Drafting for departure

It might seem strange to think about a new hire leaving, but that is what private equity firms must do in order to protect their business interests from dealmakers leaving to join other firms.

In the past, firms typically protected themselves from departing dealmakers through court enforceable non-compete clauses, or certain provisions which would cause the dealmaker to suffer financial consequences if they left on bad terms – for example clawing back bonuses, or not allowing the dealmaker’s carried interest to vest should he or she solicit other professionals or clients from the firm after leaving.

Then during private equity’s boom years the industry tended to rely on provisions that would hit the dealmakers' vesting carry (as described above), say multiple legal sources speaking with PE Manager. This was because outgoing dealmakers were primarily concerned about losing out on the most lucrative part of their remuneration package as opposed to, say, a court injunction, when joining a rival firm.

But legal sources say that in today’s leaner times (when many firms are not matching previous fund performance and dealmakers have less promise of carry), such financial provisions are not bearing as much weight as they might have in the past.

With potentially less incentive for dealmakers to take heed of financial penalties when departing, GPs need to place more attention on ensuring their contractual non-compete covenants are enforceable.

Legal sources say a mistake some firms make when drafting a non-compete covenant is writing language that is too restrictive. If so, courts can interpret them as being void, or “a restraint of trade”, in that they potentially deny an individual from making a living in their chosen profession.

For example, a non-compete restriction which covers a 10 mile radius of the firm is more likely to be enforceable than one that covers all of the UK, explains one London-based private equity lawyer. In terms of duration, the court would typically only enforce covenants not lasting more than six months. Only on rare occasions would 12 months be considered reasonable, according to legal sources.

A firm must also prove that it has a “legitimate protectable interest” in the departing dealmaker’s line of work, within certain reason, for the non-compete clause to be enforceable, says one UK-based employment lawyer.

That may not be a comfortable conversation to hold when negotiating hiring terms, but GPs must place greater weight to these types of terms now that financial disincentives no longer hold as much sway.