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Alternative Insight – December 2019

Defence against the Dark Arts: LP protections

 

Every year, MJ Hudson surveys the terms of a broad sample of recently-closed private equity (PE), venture capital (VC) and growth capital funds, where we have advised either the fund manager or at least one investor. In July, we looked at recent trends in fund economics. In October, we put GP/LP alignment under the spotlight. This month we examine how key investor protections are faring in LPAs.

Removal for cause

GP removal is the “nuclear option” of investor protection. It comes in two basic forms. For-cause removal allows LPs to vote out the management team in the event that they commit some serious error, such as fraud, gross negligence, material breach of the fund documents, bad faith, wilful default or violation of securities laws.

Removal for cause is a nearly universal form of fund investor protection: 92% of the funds in our 2019 survey allow it, a figure barely changed from the previous year’s survey. A successful cause removal resolution would need to command the support of investors representing at least a majority of committed capital. 65% of our 2019 cohort of funds set the consent threshold at a simple majority, an increase on the 44% of funds with simple-majority cause removal in last year’s survey, and 55% in the 2017 survey.

Investors do not take removal decisions lightly, and cause removal rights are often hedged with conditions that make them less amenable to activation:

  • The GP’s liability for cause may require the formal judgment of a court – which may be a first-instance judgment or, less helpfully for investors, a non-appealable final verdict.
  • LPs may have to show that the GP’s conduct has had a materially adverse financial effect on the fund.
  • Removal may be made procedurally cumbrous, for instance by insisting that it can only be passed at an in-person meeting of LPs, rather than via written resolutions circulated by email, which is the usual way in which GPs hold partnership consent votes these days.
  • Management often gets to retain a portion of carried interest post-removal. Only 32% of funds in the 2019 sample imposed a 100% haircut (up from the 25% of sampled funds which did the same thing in 2018). The rest allowed the former GP to retain at least 50% of its carried interest.

No-fault divorce

The second type of GP removal is no-fault divorce. This allows LPs to terminate the GP regardless of conduct. Investors enjoyed the no-fault divorce rights in 63% of our 2019 cohort of funds, as against 53% in the 2018 cohort. But the numbers obscure a stark geographic skew: 85% of the European funds in the 2019 sample provided for no-fault divorce, compared to just 22% of the U.S. funds in the same sample.

For a no-fault divorce resolution to succeed, it will need to command the support of investors representing a supermajority of committed capital. 85% of our 2019 cohort of funds set the supermajority threshold at no less than 75%.

It’s also increasingly common to see an exclusionary grace period. During the grace period, investors may not remove the GP without cause. Of the funds in our 2019 sample with no-fault divorce rights, 79% of them also instituted a grace period, compared to 56% the previous year and 47% in 2017. This upward trend suggests that management has been able to use the buoyant fundraising conditions of the last half-decade to gradually make the grace period market standard. In our 2019 survey, 24 months was the most common length of grace period (the clock starts at final closing); the 12-month grace period was the second most popular.

No-fault divorce comes at a price for investors:

  • The GP will almost always be entitled to receive additional compensation, usually calculated as a multiple of its annual management fee. Our survey shows 1x being the most popular multiple by far, followed by 1.5x. Third place used to be occupied by 2x, but this was overtaken in our 2019 survey by sub-1x generally.
  • Any haircut on future carried interest may also be sharply curtailed. For instance, the removed GP may be entitled to keep 100% of carry on all investments made during its period of management. It may also be entitled to cash out its GP commitment and carried interest in the fund.

It is extremely unlikely that investors would invoke no-fault divorce without having genuine grievances. However, cause removal may be unavailable for technical reasons (e.g., if the GP’s responsibility for cause has is required to be, but has not yet been, adjudicated by the courts), or the removal process may be too slow or damaging for the fund (e.g., if a final, non-appealable judgment is required to establish the GP’s cause, and the litigation simply gets dragged out). In those circumstances, investors may prefer to use no-fault divorce rather than persevere with a malfunctioning GP relationship.

Key person 

Since investors view the track record of GPs and the quality of the management teams as key factors when evaluating a fund investment, it is not surprising that key person protection is ubiquitous. 98% of funds in our 2019 survey specify certain investment professionals as “key persons”, a little up from last year’s 95%.

Key persons must fulfil an agreed minimum time commitment, which requires them to devote “substantially all” or a “substantial majority” of their business time to the fund in question (or, in a more generous formulation, to a broader spectrum of funds under the manager’s stewardship, including predecessor and successor funds, and possibly the manager’s business activities generally). Failure to satisfy the time commitment may trigger a key person default.

In practice, it isn’t easy for investors to monitor executives’ day-to-day activities. Only an executive departure will unambiguously represent a key person event. In a small fund, default may be triggered by the departure of one key person. But in big funds there may be a dozen or more professionals identified as key persons, and they may even be split into upper and lower tiers; default only arises on the departure of multiple key persons. The GP invariably has the right to nominate replacements for departing key persons, subject to LPAC approval.

In 89% of our surveyed funds, key person default results in the automatic suspension of the investment period; 74% allow the termination of the investment period if the key person default is not cured (e.g., by waiver or LPAC approval of replacement key persons) within a specified period – most commonly, six or 12 months.

MFN

Most favoured nation (MFN) clauses allow investors to elect terms and conditions offered to other investors, albeit often with important exclusions and exemptions.

68% of the funds in our 2019 survey have an MFN clause in their LPAs, a marked improvement on the 54% that did in 2018. But that doesn’t mean that the remaining 32% are MFN-free, since many investors in those funds will negotiate individual MFN rights in their side letters.

There was a big jump in the proportion of funds adopting a “tiered” MFN, i.e., the right to elect the benefit of another investor’s side letter is conditional on the requesting investor committing at least the same amount of capital as that other investor. In 2018, 30% of surveyed funds had a tiered MFN; in this year’s survey, 64% insofar as the benefit of side letter terms is concerned; 38% of funds also contained tiering provisions relating to the simple disclosure of other investors’ side letter terms.

You can download the entire 2019 MJ Hudson Fund Terms Survey (Parts I, II and III) here.