In July, we looked at the trends in fund economics revealed by our survey. Last month, we covered the impact on GP/LP alignment of evolving fund terms. In this article, the last in this mini-series, we examine what’s happening to key investor protections in fund documents, and we’ll wrap up by looking at how the market might move in 2019.
Removal for cause
GP removal is the “nuclear option” of investor protection. There are two types. “Removal for cause” allows investors 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 almost universal in fund documentation: 93% of the funds in our 2018 survey provide for it. In our survey, 44% of funds allow removal for cause by investors representing a majority of committed capital, with a two-thirds majority being the next most popular (favoured by 33% of sampled funds).
An investor does not take removal decisions lightly, and removal for cause provisions are often hedged with conditions that make them less trigger-prone:
- The GP may only be removed for cause if its liability is determined by a court – often, in a non-appealable final verdict.
- Investors may have to show that there has been a materially adverse financial effect on the fund.
- The procedure may be made more cumbrous, for instance by requiring removal to be voted on at an in-person meeting of LPs, in contrast to most LP consents, which can be obtained fairly quickly via written resolutions circulated by email.
- Management often gets to keep a portion of carried interest post-removal. Only a quarter of funds in our sample imposed a 100% haircut, whereas the remainder allow the former GP to retain at least 50% of its carried interest.
Removal without cause
The second type of GP termination is removal without cause, also known as “no fault divorce”, i.e., regardless of whether the GP has done anything wrong. It is more restrictive than removal for cause:
- Investors who want a no fault divorce will invariably need to command the support of an even bigger majority than is needed to remove the GP for cause – generally, somewhere between 75% and 90% of committed capital.
- Many funds also institute a grace period of one to three years, during which investors cannot trigger removal without cause.
No fault divorce is less commonly seen than removal for cause: only 52.5% of the funds in our 2018 survey provided for it. Our survey also reveals something of a geographical split: three-quarters of the funds with no fault divorce provisions are UK or European funds.
It is extremely unlikely that investors will invoke removal without cause without having genuine grievances. But the cause removal process may turn out to be unduly long or damaging for the fund (e.g., if litigation to determine cause drags on) or cause removal may be technically out of bounds (e.g., if the GP’s liability for cause is not expressly determined in a court judgment). In those circumstances, investors may prefer to use no fault divorce to get out of a malfunctioning GP relationship.
Removal without cause comes at a price:
- The GP will 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, and then by 2x.
- 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.
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. 95% of funds in our 2018 survey name certain of their investment professionals as “key persons”.
Key persons must adhere to a specified 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 generally). Failure to fulfil the time commitment may trigger a key person default.
In reality, it is difficult 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 83% of our surveyed funds, key person default results in the automatic suspension of investing; 61% provide for automatic 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.
Most Favoured Nation (MFN)
MFN clauses allow investors to elect terms and conditions offered to other investors, albeit often with important exclusions and exemptions.
Only 54% of the funds in our 2018 survey have an MFN clause in their LPAs. But that doesn’t mean that the remaining 46% are MFN-free, since many investors in those funds will negotiate individual MFN rights in their side letters.
Of those funds in our sample which had an MFN in their LPAs, 30% are “tiered”, i.e., the ability to request the benefit of another investor’s side letter is conditional on the requesting investor committing at least the same amount of capital as the other investor.
What to expect in 2019
With current funds on average able to raise a good deal more capital than their predecessors, aggregate fee income should remain strong for managers, but management fee percentages will remain under pressure. We can expect more funds to build systematic discounts into their LPAs, in order to incentivize investors to commit bigger amounts earlier.
You can download the entire 2018 MJ Hudson Fund Terms Survey (Parts I, II and III) here.