This is a continuation of a series of posts on fund terms. Prior posts include:
When an LP invests in a fund, it is because the LP believes that the investment team will successfully invest the fund. But what happens if members of that investment team leave the firm in the midst of investing? What happens if a key member of the team dies, or is convicted of securities fraud? A “key person” clause (historically known as a “key man” clause) provides LPs with protections in case these events, and others, occur.
To read more, please click on the "Read More" link below and to the right.
- Management Fee
- GP Commitment
- Carried Interest Overview
- Carried Interest – Preferred Return and GP Catchup
- GP Clawback
- Management Fee Offsets
When an LP invests in a fund, it is because the LP believes that the investment team will successfully invest the fund. But what happens if members of that investment team leave the firm in the midst of investing? What happens if a key member of the team dies, or is convicted of securities fraud? A “key person” clause (historically known as a “key man” clause) provides LPs with protections in case these events, and others, occur.
To read more, please click on the "Read More" link below and to the right.
In general, a key person clause is triggered when one or more key persons are subject to “key person events.” When this occurs, the fund’s new investment activities are typically suspended until the firm and the LPs can determine how to proceed, such as by appointing a new key person. If the firm and the LPs can’t agree, then the new investment suspension becomes permanent, and the fund enters harvesting (aka realization) mode. For more on the investment period and harvesting period, please see my post “LP Corner: The Four Phases in the Life of a Private Equity Fund.”
There are several aspects of a key person clause:
Who are the “key persons”?
Determining who are the “key persons” for the key-person clause is very important. Sometimes it is very simple to determine who the key persons are; sometimes it is heavily negotiated. In any case, the determination of who are the key persons is unique for each fund.
For example, if a firm is founded and managed by three partners, and all three of these partners make the investment decisions for the fund, then all three of those partners will likely be key persons. For this fund, a key person clause may provide that two of the three key persons must remain involved with the fund at all times.
In some cases, there are two levels of key persons: a senior level and a junior level. For example, a firm has eight investing partners, three of whom are senior partners and five of whom are junior partners. A key person clause might provide that at least two of the three senior partners and three of the five junior partners must be active in the fund’s affairs at all times.
What are the key person events?
The terminology is usually that the key persons must devote substantially all of their business time and efforts to the activities of the fund, with certain carve-outs (serving on public boards, charitable activities, etc.). Practically speaking, certain events will prevent a key person from devoting “substantially all of their business time to the activities of the fund” such as death, permanent disability or termination of employment (a key person quits or is fired). The limited partnership agreement ("LPA") may also provide that other specific events relating to a key person may be deemed to be not devoting substantially all of their business time and effort to the fund, such as fraud, material breach of the LPA, securities laws violations, etc.
What happens after a key person event occurs?
Once a key person clause has been triggered, generally the fund’s investment period is automatically suspended for a period of time (usually 180 days), which leads to permanent suspension of the investment period unless a majority in interest (see the Notes below for a discussion of this) or some super-majority in interest (see the Notes below for a discussion of this) of the LPs votes to reinstate the investment period. The idea is to give the GP some time to present a plan to the LPs to continue the fund’s investment strategy, such as by replacing the departed key persons. If the LPs approve the plan, then the investment period is reinstated; if they don’t, then the suspension of the investment period becomes permanent, and the fund effectively enters into realization mode. Note that sometimes it is the Limited Partner Advisory Committee that will vote on reinstating the investment period instead of a majority in interest of the LPs.
Note that the suspension of the investment period only applies to new investments – no new investments may be made while the investment period is suspended. However, the fund can continue to make follow-on investments in existing portfolio companies.
One issue is what happens to management fee during this period. In most cases, management fee is unaffected by the triggering of a key person event. The LPs continue to pay management fee to the fund.
Example:
Super Duper Capital II, a lower middle-market buyout firm, has three senior partners, Amy, Bill and Cathy, and five junior partners, Mark, Natalie, Owen, Paul and Robin. The fund has a five-year investment period. The LPA provides that two of the three senior partners and three of the five junior partners must devote substantially all of their business time to the fund’s activities, and if that ceases to be the case, then the investment period is automatically suspended for a period of 180 days, provided that a majority-in-interest of LPs can vote to reinstate the investment period during such 180-day period. If the required LP vote is not obtained during the 180-day period, then the suspension of the investment period becomes permanent.
During the second year of the investment period, Amy, Bill and Natalie leave to start a new firm. In this case the key person clause is triggered, and the investment period is suspended. Three months later, the GP has identified replacement partners, and makes a proposal to the LPs regarding hiring these individuals. The LPs are satisfied, and they vote to reinstate the investment period.
Additional Notes:
There are several aspects of a key person clause:
- Who are the key persons?
- What are the “key person events”?
- What happens after a key person event occurs?
Who are the “key persons”?
Determining who are the “key persons” for the key-person clause is very important. Sometimes it is very simple to determine who the key persons are; sometimes it is heavily negotiated. In any case, the determination of who are the key persons is unique for each fund.
For example, if a firm is founded and managed by three partners, and all three of these partners make the investment decisions for the fund, then all three of those partners will likely be key persons. For this fund, a key person clause may provide that two of the three key persons must remain involved with the fund at all times.
In some cases, there are two levels of key persons: a senior level and a junior level. For example, a firm has eight investing partners, three of whom are senior partners and five of whom are junior partners. A key person clause might provide that at least two of the three senior partners and three of the five junior partners must be active in the fund’s affairs at all times.
What are the key person events?
The terminology is usually that the key persons must devote substantially all of their business time and efforts to the activities of the fund, with certain carve-outs (serving on public boards, charitable activities, etc.). Practically speaking, certain events will prevent a key person from devoting “substantially all of their business time to the activities of the fund” such as death, permanent disability or termination of employment (a key person quits or is fired). The limited partnership agreement ("LPA") may also provide that other specific events relating to a key person may be deemed to be not devoting substantially all of their business time and effort to the fund, such as fraud, material breach of the LPA, securities laws violations, etc.
What happens after a key person event occurs?
Once a key person clause has been triggered, generally the fund’s investment period is automatically suspended for a period of time (usually 180 days), which leads to permanent suspension of the investment period unless a majority in interest (see the Notes below for a discussion of this) or some super-majority in interest (see the Notes below for a discussion of this) of the LPs votes to reinstate the investment period. The idea is to give the GP some time to present a plan to the LPs to continue the fund’s investment strategy, such as by replacing the departed key persons. If the LPs approve the plan, then the investment period is reinstated; if they don’t, then the suspension of the investment period becomes permanent, and the fund effectively enters into realization mode. Note that sometimes it is the Limited Partner Advisory Committee that will vote on reinstating the investment period instead of a majority in interest of the LPs.
Note that the suspension of the investment period only applies to new investments – no new investments may be made while the investment period is suspended. However, the fund can continue to make follow-on investments in existing portfolio companies.
One issue is what happens to management fee during this period. In most cases, management fee is unaffected by the triggering of a key person event. The LPs continue to pay management fee to the fund.
Example:
Super Duper Capital II, a lower middle-market buyout firm, has three senior partners, Amy, Bill and Cathy, and five junior partners, Mark, Natalie, Owen, Paul and Robin. The fund has a five-year investment period. The LPA provides that two of the three senior partners and three of the five junior partners must devote substantially all of their business time to the fund’s activities, and if that ceases to be the case, then the investment period is automatically suspended for a period of 180 days, provided that a majority-in-interest of LPs can vote to reinstate the investment period during such 180-day period. If the required LP vote is not obtained during the 180-day period, then the suspension of the investment period becomes permanent.
During the second year of the investment period, Amy, Bill and Natalie leave to start a new firm. In this case the key person clause is triggered, and the investment period is suspended. Three months later, the GP has identified replacement partners, and makes a proposal to the LPs regarding hiring these individuals. The LPs are satisfied, and they vote to reinstate the investment period.
Additional Notes:
- Other Actions on Trigger. Less commonly, when a triggering event occurs the LPs may be able to vote to dissolve the fund or to replace the GP.
- Devoting sufficient time. The requirement stated above was that a key person had to devote "substantially all of their business time and efforts" to the activities of the fund. Another version of this is that the key person had to devote "sufficient time" to the fund. Both of these phrases are subjective in nature and can lead to disagreements of whether the standard is being met.
- Majority-in-interest. LPs in a fund don't commit the same amount in the fund. In a mega-buyout fund, a very large sovereign wealth fund or public pension fund may commit $100 million or more to the fund, while other investors commit $50 million, or $25 million or $10 million or $5 million. A "majority in interest" means those LPs whose commitments total in excess of 50% of the total capital commitments in the fund. For example, in a $1 billion fund, a vote by a majority in interest in the fund means that LPs representing $500,000,001 in capital commitments.
- Super-majority in interest. A super-majority in interest means those LPs representing committed capital in excess of a certain threshold in interest. Super-majority thresholds can be 60%, 2/3, 75% or 80%. For example, a reinstatement of the investment period could require a vote of 2/3 in interest of the LPs in a fund.
