The Role of Key Persons in Private Equity Funds
A “key person” is an important employee or executive who is crucial to the operation of a business. They are generally considered to have skills, knowledge, leadership abilities, and experience that is critically important to business success. The death, absence, or disability of a key person is likely to have significant negative side effects on the operation of the company.
If one or more key persons have been identified as critical to the success of a business, it is important to secure necessary protections relating to the involvement of that key person.
Private equity, venture capital, and, to a certain extent, hedge funds often are built around a number of key persons in recognition of their ability to drive returns to the investors that trust in them. These key persons tend to raise the fund, manage its deployment, and run the deployed portfolio of investments. As such, these trusting investors tend to seek protection from events that impact these key persons’ dedication to the fund. After all, investors do not want to hand over money to be managed by a junior team of resources.
So important is this protection that ILPA (Institutional Limited Partners Association) principles, which are largely accepted as market standard for private funds, dictate that key persons in a fund should devote substantially all of their business time to the fund, its predecessors and successors within a defined strategy, and its parallel vehicles. The ILPA principles go on to provide that a key person to a fund, as identified by a Limited Partnership Agreement (a “LPA”), should not act as a General Partner (“GP”) for a separate fund managed by the same firm with substantially equivalent investment objectives during the investment period of the fund in which he is a key person.
The ILPA Model LPA language below provides an example of standard language governing the key persons’ time dedication to the fund:
• 9.1 Successor Fund. Until the earliest of (i) the termination of the Commitment Period, (ii) the date when 80% of Commitments have been funded, invested, committed or reserved for investments (including Follow-on Investments) or funded or reserved for Fund Expenses; (iii) the date when 60% of Commitments have been funded for investments; and (iv) the termination of the Fund, the General Partner and the Fund Manager shall not, and hereby commit that none of their Affiliates shall, directly or indirectly, accrue any management or advisory fees relating to any vehicle or account (other than any Fund Vehicle), having investment objectives that materially overlap with the Investment Objectives (“Successor Fund”), in each case except with the prior written consent of a Majority in Interest.
• 9.2 Time and Attention. Prior to the termination of the Commitment Period, the General Partner shall cause each of the General Partner, Fund Manager, and the Key Persons to devote substantially all of such Person’s business time to the affairs of the Fund, the General Partner, the Investment Manager, any Alternative Vehicles, any Parallel Vehicles, any co-investment, Prior Funds, or other investment vehicles permitted by this Agreement. After the termination of the Commitment Period, the General Partner shall cause each of the General Partner, Fund Manager, and Key Persons to devote that portion of their time to the affairs of the Fund as is necessary for the management of the Fund.
Key Person Provisions in the LPA
Because key persons are the individuals on whom the success of the fund is highly dependent, any significant change in those individuals or event impacting their ability to dedicate to the fund the agreed amount of time and attention should allow investors in the fund (referred to as Limited Partners or “LPs”) to reconsider their decision to commit to the fund, and changes to key persons customarily require the approval of limited partners’ advisory committee (“LPAC”) or a majority of the LPs.
Where a key person event takes place, market standards in private equity and venture capital dictate that the investment period of the fund, and thus the GP’s ability to call on capital commitments to make new investments, would be suspended. If this happens, the GP will customarily devise a plan to remedy the event, including proposing alternative key persons, and submit such plan to the LPAC or LPs to seek approval to lift the suspension. If the suspension is not lifted after a period of time (usually between 90 and 120 days) the fund’s investment period will permanently be terminated, and the fund will no longer be able to make new investments.
Fund Manager Growth
Fund managers grow through attracting more investor funds or ‘assets under management – AUM’. AUM determine the level of management fees that the fund manager is able to generate in aggregate across its various funds, which directly tie to its ability to grow its team and resources, and thus identify and manage more and better transactions. The conundrum in which fund managers find themselves in in light of the key person principles, which is acute for fund managers who are negotiating the terms of their first fund, is that key person principles significantly restrict the fund manager’s ability to raise a second and a third fund during the first fund’s investment period, which is customarily 4 to 5 years from the fund’s first closing. This is understandable because on one hand the fund manager’s key persons should – and want to – focus their time on the fund, but on the other hand the fund manager’s management team wants to grow the business.
One way to solve for this is for the fund management company to expand its pool of senior fund managers who can act as key persons for different funds. This customarily requires the founding managers to give up some equity, but it also drives efficiency because some resources can be shared across a number of funds.
Additionally, the GP can seek to mitigating some of the restrictions noted above, and one such mitigant, which is utilized in the above quoted ILPA Model LPA provisions, is for the GP to negotiate that the launch of a successor fund be permitted when the [original] fund is ‘fully invested’. In such scenarios, the concept of ‘full investment’ is defied in the LPA and customarily means the investment or reservation for investment of 75% to 80% of aggregate fund commitments. The GP may also seek to define the ‘launch’ of a successor fund to either closing on such fund, thus permitting itself to market and raise the successor fund without violating the original fund’s LPA, or to drawing management fees from the successor fund. LPs will customarily negotiate additional parameters to how ‘full investment’ can be achieved, such as restricting the GP’s ability to reserve commitments for follow-on investments to 15% or 20% of the aggregate fund commitments.
In the end, fund managers should reach a balance between restrictions on growth imposed by their funds’ LPs and their own growth strategies.
The GP Series
The GP Series is a series of practical guidance notes prepared by Hammad & Al-Mehdar’s PE and VC team that are designed to guide GPs and practitioners on best practices relating to private equity fund management.
The attorneys at Hammad & Al-Mehdar represent over 35 years of experience in providing legal services in Saudi Arabia and the UAE at international standards. Contact us today to discuss how we are able to support the legal demands of your private equity fund.