Enhanced ability to recycle and/or redraw capital
Other than in some limited and specified circumstances, an LPA typically provides that once proceeds of investments have been received by a fund — subject to the fund paying expenses, liabilities and management fees — the proceeds are distributed to investors and the GP has no ability to redraw these amounts. There have been some cases where GPs have requested that investors agree to part of these distributed proceeds being made available to be re-committed to a fund for further investment. The reasons for GPs requesting such amendments to the LPA vary and tend to be fairly case specific. Some investors are very supportive of a fund being able to redeploy distributed proceeds, which often ensures that close to 100 percent (and sometimes in excess of 100 percent) of the capital in a fund is used to make investments that should result in the difference between a fund’s gross and net IRR being less significant. On the assumption that these investments are successful, this enhances the return on the fund and mitigates the negative impact of ‘dead capital’ (such as capital used to pay fees, establishment costs and operating expenses), on which it is not possible to generate a return on the overall performance of the fund.
Investors are not supportive of these types of proposals if they perceive that the GPs:
- may have overinvested their funds and have, therefore, run out of follow-on capital to support their buy-and-build investment strategies; or
- will use the recycled capital to support ailing or badly performing portfolio
A number of requests from GPs in 2007 and 2008 to enhance recycling provisions were rejected by investors on these grounds, but it should also not be forgotten that at this time there were also a number of macroeconomic issues driving investors to decrease their exposure to, or withdraw from, the asset class. When considering whether to put proposals to investors to increase the recycling provisions within funds, a GP should demonstrate clearly how it proposes to use this additional capital and how deploying the additional capital will enhance returns for investors. GPs should carefully consider the following:
- the fees they would charge on this additional capital when deployed;
- the time frame for being able to access this additional capital, and
- the appropriate limits on how much additional capital can be drawn down from investors.
It would be unusual for the LPA provisions to legislate what consent would be required for the GP to increase the ability to recycle capital within a fund. GPs, therefore, typically need to rely on the general variation and amendment provisions, and consider what level of consent is required from investors in order to implement such arrangements.
Amendments to investment strategies/exclusivity provisions/investment restrictions
Although less common than the amendments set out above, there have nevertheless been examples of GPs requesting that investors consent to amendments to a fund’s investment strategy or to the diversification restrictions (for example, how much can be invested in a single portfolio company or how much can be invested outside the core geographic focus of the fund) or to borrowing limits that may have been negotiated at the time the fund was raised. The success of these proposals varies and GPs should ensure that, before seeking formal investor approval, they have the support of investors on the LPAC and from other strategic and large investors. To the extent they are looking to expand a fund’s investment strategy, GPs should demonstrate clearly:
- how such a strategy will enhance value for investors,
- that it will not detract from the fund’s core investment strategy, and
- that it has the right skilled people to implement and act on the enhanced investment strategy.
Regarding proposals seeking consent to raise top-up funds and co-investment funds, GPs need to explain in detail:
- how conflicts of interest between the fund and these new vehicles will be managed,
- how investment opportunities will be allocated, and
- why it is in the best interests of the fund and its investors to allow for the formation of these additional investing vehicles.
Most LPAs have provisions that identify the key executives and legislate what happens if a specified number of these key executives cease to devote their time and attention to the fund. These provisions are often heavily negotiated and can be structured in different ways depending on the nature of the fund and the manager raising the fund. It is, however, common in most LPAs for the manager to replace a key executive who has ceased to devote his or her time to the fund — because of a departure, retirement or death — with another executive from within the management team.
Typically, such replacements require either the approval of a majority of LPAC members or an investor vote. This allows the GP to ensure that there is a sufficient number of approved key executives devoting their time to the fund to avoid what is commonly referred to as a key-executive event, which typically suspends the GP’s ability to make new investments in the fund. In seeking the relevant approval from the members of the LPAC or investors, the GP should ensure communication with them takes place early and that there is a degree of informal consultation as to who the replacement executive should be prior to seeking formal approval. GPs should also ensure that they demonstrate that both the fund and itself will not be destabilised, and that they have the capability and skills to continue to pursue the fund’s investment strategy notwithstanding the departure, retirement or death of the key executive they are looking to replace.
There have been situations where succession planning within a GP has required the wholesale renegotiation of these key-executive provisions. This is undesirable as it could create the impression among investors of instability within the team. GPs should endeavour to manage succession planning within the constraints of the provisions of the key-executive clauses in the LPA. In circumstances where this is not possible, GPs must:
- carefully consider what level of consent is required from investors to amend the key-executive provisions
- ensure informal communication and consultation with members of the LPAC and strategic investors takes place at an early stage;
- demonstrate clearly why the change is in the best interests of investors, and
- allow a long lead time or transition time for the implementation of the proposed changes
Increasing fund sizes
In the current fundraising environment, it is rare for GPs to seek consent from their investors to increase the size of their fund after they have had a first closing. However, there have been a few notable exceptions. Investors want comfort that the GP will be able to effectively invest the full fund at its enhanced size without deviating from the fund’s core investment strategy. GPs need to provide investors with comfort on deal pipeline and demonstrate that it has the bandwidth within the investment team to make additional investments with the increased capital.
Change of control
Since 2011–12, it has become common for investors to negotiate provisions that ensure the ownership and control of the GP (and to the extent different, the vehicle entitled to the carried interest) does not change significantly. There are generally two scenarios where this restriction has required fund terms to be renegotiated:
- Where a captive team of a financial institution (such as a bank or insurance company) has spun-out due to the institution determining that private equity is no longer within its strategy or the institution is subject to regulation compelling it to dispose of its private equity business. In such cases, the change of control would most likely need to be approved by investors. In granting their approval, investors focus on whether the newly independent team is stable and sustainable. Further, before consenting to the change of control, investors want to understand what, if any, economic interest the financial institution will retain in the fund, in the GP or in the vehicle entitled to receive carried
- Where private equity houses have sold minority stakes in their businesses to strategic investors (although renegotiation of the LPA is less likely to be needed if structured correctly). In most of these cases, investors have not been required to consent to these minority stakes being sold and, therefore, LPAs tend not to have to be renegotiated.
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, spin-outs and restructurings.