Renegotiating the LPA: extensions

Proskauer’s Nigel van Zyl discusses investment period and fund term extensions, in this extract from The LPA Anatomised.

Click here for part I.

Investment period extensions

Following the 2007–08 financial crisis, there were a significant number of requests by GPs to extend the investment periods of their funds raised during and post the financial crisis. These requests are driven primarily by the fact that the amount of capital deployed by GPs immediately after the crisis slowed significantly and therefore funds were not invested to the optimal levels required to deliver expected returns to investors in their initial five-year period. The majority of GPs have been successful in agreeing these extensions with their investors.

GPs must demonstrate the quality of their deal pipelines to investors and that there is a strong likelihood that they will deploy capital in attractive investment opportunities during the extended investment period. Another key point that needs careful consideration by GPs is what management fees they will look to charge during the extended investment period. Most partnership agreements are drafted so that the management fee reduces  in some manner at the end of a fund’s investment period. This is a significant point for investors that expect the management fees they have been paying to reduce at the end of the original investment period. In most cases, depending on how much capital remains invested at the end of the original investment period, investors will typically have an expectation that the management fee charged during any extension is based on a post- investment period calculation methodology. However, there are circumstances where GPs have justifiable commercial reasons to charge management fees during the extended investment period.

Obviously, a GP has expenses it is required to meet and an investment team it needs to continue to pay. If the level of invested capital is low, it could place the GP in a difficult position where it is unable to meet its overheads to continue to operate in a manner that is in the best interests of the fund. Therefore, if GPs are going to request that investors pay a management fee during the extended investment period, which is higher than what investors would pay after the end of the original investment period, they need to be willing to demonstrate why this is required and put innovative proposals to investors that address their concerns about paying additional fees, while continuing to operate at optimal levels in the best interests of the fund. Therefore, when seeking investor consent to extend the investment period, GPs need to determine strategically how to structure their proposal on management fees to provide investors with a degree of comfort that the request for an extension is not going to result in more management fees being paid to the GP over the life of the fund.

Unless the LPA expressly contemplates an ability to extend a fund’s investment period, which is now becoming more common, and stipulates what level of consent is required from investors, GPs need to seek an amendment to the partnership agreement to extend the investment period under the general amendment and variation clauses. How these clauses are drafted, and what the proposal is that is being put to investors, determines what level of investor approval is required to extend the investment period. This is often investors representing 75 percent of capital but, at times, could require the consent of all investors.

It is important for GPs to obtain clear legal advice as to what the position is under the LPA and what their options are, as this often determines how they structure the terms of the proposal that they wish to put to their investors.

Fund term extensions

LPAs generally provide for private equity funds to have 10-year terms (other alternative asset classes, such as infrastructure or real estate tend to have longer or shorter terms) with the ability to have these terms extended by between one and three years (or often two or three one-year extensions). The ability to make these extensions is sometimes at the discretion of the GP, but more often either require LPAC approval or an investor vote.

Most LPAs do not regulate what the position is after a fund has used all these extensions. To date, the position most investors have taken on fund extensions has been to approve them because the alternative is for the GP to wind up the fund and distribute the stock and securities in the remaining portfolio companies (which are typically unlisted and cannot be traded) to the investors.

However, there is often a discussion on what fees, if any, the GP can continue to charge and what obligation the investors have to continue to advance capital to the fund (to the extent capital remains available to be drawn down by the GP). Investors pay close attention to the value and quality of the remaining unrealised investments and want a clear understanding of what plans the GP has to dispose of these investments in the short term at the highest possible value.

GPs have a difficult time convincing investors to extend the life of a fund, pay management fees and advance additional capital to the fund if the remaining unrealised investments are valued significantly below cost and there is no clear strategy on how it proposes to enhance the value and/or dispose of these investments in the short term. Often in such cases, investors request that the GP writes off the investments and commences winding up the fund. GPs should, therefore, consider carefully whether they request a continuing management fee or whether they agree that no further management fee will be charged. They should also demonstrate clearly their plans to protect or enhance the value of, and dispose of, the unrealised investments in the short term. It has become more common in recent LPAs to legislate, at the start of the fund, what management fee levels will be during any extension to the fund term contemplated by the LPA.

Investors are particularly sensitive to requests from GPs that they perceive as simply an attempt to hold on to assets and extend the life of funds to generate an income stream for the GP. This is particularly the case with GPs that have not raised successor funds.

Over the past few years it has become more common for GPs to seek to implement solutions in respect of older funds that may be near the end of their term where the GP is of the view that there is still significant potential future value to be achieved from the existing assets but more time and additional capital (which the fund may no longer have) are needed to achieve this. It has, therefore, become common for the GPs of these funds
— often with the assistance of a new strategic investor such as a secondary fund — to approach investors to restructure the fund by way of a sale of the existing portfolio to a new investment fund managed by the GP.

These transactions can be complex and there are many issues a GP needs to consider, including its fiduciary duties and how it manages the inherent conflicts of interest that arise in these transactions. The LPA provisions that may need to be considered, and sometimes varied, in these types of transactions include:

• Extensions to the fund’s term.
• Whether LPAC or investor approvals are required for related-party transactions.
• How to ensure investors that elect to support the transaction, and not bought out, participate in the restructured fund broadly on the same basis as they had prior to the restructuring.

Nigel van Zyl is a partner and head of the European Private Investment Funds Group at Proskauer. He advises private equity fund managers, institutional investors and investment advisors on a broad range of issues, including fund formation, secondaries transactions, fund investments, spinouts and restructurings.