LPs seek stricter investor protection clauses

Much has been written about private equity’s shrinking management fees on the topic of fund terms and conditions. But less has been said about LPs growing appetite to negotiate stricter investor protection clauses.

It should come as no surprise to GPs that pressure on legal terms has been high on LPs’ agenda. Last year PE Manager reported a study from placement agent Acanthus Advisers, which revealed nearly half of LPs are not satisfied with their current agreed fund investor protection clauses.

So why all the disappointment in investor protection provisions?  Legal sources point to the failings of some alternative investment funds during the financial crisis. During that time a number of funds experienced their investor protection clauses becoming triggered, and lessons learned from the crisis are now being applied to funds today, says Alex Amos, funds partner at law firm Macfarlanes.

However, other lawyers argue LPs have always been interested in beefing up their investor protections. But only now in a tough fundraising environment have they achieved the negotiating power to actually force GPs’ hands.

It’s worth mentioning though that the trend has not been felt amongst all GPs. Duncan Woollard, partner in law firm SJ Berwin’s funds practices, says fundraising is bifurcated, and the stronger GPs are not generally making concessions on LP rights. Woollard says there is a small select group of GPs that investors are willing to forgo certain investor protections that they now require from less in-demand fund managers.

HOLDING THE KEY

For the majority of firms on the fundraising trail, the key man clause is often the first provision LPs want to heavily negotiate once the economics have been agreed, according to legal sources. Key man clauses allow investors to suspend a fund’s activities in the event a senior partner leaves the fund. 

Over the years LPs have been keen to try and encompass more people, especially at larger firms, into key man clauses. Consequently, explain lawyers, the wider key man net has captured a big raft of mid-level investment managers. A clause might state that if five out of ten of those professionals left the firm, then it would trigger the suspension of the fund.

LPs argue five people leaving the fund is a mark of team instability. But lawyers advise firms to resist labeling relatively junior professionals as key men because it effectively promotes them to mid-level managers. Why is that an issue? “It can shift the power balance in the GP,” says Woollard.

Where LPs are negotiating a more traditional key man clause, one that for example only encompasses two or three senior partners, the pressure for GPs is convincing investors that the key men will be devoting enough time to the fund, which may be competing for senior partners’ time with sister funds under the adviser’s umbrella.

“It is common for investors to ask questions on the external activities of key men partners,” says Amos. For example: are they managing other funds; are they managing separate accounts; do they have outside interests like family trusts; what type of non-executive roles do they have and so on, Amos elaborates. 

If LPs are able to successfully negotiate key man time requirements, how do they know if it’s being enforced? The answer may be that they don’t. “They are relying on the good faith of the manager to monitor time devotion to see if it has been triggered,” says Amos.

REMOVING THE MANAGER

Arguably the most fundamental protection for investors is the power to sack an incompetent or faulty fund manager. Typically this is dealt with in “removal with fault” clauses, or the more LP-friendly “no fault removal” clause. Both have long been standard in Europe, but in the US some funds are still resisting no fault removal, according to legal sources.

GPs have long been happy to give LPs the removal with fault clause as it is rarely enforced. The clause generally says fault occurs when the GP commits gross misconduct, fraud, gross negligence, and so on. “In reality it’s a very high bar and it is very difficult to prove,” says Amos. “From bitter experience, removing a manager for cause is very difficult in practice.”

What’s more is that GPs can be frustrated by protection-seeking investors asking for this bar to be lowered. Legal sources say they have seen LPs ask for it to cover poor performance, technical regulatory breaches and in one instance even a key man event. For their part GPs have generally been able to defend their position,  and walk away with a more traditional fault removal clause, according to fund lawyers.

When removing a manager without cause, typically 75 percent of the fund’s LPs must vote in favor of removal. But it is often difficult to enforce this rule due to negotiated compensation arrangements. The manager is usually entitled to a compensation payment equivalent to one or two year’s management fees. In addition, and subject to any specific formula set out in the partnership agreements, there will also be negotiations on how much of the unpaid accrued and any future carry the manager is entitled to, according to funds lawyer Gawain Hughes of law firm DLA Piper.

One LP told PE Manager paying off the GP was a real low blow as the manager is being rewarded when it’s not deserved. “Many investors are applying greater pressure to this aspect of the clause in order to make it more palatable to remove the manager,” the LP said.

However, many LPs are reluctant to enforce the no fault removal as it means having to find a replacement manager to wind down the fund and sell the assets at a profit. Not always an easy task considering the amount of LP consensus needed to enforce a no fault removal, according to sources. 

NO NEED TO PANIC

Despite the increased focus from LPs on investor protection clauses, it is still incredibly rare for them to be enforced. ““It’s almost unheard of to be honest, but they form the basis for negotiations,” says Woollard.

Normally what happens when an investor protection clause comes close to being violated, GPs and LPs come together to agree the relationship should end, resulting in the GP voluntarily stepping down, say sources. The same is true for key man clauses. A key man will leave and the fund will continue, perhaps writing smaller tickets or giving LPs the opportunity to opt out of certain investments, after LPs and the firm have reached an agreement, according to multiple sources.

The investor protections form the backdrop for those re-negotiations, and act as more of a last resort if an agreement cannot be reached.

However, before conceding terms to investors in a bid to reach your first close, GPs should remember one thing: “You will be stuck with those terms for the rest of your relationship with that investor,” says one funds lawyer. And as each LP has their own agenda and needs, a GP could very well experience one LP who perhaps wants a strict key man provision, and another who requests a tightly drafted no fault removal clause. Taken all together, the GP may end up in a situation where investors have lots of areas to apply pressure in the future. If so, GPs may start looking for more protections of their own in fund agreements.