Clause for thought

Private equity is a people business. As such, key-man clauses are among the most important sections in a limited partnership agreement.

“For the LP clients that we represent, it is near the top of their diligence and terms lists for funds that they are considering investing with,” says Heather Stone, a funds lawyer at Locke Lord in Boston. “It is the starting point for the LP’s diligence on team, incentives, track record and succession planning.”

The clauses identify a person or group of people who, were a prescribed number of them to leave, trigger a suspension of the investment period and allow the limited partners to decide whether the fund should have a future.

With Vista Equity Partners’ recent $10.5 billion fund, for example, an event is triggered if either of the co-founders, Robert Smith and Brian Sheth, “cease to devote substantially all their time” to the business, or if a proportion of nine top execs were to do the same, according to documents prepared by StepStone for a client.

Protective embrace
So it is a perfectly sensible investor protection, right? Not everyone thinks so. To an outsider, they can seem unnecessary or even counterproductive.

Sister publication Private Equity International recently interviewed chairman Carlo Pesenti and chief executive Mario Fera from Italy’s largest domestic private equity firm Clessidra.

Both arrived from outside private equity, having been part of Italmobiliare, the investment holding company that bought Clessidra following the death of the firm’s founder Claudio Sposito.

Both criticised key-man provisions. Sposito’s death had led to nine months of uncertainty. “That would have almost certainly destroyed most firms of that size,” says Fera.

Pesenti argued a credible succession plan should make the provisions unnecessary.
Someone with direct experience of the key-man clause is UK investor Jon Moulton, who trigged one when he left the firm he founded – Alchemy Partners – in 2009. These provisions are “mostly stupid,” he says.

“If the key man takes to the bottle or the secretaries, or gets a criminal investigation, or simply stops trying, the key-man clause becomes a major obstacle to sorting things out.”

In the case of Clessidra, the story had a happy ending: the firm is today investing its €607 million third fund. Alchemy Partners is also still investing.

So is are the provisions unnecessary? No, but they do need to be thought through before fundraising begins and “before third parties – ie, LPs – become involved in the conversation,” says Stone.

Some clauses are better drafted than others. “There are as many key-men clauses structured with nuances as there are GPs with nuanced investment strategies,” says Klaus Bjorn Ruhne, a partner at ATP Private Equity Partners, which invests on behalf of a $113 billion Danish pension fund.

The jury may be out on key-person clauses – investors have differing and strong views – but they are here to stay. In the words of one LP, “It’s definitely a case of better to have one and not need it versus the other way around.”