. As limited partners identified and more frequently litigated bad acts of certain fund general partners (e.g., overcharging of fees, unauthorized cross-fund investing or lending, lack of transparency regarding conflicts and similar issues), limited partners found that their much-negotiated for-cause remedies did not provide a sufficient or timely remedy, particularly those that required a “non-appealable finding by a court of competent jurisdiction” prior to the exercise of remedies for “cause”. As a result, many of the larger limited partners with leverage often now seek more expedited remedies, typically no-fault rights on the vote of a supermajority (e.g., 75% or 80%) in interest of the limited partners. These rights often include one or all of the no-fault rights to suspend the investment period, remove the general partner or dissolve the fund for any reason.

Not surprisingly, general partners have sought protection of their own interests in the context of no-fault rights. These protections have tended to be some variation of the following, depending on the experience of the fund and its leverage:

  • Seeking grace periods of one to three years before the no-fault rights could be invoked;
  • Limiting no-fault rights to the class least likely to impact a proprietary portfolio (i.e., only permitting a no-fault right to suspend the investment period, but requiring a showing of cause for removal or termination of the fund) or least likely to be exercised by the limited partners (i.e., terminating the fund and forcing a fire sale liquidation of the fund assets);
  • Permitting a general partner who is removed without cause to retain 100% (or some smaller but still significant portion) of its carry on investments made during the general partner’s tenure, sometimes payable immediately upon removal.

These terms continue to be at the heart of each negotiation, with each side trying to achieve a balance appropriate for the fund, its portfolio and its partners.

Another area of governance that have been impacted by the 2007-08 financial crisis includes the increasing role of the limited partner advisory committee (“LPAC”). As sponsors sought to have greater agility in decision-making and deeper relationships with key limited partners, they attempted to move more decisions away from a full limited partner vote and towards an LPAC vote. While LPACs have traditionally been given authority to make binding determinations regarding conflicts and approve valuation methodologies, post-2008 members of the LPACs were being asked to vote on a larger range of issues, ranging from extensions of the term to early termination of the investment period, waivers of investment restrictions, and approval of replacement key persons.

In sum, since 2008, terms related to greater governance rights and oversight with respect to the funds have become an increasingly important part of most fundraising discussions.