More specifics, please

Key person clauses have been a fixture of private equity limited partnership agreements (LPAs) since the advent of the industry. And while the clauses themselves can vary significantly from shop to shop depending on the size and structure of each team, every provision of the kind is in place to ensure one thing: that senior dealmakers are devoting their time and energy to one particular fund.

As the industry has evolved, the language within the provisions has not changed much, sources tell pfm, but the negotiations during drafting have become more heated, as LPs demand more detailed time commitments and reassurance that essential personnel will be sticking around for the long haul.

“Historically, people didn’t pay a lot of attention to key man clauses, but it’s one of those areas that they focus on so heavily now, along with economics and transparency,” says Macfarlanes fund formation lawyer Chris Good.

Indeed, the current bifurcation of the industry – which has smaller funds competing for LP capital while large established funds turn investors away – has trickled down to impact the key person clause. For small to mid-sized managers, which tend to be comprised of a few star performers, investors tend to push for narrow terms focused on one or two people with specific time commitments to ensure they are spending substantially all of their time working on the fund.

On the other end of the spectrum, clauses are much broader. Mega funds may state that three of seven key people have to exit in order to suspend investing, or one founder plus any five of ten principals, for example.

“Over the last five to seven years, LPs have become much more tolerant of key man clauses in high-performing, oversubscribed funds being a ‘take it or leave it’ situation: either the clause doesn’t exist or it’s completely watered down,” says Sunaina Sinha, managing partner at secondaries advisory firm Cebile Capital.

Indeed, pfm has heard of at least one large firm that has done away with the key man clause entirely, arguing that it is an institution, rather than a team of a few important figures. But Good comments that it’s unlikely many funds will make such a change unless they have “a very good excuse.”

 

Locked in

Most clauses dictate that key people spend “all or the majority” of their time working on a fund, and recently LPs have been asking more questions about what “majority” really means.

During due diligence, LPs want to know exactly how involved each partner or principal will be in the fund. They may get into specifics about how many hours per week each team member is working, or insist that partners who straddle multiple strategies devote themselves to one particular fund.

“These questions have been arising in recent years now that more firms are running multiple funds,” says Good.

Investors are also wary about partners at smaller firms contributing often in the media or in politics to the point where they are “quite clearly not at their desk doing their day job,” Good adds.

Most provisions only apply to partners’ involvement during the investment period, but LPs are now pushing back on that practice, attempting to extend the power of a key person clause while the fund maintains and sells assets.

“Investors know it’s not as simple as just picking the right things to buy in the investment period  – you also need to be around to manage it and see it through to exit – they want to make sure the key team is staying around for that,” says Good.

To address this concern, investors may look at GPs’ vesting schedules to ensure that there’s a decent amount of carried interest available after the investment period. While Good has not seen a key man provision stretching beyond the investment period and tying people to selling assets, he says it’s “not inconceivable that that will be the next thing [investors] start to ask for.”

Of course, making any kind of promise in fund documents is not an option for most GPs, as once their five-year investment period has passed, they will likely be off to the races with a new fund, with its own key person clause taking priority.

The key person provision is also becoming more essential as LPs and regulators like the US Securities and Exchange Commission increase their focus on succession planning.

When making follow-on commitments, more LPs are paying close attention to the junior-level executives backing up the fund’s key people, asking what kind of incentives (both financial and otherwise) those people have, notes Dechert partner Carl de Brito.

“That’s coming up more and more because the industry is maturing and some of the senior people are moving on. It was happening 10 years ago, especially with first time funds, but there’s more of that now,” he says.

As long as a generational shift is handled well, LPs will be understanding, notes Sinha. Investors are always reassured when a former key person maintains their presence at the firm as they transition into retirement, stepping into roles like chairman of the fund’s board, for example.

“LPs know that, for a lot of these firms, new blood is needed,” says Sinha.

Although negotiations may be getting more intense, Sinha adds that she has never seen an LP walk away from a fund because a compromise could not be achieved on the key person provision. Once an LP is at the point where they are combing through the key team clause language, it is likely that they will invest, even if the clause does not turn out to be as detailed as they might have hoped.

But after spending all that time negotiating, how can an LP ensure the time provisions they have fought so hard for are actually being followed? The reality is, it doesn’t keep them up at night, Good says.

“I asked this of an LP, and he said, ‘we just know,’” he says. “If you’re an LP in a number of different funds and you talk to your peers, you just know if one executive is not doing his job.”

Key person clauses may all have the same goal, but upon closer inspection, it’s clear that certain provisions in some funds swing more in the GP or LP’s favor.

Take, for example, Windjammer Senior Equity Fund IV, a 2012 offering from middle market buyout firm Windjammer Capital Investors. Rather than a traditional “key man event” clause, Windjammer uses a “General Partner Time and Attention” clause regarding “Approved Executive Officers.”

The clause states that “each Approved Executive Officer […] shall devote substantially all of such person’s business time and attention to the affairs of the partnership […] except for time and attention devoted to the affairs of existing funds and such industry, business development, educational, civic and charitable activities as do not otherwise interfere with such person’s obligations to the partnership.”

Windjammer takes a more GP-friendly slant with this language, ensuring its key people won’t be precluded from certain non-fund related activities by specifically naming them within the document.

In contrast, other LPAs contain more LP-friendly nuances. For example, what occurs following a key person event varies from firm to firm. Either a GP will notify LPs regarding a key person’s departure and LPs then have the option to vote to suspend the investment period, or the departure can automatically trigger the suspension of the investment period and LPs must vote to turn investing back on. Most GPs push for the former in order to continue investing uninterrupted, one placement agent tells pfm. The LPA for Platinum Equity Capital Partners III, takes the more LP-friendly approach by automatically suspending investing, stating that investing can be reinstated “only upon the approval of the General Partner and 66 2/3 percent in interest of the limited partners.”