Sit right back and you’ll hear a tale…
In this fictional account, Able Bentley Capital is a $500 million private equity fund (“ABC”). ABC is formed as a Delaware limited partnership, and the general partner (“GP”) is ABC Partners. (For a discussion of limited partnerships, see my post “LP Corner: US Private Equity Fund Structure - The Limited Partnership.”) ABC makes a number of international investments. Bill Smith is one of managing partners of the management company and a member of the GP. Bill sources and leads several international investments. It is common in international investments to have the fund’s investment flow through one or more intermediate (known as “blocker”) shell companies in order to shield the fund from negative tax consequences. Using a complicated blocker structure, Bill was able to defraud ABC out of several million dollars. The fraud was eventually discovered and after several years Bill was convicted of fraud and embezzlement.
Situations where a GP (or a principal of the GP or management company) behave truly badly are rare, but they do occur. The question becomes, what should happen when really bad behavior occurs? Read on to find out!
To read more, please click “Read More” below.
In this fictional account, Able Bentley Capital is a $500 million private equity fund (“ABC”). ABC is formed as a Delaware limited partnership, and the general partner (“GP”) is ABC Partners. (For a discussion of limited partnerships, see my post “LP Corner: US Private Equity Fund Structure - The Limited Partnership.”) ABC makes a number of international investments. Bill Smith is one of managing partners of the management company and a member of the GP. Bill sources and leads several international investments. It is common in international investments to have the fund’s investment flow through one or more intermediate (known as “blocker”) shell companies in order to shield the fund from negative tax consequences. Using a complicated blocker structure, Bill was able to defraud ABC out of several million dollars. The fraud was eventually discovered and after several years Bill was convicted of fraud and embezzlement.
Situations where a GP (or a principal of the GP or management company) behave truly badly are rare, but they do occur. The question becomes, what should happen when really bad behavior occurs? Read on to find out!
To read more, please click “Read More” below.
Defining the Bad Behavior
The first consideration is defining the bad behavior that would trigger the clause. Bad behavior (sometimes called “Disabling Conduct” in the limited partnership agreement (“LPA”)) that could trigger a “For Cause” clause may include the following:
Note that what is included as Disabling Conduct is heavily negotiated. The GP wants the definition of Disabling Conduct to be as narrow as possible, while the LPs want the definition to be as broad as possible.
Also, these “For Cause” clauses often require a final, non-appealable determination from a court that Disabling Conduct occurred before the clause is triggered. What this means is that the GP remains in place and the fund operates as usual until a final, non-appealable determination is reached. This requires that the matter go through a court process and that all appeals are exhausted. The problem here is that it can take many years for a “final, non-appealable determination” to be reached. A more LP-friendly approach is for the clause to be triggered on a preliminary finding of culpability. This would reduce the time required for the clause to be effective.
Who is covered?
The next question is who is covered by the clause. It can be the GP, the management company, and/or certain principals of the GP or management company. From an LPs perspective, the broader this is, the better.
When Disabling Conduct Occurs
What happens when Disabling Conduct occurs? There are several possible approaches.
Opportunity to Cure. The GP may have the opportunity to “cure” the Disabling Conduct by removing the person who engaged in the Disabling Conduct within a certain period of time, and/or by making the fund whole for any economic losses the fund has incurred. If the GP cures the Disabling Conduct, then the fund continues on in the normal course.
GP Removal. The most traumatic outcome is the removal of the GP. This option operates as follows: After a Disabling Conduct occurs, then within a certain frame (ranging from 90 to 180 days) the LPs can vote to remove the GP. The vote threshold to remove the GP can range from a majority in interest to a 2/3 vote in interest of the LPs (compare this to the 2/3 to 80% voting threshold for “no fault” actions). Removing a GP has many complexities, which are discussed below.
LP Vote to Terminate Investment Period. Another approach is for the LPs to vote to terminate the fund’s investment period. In this scenario, after Disabling Conduct occurs, the LPs have the right to vote to terminate the fund’s investment period within a certain timeframe (such as 60 to 90 days after the Disabling Conduct). The vote threshold is anywhere from a majority in interest to a 2/3 vote in interest of the LPs. A difficulty with this approach is what happens if the Disabling Conduct occurs after the investment period is over? Then there’s effectively no remedy for the LPs.
LP Vote to Liquidate the Fund. An alternative to the above approach is for the LPs to vote to liquidate the fund rather than terminate the investment period. In this scenario, the fund enters formal liquidation and the GP must work to wind-down the fund.
Automatic Suspension of Investment Period. A more LP-friendly approach is that after Disabling Conduct occurs, the fund’s investment period is automatically suspended, and can only be reinstated upon a vote of the LPs (usually a majority in interest to 2/3 in interest) within a certain timeframe (such as 60 days). If the LPs do not vote to reinstate the investment period, then the investment period is terminated. This approach is more LP-friendly as it provides for an automatic stay of the investment period and requires an affirmative action by the LPs for the fund to continue its investment period. However, this approach suffers from the same issues as the previously discussed approach.
Implications
Each approach has different implications.
GP removal. A removal of the GP for cause is a traumatic event for a fund and has many complications. Key issues include (1) whether the GP should receive any of the future management fees, (2) whether the GP should receive any carried interest, (3) what happens to the GP’s commitment to the fund, and (4) who will the substitute GP be and what compensation will they receive as compensation. Often, in these “for cause” removals, the GP forfeits all management fee and carried interest (or takes a significant “haircut” on their carried interest). All of these issues are highly sensitive and intensely negotiated.
Termination of Investment Period. If the investment period is terminated, then the fund makes no new investments and the GP tends to the existing portfolio, working to realize exits and distribute proceeds to the LPs over the normal course of time. As mentioned above, one problem with the termination of investment period approach is that it is useless if the investment period has already expired. Investment periods range from the first three to five years of a fund’s life. If the Disabling Conduct occurs in year 6, then practically speaking there’s no remedy for the LPs under this approach.
Fund Liquidation. If the LPs vote to liquidate the fund, then the GP must use its best efforts to sell the portfolio and distribute proceeds to the LPs. This should be a shorter time frame than if the investment period is terminated.
ILPA View
The Institutional Limited Partners Association (“ILPA”), in their Private Equity Principles (version 2.0, January 2011), provides that if a “for cause” event occurs, then the investment period should be automatically suspended unless a super-majority of LPs in interest vote to reinstate the investment period within 180 days. In addition, a majority in interest of LPs may remove the GP in a “for cause” event. The ILPA website can be found at https://ilpa.org/ and the ILPA Private Equity Principles can be found here: https://ilpa.org/ilpa-principles/.
Additional Notes:
This is a continuation of a series of posts on fund terms. Prior posts include:
© 2018 Allen J. Latta. All rights reserved.
The first consideration is defining the bad behavior that would trigger the clause. Bad behavior (sometimes called “Disabling Conduct” in the limited partnership agreement (“LPA”)) that could trigger a “For Cause” clause may include the following:
- Fraud, willful misconduct, gross negligence or reckless disregard that harms the fund
- These terms are legal standards of care that mean the partner intentionally performed an act to harm the fund or performs an act that the partner should have known would harm the fund, or did not follow a customary standard of care.
- Felony in connection with the fund
- This could be theft or embezzlement (our hypothetical above)
- Felony involving moral turpitude
- Moral turpitude may include crimes such as arson, blackmail, burglary, embezzlement, extortion, grand theft, bribery, counterfeiting, willful tax evasion, kidnapping, assault with a deadly weapon, murder, and more.
- Material breach of the LPA that isn’t cured (fixed) within a specific period of time (such as 30 to 60 days)
- Breach of fiduciary duties to the fund and LPs
- Fiduciary duty refers to the duty a manager has to act in the best interests of the fund and the LPs, and can’t put the manager’s interests ahead of those of the fund and its LPs.
- Violation of securities laws.
Note that what is included as Disabling Conduct is heavily negotiated. The GP wants the definition of Disabling Conduct to be as narrow as possible, while the LPs want the definition to be as broad as possible.
Also, these “For Cause” clauses often require a final, non-appealable determination from a court that Disabling Conduct occurred before the clause is triggered. What this means is that the GP remains in place and the fund operates as usual until a final, non-appealable determination is reached. This requires that the matter go through a court process and that all appeals are exhausted. The problem here is that it can take many years for a “final, non-appealable determination” to be reached. A more LP-friendly approach is for the clause to be triggered on a preliminary finding of culpability. This would reduce the time required for the clause to be effective.
Who is covered?
The next question is who is covered by the clause. It can be the GP, the management company, and/or certain principals of the GP or management company. From an LPs perspective, the broader this is, the better.
When Disabling Conduct Occurs
What happens when Disabling Conduct occurs? There are several possible approaches.
Opportunity to Cure. The GP may have the opportunity to “cure” the Disabling Conduct by removing the person who engaged in the Disabling Conduct within a certain period of time, and/or by making the fund whole for any economic losses the fund has incurred. If the GP cures the Disabling Conduct, then the fund continues on in the normal course.
GP Removal. The most traumatic outcome is the removal of the GP. This option operates as follows: After a Disabling Conduct occurs, then within a certain frame (ranging from 90 to 180 days) the LPs can vote to remove the GP. The vote threshold to remove the GP can range from a majority in interest to a 2/3 vote in interest of the LPs (compare this to the 2/3 to 80% voting threshold for “no fault” actions). Removing a GP has many complexities, which are discussed below.
LP Vote to Terminate Investment Period. Another approach is for the LPs to vote to terminate the fund’s investment period. In this scenario, after Disabling Conduct occurs, the LPs have the right to vote to terminate the fund’s investment period within a certain timeframe (such as 60 to 90 days after the Disabling Conduct). The vote threshold is anywhere from a majority in interest to a 2/3 vote in interest of the LPs. A difficulty with this approach is what happens if the Disabling Conduct occurs after the investment period is over? Then there’s effectively no remedy for the LPs.
LP Vote to Liquidate the Fund. An alternative to the above approach is for the LPs to vote to liquidate the fund rather than terminate the investment period. In this scenario, the fund enters formal liquidation and the GP must work to wind-down the fund.
Automatic Suspension of Investment Period. A more LP-friendly approach is that after Disabling Conduct occurs, the fund’s investment period is automatically suspended, and can only be reinstated upon a vote of the LPs (usually a majority in interest to 2/3 in interest) within a certain timeframe (such as 60 days). If the LPs do not vote to reinstate the investment period, then the investment period is terminated. This approach is more LP-friendly as it provides for an automatic stay of the investment period and requires an affirmative action by the LPs for the fund to continue its investment period. However, this approach suffers from the same issues as the previously discussed approach.
Implications
Each approach has different implications.
GP removal. A removal of the GP for cause is a traumatic event for a fund and has many complications. Key issues include (1) whether the GP should receive any of the future management fees, (2) whether the GP should receive any carried interest, (3) what happens to the GP’s commitment to the fund, and (4) who will the substitute GP be and what compensation will they receive as compensation. Often, in these “for cause” removals, the GP forfeits all management fee and carried interest (or takes a significant “haircut” on their carried interest). All of these issues are highly sensitive and intensely negotiated.
Termination of Investment Period. If the investment period is terminated, then the fund makes no new investments and the GP tends to the existing portfolio, working to realize exits and distribute proceeds to the LPs over the normal course of time. As mentioned above, one problem with the termination of investment period approach is that it is useless if the investment period has already expired. Investment periods range from the first three to five years of a fund’s life. If the Disabling Conduct occurs in year 6, then practically speaking there’s no remedy for the LPs under this approach.
Fund Liquidation. If the LPs vote to liquidate the fund, then the GP must use its best efforts to sell the portfolio and distribute proceeds to the LPs. This should be a shorter time frame than if the investment period is terminated.
ILPA View
The Institutional Limited Partners Association (“ILPA”), in their Private Equity Principles (version 2.0, January 2011), provides that if a “for cause” event occurs, then the investment period should be automatically suspended unless a super-majority of LPs in interest vote to reinstate the investment period within 180 days. In addition, a majority in interest of LPs may remove the GP in a “for cause” event. The ILPA website can be found at https://ilpa.org/ and the ILPA Private Equity Principles can be found here: https://ilpa.org/ilpa-principles/.
Additional Notes:
- Exercise of these “For Cause” clauses are rare, but it does happen.
- These clauses are heavily negotiated, and many LPAs don’t have a “For Cause” provision. In my opinion, this clause, the no-fault removal clause and the Key Person clause are critical for the proper governance of a fund.
- If a partner of the GP is charged with a felony that is Disabling Conduct but pleads the felony down to a misdemeanor, then the action would no longer be Disabling Conduct and the clause would not be triggered.
This is a continuation of a series of posts on fund terms. Prior posts include:
- Management Fee
- GP Commitment
- Carried Interest Overview
- Carried Interest – Preferred Return and GP Catchup
- GP Clawback
- Management Fee Offsets
- Key Person Clauses
- No Fault Divorce
© 2018 Allen J. Latta. All rights reserved.
