A few key men

When one of the names on the shingle walks out the door, the remaining managers of a private equity fund need to have a plan of action in place so that its investment activities can continue with as little disruption as possible. A fund’s limited partners will also want some assurance if the charismatic GP they initially entrusted their money to is suddenly out of the picture.
The drafting of a clear and effective key man provision is a process all parties have a stake in. Consequently, the mechanics of a key man provision is often one of the more contentious areas of the limited partnership agreement.
There are two main areas of the provision that need to be negotiated. One, what will be sufficient to trigger a key man event? And two, what are consequences once the clause is triggered?
The triggers of the key man event vary widely from firm to firm.
For a larger, more institutional firm with a broad bench and a complex infrastructure, GPs can rightly say that no one person is ultimately responsible for the success of the firm. Key man provisions for this type of firm might require that a certain number of people leave from a certain level of the firm during a specified period of time. But for a small venture capital firm that maybe only has three partners to begin with, the departure of a single one of those partners will dramatically alter the dynamics of the firm.
Not only does a more stringent trigger agreement increase the risk that the fund’s investment activities will be disrupted, it can also alter the dynamics within the general partnership, says Ian Warner, a partner in the investment funds practice of Pinsent Masons in London. A partner designated as a key man will necessarily have more leverage within the firm.
“I think for a very small fund manager, where there is only one or two key people, they need to think very long and hard about how they draft these clauses, and perhaps have some very frank discussions with their LPs about what would happen,” Warner says. “Because what you don’t want is when you get a bit farther down the line and find that somebody’s become so entrenched in the fund that they can almost hold the wider team to ransom.”
It’s also important to make sure that the LPs truly understand who is important within the firm, says Robert Friedman, a partner in Dechert’s private equity and venture capital practice.
“Limited partners will see results of investment in portfolio companies, but they don’t necessarily know who is actually doing the heavy lifting in terms of generating the deal flow and the success of specific deals,” Friedman says. “If you haven’t introduced the entire investment team at an early point in the life of a fund, you could end up having a problaem in a key man event because the LPs don’t necessarily know, looking behind the performance numbers, which of the eight members of the investment team are the ones that are really responsible for performance. So I think if a general partner has people that are good and that it believes represent the future of the firm, it will want to bring them in front of the LPs sooner, rather than later, so the LPs can begin to get comfortable with them.”
The second area of negotiation is the consequences of a key man event, once it is triggered. Will the fund’s investment activities automatically halt, or will the LPs need to take some sort of collective action to stop the investment period?
The latter is a more “GP friendly” approach, Warner says. GPs with this type of agreement hope that “LP inertia” will work in their favor. But far more common is an automatic suspension, which puts the onus back on the GP to put together a proposal to replace the key man that will be palatable for the LPs. LPs will fight for this, because what they want most is a voice in the proceedings, says Carl de Brito, also a partner in Dechert’s private equity group.
“The goal of the LPs in a key man event is to make sure they’re a part of the process of determining whether the investment period continues, that they’re a part of the process of approving whoever it is that replaces the key man,” Brito says. “GP sponsors on the other hand are interested in having a broader group of key persons and requiring a number of them to be absent before a key man event is triggered.”
Ultimately, Brito and Friedman stress that the underlying issue in a key man provision is succession planning, and that isn’t something affects only one fund.
“You can address it in the document by having a larger group of people that the LP group will accept to continue the fund,” Friedman says. “But beyond that, you want to have a plan that the LPs are advised of, so they understand what the goal of the firm is in transitioning.”