This is Part 2 of our series on private equity funds (Funds). As mentioned in Blakes Bulletin: Fund Formation 101: Issues to Consider When Forming a Private Equity Fund - Part 1 Structuring, there are many factors and issues to consider when forming a Fund, and different Funds will have different issues based on how they are structured, the track record of the sponsor with previous funds, the target investment type and industry, and the past experience of investors and their counsel. This week we are focussing on the top commercial considerations for Fund formation:
- Removal of General Partner or Manager. Almost
all limited partnership agreements will include provisions relating
to how the general partner and/or the manager can be removed. As
you can imagine, given that it created the Fund, a general partner
will try to negotiate a very limited set of circumstances in which
it, or the manager, can be removed. Most general partners try to
limit removal to situations where there is a "for cause"
event that cannot be cured (such as ongoing breach of the limited
partnership agreement, failure to perform its duties, or a final
court finding of a material criminal offense) for which the limited
partners authorize termination by a relatively high threshold
(two-thirds or more). Occasionally, limited partnership agreements
will allow for termination of the general partner without cause
with the approval of the limited partners, again, usually at a
fairly high threshold. As sponsors are not normally interested in
being passive investors in a Fund they don't control, where a
general partner is removed, its related party limited partner will
often have the right to have its units bought out and for its
manager to resign. The limited partnership agreement will provide
specified economic terms for how the general partner's (and
affiliated entities) interests in the Fund, both entitlements to
carried interest and direct holdings, will be treated, depending on
if the removal was for cause or convenience. The limited
partnership agreement will need to include provisions dealing with
how a related limited partner's units are valued in such
circumstances.
- Key Person Provisions. Most Funds will include
key person provisions, which stipulate that certain individuals
(each a Key Person) are required to dedicate a specified level of
time and attention to the Fund throughout the commitment period.
The level of time and attention can differ between Key Persons,
depending on their role in the Fund. For example, while the
managing director of a large sponsor platform may be included as a
Key Person, their time and attention could be directed at the
entire equity strategy of the sponsor, as opposed to the Fund
specifically, while others will be required to dedicate all of
their business time and attention to the specific Fund (and perhaps
its predecessor Funds).
A Key Person event (Key Person Event) is triggered when a specified Key Person or multiple Key Persons no longer dedicate the required time and attention, either because they have left the sponsor or because they have moved to advise on a different part of the platform. If a Key Person Event is triggered, the commitment period is generally suspended for a period of time until either the Fund's LP Advisory Committee (LPAC), or a specific percentage of limited partners vote to replace the absent key person or to continue the commitment period without a substitute key person. If neither is approved, the commitment period will automatically terminate after a set period of time.
Key Person Events can be triggered if one specific individual leaves, especially in the case of a newer sponsor, or more commonly with more sophisticated sponsors, if a number of specified individuals leave the Fund. There is also a growing trend of using a "points-system" where each Key Person is designated a number of points, often between half a point and two points. If the total number of Key Person points drops below a specified number, a Key Person Event is triggered (e.g., a Fund has 13 Key Person Points to begin with, and if there are ever less than seven Key Person points, a Key Person Event is triggered). This allows for additional flexibility on the sponsor side.
More recently, some sophisticated sponsors have removed Key Person Events from their limited partnerships agreements entirely, on the basis that the Fund's success is dependent on the sponsor's entire platform, as opposed to the expertise of a few individuals. This approach, however, is less common and limited partners continue to push for the inclusion of Key Person provisions.
- Conflicts of Interest and Competing Funds.
Many successful Fund sponsors have a number of different Funds or
other investment structures in place, including joint ventures with
other parties outside a fund structure and separate managed
accounts, and the parties will need to negotiate how best to deal
with those potential conflicts of interest. The sponsor will want
to be sure that its other investment activities are not restricted,
while the limited partners will want comfort that the general
partner is focused on the success of the Fund in which they are
invested, and they are getting the "first look" at
opportunities that fit their Fund's investment guidelines. One
area general partners are wise to focus on is their investment
guidelines to make sure they are clear on the type of investments
that the Fund can invest in. Some Funds also have inter-group
agreements or a formal allocation policy in place that make it
clear that the Fund, as between the members of such group, will
have a right of first refusal on applicable opportunities. For
Funds that are one in a series of funds launched by a sponsor in
the same asset class (e.g., Infrastructure Fund I, Infrastructure
Fund II etc.), the limited partnership agreement will also normally
include a prohibition on the sponsor launching a subsequent
competing or similar fund until either the end of the Fund's
investment period or a significant amount (e.g., 80%) of the
Fund's committed capital has been invested.
- Co-Investments. Many limited partners, as a
condition to investing in the Fund, will ask for a right to
"co-invest" with the Fund on investments that require
capital in excess of the amount the Fund is able to invest.
Co-investments are often granted to anchor or other large investors
that make a capital commitment above a certain threshold. Key
considerations include whether limited partners have the right to
participate in any co-investment opportunity or such opportunity is
only at the discretion of a general partner, and what fees, if any,
the co-investing limited partners will pay the manager outside
those indirectly payable through the limited partner's interest
in the Fund. Co-investments can be an important marketing tool for
sponsors, as limited partners are increasingly interested in direct
investments. More recently, due to fundraising challenges,
investors who are interested in co-investing with the sponsor may
be offered such an opportunity provided they also invest in the
sponsor's Fund or as enticement to invest in the Fund.
- Use of Side Letters. One of the big decisions facing a Fund is whether to allow for "side letters." A side letter is an agreement between the general partner and a limited partner that exists outside the limited partnership agreement and provides for additional rights in favor of the limited partner as it relates to the Fund. In our experience, the majority of Funds allow for side letters, especially if marketing to institutional investors. Many sophisticated investors have their own form of side letter that they expect the general partner to accept in the normal course or adapt to fit within the Fund's standardized language. While a detailed examination of the many different types of provisions often included in side letters is beyond the scope of this bulletin, common provisions include restrictions on the use of the limited partner's name, enhanced reporting rights, advance consents to unit transfers, appointments to the Advisory Committee (where applicable) and provisions relating to specific regulatory concerns for institutional investors (e.g., regulated pension plans). Many side letters also include a "most favoured nations" (MFN) clause that requires the general partner to offer a limited partner the same side letter rights granted to any other investor whose commitment is the same or below that of the limited partner. General partners are advised to think carefully about what is being asked in a side letter to make sure they have the discretion to grant those rights, and that rights granted are done so consistently to make the MFN process easier. What a general partner cannot do is agree to a side letter provision that has the effect of amending (or worse, breaching) a provision of the limited partnership agreement, even if it relates only to the requesting limited partner.
Your legal advisors can assist you with understanding the various factors that should be considered when forming or investing in a private equity fund so you can determine how best to address those factors in your own Fund/investment.
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