Asia’s key-man challenge

Key-man clauses are vital in any market. After all, in private equity investors are backing people as much as a strategy. So investors are keen to ensure the vital team members driving fund performance remain in place during the life of the fund – and to have options available to them to suspend the fund/replace management should a key senior executive leave.

Yet in Asia key-man concerns are taking on a particular significance as team instability continues apace. Over recent times, entire teams have spun out, such as at IDFC Capital and Sequoia India, to form new firms. A number of high profile individuals have also struck out on their own. TPG Capital lost Mary Ma and Weijian Shan, while Providence Equity Partners saw the departure of Sean Tong. There are plenty more examples, including two of the three founders of Hopu Investment Management, who chose to leave after the firm had raised just one fund.

“In some ways, what we’re seeing in Asia is a natural evolution as teams spin out,” says Brian Lim, partner at Pantheon. “It’s been happening for a while but has accelerated over the last few years. It is being driven by a number of factors – LPs are looking for greater choice of investments and that is encouraging people to leave and set up new teams, there are the usual partnership dynamics at play, and there are the economics where carried interest is not being distributed fairly or the fund has performed poorly and so there is no chance of carry.”

Chris Loh, partner at Axiom Asia Private Capital agrees. “It depends on the market as to why so many spin-outs are happening,” he says. “In China, for example, funds are doing very well – possibly too well. Many people are feeling that they are not being adequately rewarded where they are and so leave to start on their own. Either that, or their fund doesn’t have a future.”

THE FINE PRINT

So how is this affecting the way that key-man clauses are being drawn up in the region? “The provisions themselves are no different from other regions,” explains Lynn Chan of law firm O’Melveny & Myers. “It’s just that key-man is a more serious issue here and there are heightened concerns among LPs about team instability, partly because people do move around more than elsewhere but also because it is very difficult to find replacements when people do move.”

In some markets, key-man clauses are not yet as common as elsewhere in the world. For example, a recent study by the Chinese Venture Capital and Private Equity Association found that as many as 47 percent of RMB funds did not have a key man clause (by comparison, all US dollar-denominated funds in the market did have one). This is changing as local investors become more sophisticated in their private equity investments.

Where they do exist, the key-man clause is highly individual to the fund. Getting this right depends on LPs having a deep understanding of the dynamics of the team in question. “We spend a lot of time getting to know the team, the personalities and seeing how people interact,” says Lim. “We also want to see how the economics are shared. Part of making sure you are protected as an investor is ensuring that the right people are covered by the clause. In Asia, that takes a lot of judgment as a lot of the track records you have to assess are still unrealised.”

However, there are some trends apparent across Asia. One is an increased willingness among GPs to work with LPs on key-man clauses. “Three years ago, you saw a lot of push-back by GPs on key-man,” says Sheng Lu, partner at Capstone Partners Asia. “Now, we are seeing GPs asking us for help to structure key-man clauses appropriately to ensure a greater alignment of interest with LPs.”

Terms relating to key-man have become more LP-friendly. “It used to be that you had to get a super majority vote among LPs for a key-man event to be triggered and a fund suspended,” explains a senior Hong Kong-based lawyer. “That is coming under a lot of pressure as it is very hard to get the LP votes in and so more clauses are now being drafted where there is an immediate suspension when a key-man event occurs so that the onus is entirely on the GP at that point to find a cure.”

EVOLVING TERMS

Just as the private equity industry is maturing in Asia, key-man provisions too are developing. While it is still common to see key-man clauses relating to just one partner, particularly where there is a dominant founder or in firms that have raised only one fund, provisions are starting to broaden as firms become more institutionalised. “We like seeing situations in which there are two tiers of key man,” explains Lim. “In that you’d have a ‘super key man’ where there is a clear leader covered, but below that there is a second tier of people covered so that if, say, two-thirds left, a key man event would be triggered. This kind of structure is increasingly being incorporated and accepted by GPs.”

Many argue that having more partners covered by the agreements offers greater protection for LPs and ensures funds are better managed. “We have not had many departures – the same three who founded the firm are still active,” says Nicholas Bloy, co-managing partner at Southeast Asia-focused Navis Capital. “We never wanted a single person to be a key man as this creates fault lines. Our provisions are set up so that if two of the founders left or if half of the rest of the team left, a key man event would be triggered. If you have a single person as a key man, it puts the firm at the mercy of that one person – it’s much more destabilising.”

This kind of structure also engenders greater equity in the team. “There is a healthy development now where firms are looking at having at least two or three people covered by key-man,” says Lu. “It means there is a greater willingness to share responsibility and economics as firms are looking at creating more institutionalised structures. They want to build a brand and a legacy.”

So, as the issue of key-man clauses has risen up LPs’ agendas in Asia and as the industry is deepening, firms’ structures are developing along more institutional lines. It may even be that a few years from now that team instability becomes less of an issue.

Yet for now, challenges still remain: one is a relatively shallow pool of private equity professionals and another is a lack of infrastructure that can help when key-man clauses are triggered. As many in the industry admit, it’s hard to find new replacements and even harder to deal with serious team issues.

“It’s all very well as an LP to be comforted by having a clause in place that covers the right people,” says Bloy. “But LPs also need a strategy for dealing with a portfolio if things do go wrong. There is a lot of hot air in negotiations, but the practical issues often aren’t addressed: how would you find someone to take on a portfolio if you fire the manager?” That’s an issue that may take a while to solve.