Can strict key man clauses actually harm LPs?

Investors are insisting on stricter key man clauses in fund documents. But these do not work always work in LPs' favor, observe legal sources.

In a tough fundraising environment LPs have been demanding GPs tighten their investor protection clauses before committing to a fund. However, this has resulted in some unintended consequences. 

Legal sources speaking with PE Manager pointed to a trend in LPs asking for stricter key man clauses as an example of demanding more and getting less. 

Key man provisions can result in an automatic suspension of the fund's activities when a designated “key man”, typically the two or three senior partners, leaves the firm. The provision is designed to preserve the fund's leadership, or allow LPs to cease the fund's investment activity if it no longer remains intact. 

Over the past few years LPs have been asking for more partners to be included in the key man provision, and including more specific obligations for key men to meet. For example LPs want provisions that set a specific amount of time that key men must commit to working on their fund, which can increase the chances a key men clause is violated by the GP.  

Legal sources said that in some cases too many people have been included in the key man provision, resulting in a suspension of the fund when one partner leaves, when in fact most LPs would have been happy to allow the fund to continue with the remaining key men. 

…often what ends up being signed is a more strict automatic suspension of the fund when the clause is triggered

“At the time of negotiating the LPs always say they simply want the option to suspend the fund in the event a key man departs, but often what ends up being signed is a more strict automatic suspension of the fund when the clause is triggered,” said one UK-based funds lawyer.

When these events are triggered, LPs must often re-negotiate terms with the GP in order to get the fund back up and running, which can take considerable time, according to lawyers. 

A separate funds lawyer said that he was involved in a situation where a key man event was triggered and a replacement was named by the firm. But although most investors were happy enough to accept the replacement, some LPs were concerned.

“These LPs did extra due diligence and held several meetings with the replacement, taking up considerable time, before agreeing that the replacement was suitable,” the lawyer said. 

However, legal sources stress that such events are rare. What is far more common is the negotiation of a replacement before the key men clause is triggered.

Typically firms will give LPs advance notice about the departure of a key man, and negotiate the continuation of the fund before the key man clause becomes activated. Negotiations can include ways for investors to opt out of certain deals, limitations on deal sizes and so on.

For a more in-depth look at investor protection provisions be sure not to miss PE Manager’s June issue.