Copyright 2009, Blake, Cassels & Graydon LLP
Originally published in Blakes Bulletin on Private Equity, January 2009
It appears that the coming year will be a turbulent one for both private equity funds and their limited partners as the volatility in the financial and credit markets continues. As sponsors and investors navigate their relationships in 2009, a number of fund documentation terms will likely receive increased attention in both the management of existing funds as well as in the negotiation of new funds. The following canvasses some of the key issues that we see for the year ahead for both private equity funds and their limited partners.
Limited Partner Defaults and the Need for Creativity in Capital Commitment Solutions
Limited partner concerns over their ability to meet their capital commitments are emerging as an issue for some investors and private equity funds. Fund limited partnership agreements typically require capital to be provided within five to 10 business days of the receipt of a call notice from the general partner. Unless a solution can be reached between the general partner and the limited partner, a limited partner's failure to fund is normally met with harsh penalties. For example, a fund's limited partnership agreement may permit the general partner to charge top dollar interest on the defaulted amount, cease all future distributions to the limited partner, freeze the limited partner's ability to participate in future investments and forfeit the limited partner's interest in the fund.
In order to avoid a default scenario, which benefits neither the fund nor the limited partner, a number of general partners are exploring creative solutions to accommodate limited partners suffering funding constraints. Well-publicized examples of this approach include the most recent offer by Permira, the global buyout fund, to its limited partners to reduce original capital commitments by as much as 40%, while inviting other limited partners to increase their commitments with the incentive of paying no management fees on the new commitments taken up.
In addition, it was recently reported that the Texas Pacific Group buyout fund will not only allow limited partners to reduce their commitments by up to 10% or US$2-billion, but will cut its annual management fee by 10% and, unless otherwise approved by the advisory committee, cap its 2009 capital calls at 30% of a limited partner's commitment.
Other sponsors have also sought to amend their governing documentation in creative ways to address this issue. One approach is to limit the obligation of specified limited partners to participate in future investments, while maintaining the right for other limited partners to participate, essentially creating a separate "fund within a fund". Another approach would be to convert a single limited partnership fund structure into a multi-partnership or feeder fund structure in order to introduce new capital from additional investors. These solutions and others like them will be challenging to implement and will present issues given current valuation difficulties. In any event, creativity in structuring solutions will be key for many funds and limited partners as they deal with the market conditions in the year ahead.
Secondary Sales of Limited Partner Interests
Given that the term of private equity funds is often at least 10 years, and that they do not offer redemption rights (as are commonly found in hedge funds), private equity fund investments are, by their nature, illiquid. As a corollary to the default issue discussed above, some limited partners are not only decreasing their commitments to new funds due to reduced private equity investment allocations but are increasingly seeking to liquidate their interests in an effort to reduce obligations for unfunded capital commitments. Fund documentation typically includes substantial restrictions on the transfer of limited partner interests, which is understandable given that general partners require stability in their investor base to operate their funds and need to be assured of the financial soundness of their committed capital.
A transfer of a limited partnership interest to a third party normally requires the consent of the general partner, which, in certain cases, may be withheld in the general partner's sole discretion. Limited partnership agreements may also include a right of first offer to other limited partners, require that the transferor pay all expenses incurred with the transfer and stipulate the delivery of a legal opinion to the general partner. The transfer process typically involves a purchase and sale agreement among the transferor and transferee as well as the execution of transfer and subscription documentation required by the general partner pursuant to the fund's governing documentation. Some issues that may present challenges in the secondary market include discounts to net asset value, side letter requests from new transferee limited partners, and indemnity arrangements between transferor and transferee limited partners. Relevant transfer provisions should be reviewed carefully by buyers, limited partners and sponsors prior to commencing any secondary fund interest sale process. In the current environment, more than ever, limited partners wishing to transfer their interests will benefit from up front discussions with the general partner as to their intentions.
Some recent surveys have indicated that pricing in the secondary market has dropped to levels reaching approximately 60% of net asset value. For this reason, fund sponsors may have to take a more active role in assisting their limited partners who want to complete a secondary sale in order to maintain their limited partner base and protect the sponsor's existing franchise.
General Partner Clawback Provisions
There is likely to be increased scrutiny on the so-called "General Partner Clawback" provisions commonly included in North American fund partnership agreements. This protection measure is found in partnership agreements where the distribution waterfall prescribes that distributions be made to limited partners and the general partner on a deal-by-deal basis (rather than an "aggregate" waterfall, common in Europe, where there is a return of 100% of a limited partner's aggregate contributions plus a preferred return before the general partner receives its carried interest). The deal-by-deal waterfall can lead to situations where the general partner receives more than its carried interest as a result of early investment wins by the fund that are followed by losses. The General Partner Clawback addresses this by requiring a true-up of the waterfall and the return to limited partners of any excess distributions received by the general partner at the end of the fund and, in some agreements on an interim basis (for example, after the fifth year of the fund's term). The escrow of distributions to the general partner for a period of time may also be required. Given the losses that some funds are experiencing, we can expect that there will be greater focus on the terms of interim and final General Partner Clawbacks in new funds (and perhaps a shift to the "aggregate" waterfall model) and that limited partners of existing funds may request ongoing assessments going forward as to whether clawback payments are or will be due.
Limited Partner Clawback Provisions
Many fund limited partnership agreements provide that, subject to prescribed caps, distributions to limited partners may be subject to recall to satisfy fund indemnity obligations on disposition of fund investments. These provisions are increasingly likely to be invoked in funds disposing portfolio investments as buyers negotiate and enforce buyer friendly representation and warranties, and corresponding indemnities, in the new "buyer's market".
Extension of Commitment Period
Given the difficulties for sponsors in both the pursuit of new acquisitions and the exiting of existing investments as a result of the current market instability, funds may seek to amend their "commitment period", being the period of time within which a fund can make capital calls for new investments. Depending on the term of the fund, commitment periods typically range from five to eight years. Limited partnership agreements do not generally permit the extension of the commitment period unless an amendment to the agreement is sought, which normally requires approval by a certain percentage in interest of limited partners ranging from 50-75%. Investors and sponsors need to carefully consider the impact of a commitment period extension on their timing expectations for distributions as well as the interrelated aspects of a fund's formation documentation, such as management fee step-down and successor fund formation.
Termination of Commitment Period
Limited partners concerned that a fund's investment thesis is no longer valid in the current environment may, on the other hand, seek to terminate the commitment period. Many limited partnership agreements provide for the ability of limited partners to terminate the commitment period early (or in some cases, early terminate the fund or remove the general partner "for convenience"), with approval of limited partners holding some super majority (usually 66-2/3%) of limited partnership interests. In lieu of exercising such a right, limited partners may seek concessions from the general partner, including concessions on the management fee payable on the balance of the commitment period. If such an early termination right is not available, limited partners seeking early termination will need to negotiate with the general partner regarding an amendment to the limited partnership agreement.
Amendments to Permitted Investments
In order to capitalize on new opportunities in the current market, including distressed investments, sponsors may seek limited partnership agreement amendments to provide greater flexibility for the scope of their investments. A fund's governing documentation generally stipulates caps with respect to the amount of capital commitments that can be invested in specific types of investments as well as the geographical location of such investments. A general partner seeking to vary such restrictions must typically seek approval from the limited partners or the fund's advisory committee. Again, both general partners and limited partners should be mindful of the mechanics and ramifications of variations to a fund's governing documentation.
Extensions of Final Closing Date
Given the difficulties experienced by certain sponsors fundraising in the current market, many funds with first closings in 2008 have been asking investors to extend the outside closing date for subscriptions set out in the fund's limited partnership agreement. Limited extensions seem to be available where the fund has interest from prospective investors with a good probability of closing. However, fund sponsors without concrete prospects will have greater difficulty in obtaining extensions.
The scarcity of credit is expected to impact the terms and conditions under which private equity funds are able to obtain financing, in respect of both any subscription credit facility available to the fund and portfolio company financing. In the post "covenant-lite" world, lenders granting new subscription credit facilities, or seeking further assurances on existing facilities, may seek additional comfort from limited partners regarding the existence and enforceability of their commitments securing the facility in the form of enhanced acknowledgements and legal opinions. These further assurances will be poorly received by many investors.
Lenders to portfolio companies may also request cross-collateralization and guarantees by the fund of portfolio company obligations. General partners may, depending on the fund's formation documents, need to seek advisory committee or limited partner consent to this additional security.
Given current market conditions, the coming year will be challenging for limited partners and general partners alike. In both the formation of new funds and the management of existing funds, there will be increased focus on a number of key issues which will determine how relationships are governed going forward amidst the market uncertainty.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.