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The GP Series Part 3: Socially Responsible Investing and the Role of Excuse Provisions

When monitoring the investments management world, it is very easy to see a strong move by investors to invest in a manner that reflects certain social values they hold important. Investors generally, and sovereign wealth especially, are taking active steps that seek to ensure that their money supports companies that align with their values, be it socially, economically, or religiously driven. Of these values, investing according to certain social values, or Socially Responsible Investing, has become a widespread practice that has skyrocketed in popularity.

This article discusses socially responsible investing, and how fund managers or general partners (referred to as “GPs”) and fund investors or limited partners (referred to as “LPs”) may use excuse provisions in fund documentation to ensure that their investment dollars are invested in line with their social values.

What is Socially Responsible Investing (SRI)

Socially responsible investing (“SRI”) refers to investing in a manner that supports companies that are good corporate citizens and have a beneficial societal impact. SRI, over time, has developed into a strategy adapted by investors in issuing their investment mandates or selecting direct and indirect investments. The basic premise of such strategy is that social responsibility derives sustainability and results in long-term returns. In a survey carried out by TIAA, one third of investors have specific SRI investments.

SRI inspired former-acting United Nations Secretary-General Kofi Annan to ask the world’s leading institutional investors in 2005 to help develop the U.N. Principles for Responsible Investment (UN PRI), and the U.N. officially announced its UN PRI in April 2006 at the New York Stock Exchange. Now, the number of investment managers that signed up for the program stands at over 3,000 investment managers.

Recognizing this trend, a significant number of fund managers started offering investment funds that fully or partially invest in socially responsible businesses, or follow a specific SRI policy or guidelines. But for LPs in private equity or venture capital funds that have specific SRI goals, an additional tools is available that helps them direct their investment dollars in accordance with such goals. This tool is the excuse provision commonly negotiated in private fund documents.

SRI and the Excuse Provisions

An excuse provision is a provision that is commonly negotiated into private fund documents (be it the terms and conditions, limited partnership agreement (“LPA”) or side letter) that permits the investor to excuse itself from participating in a fund investment into a company or opportunity. This provision is a powerful tool for investors that allows them to dictate the social (and other environmental, national, or religious) parameters pursuant to which their capital is invested by the GP. To effect the use of such provision, LPs tend to deliver to the GP a set of social (or other) investment parameters along with their investment documents to make the GP aware of the type of opportunities that the LP will avoid through the exercise of its excuse right if they are pursued by the GP.

Standard excuse provisions provide for the LP to notify the GP of its exercise of the excuse right within a specific period following receiving the GP’s capital call. This of course requires that the GP specifies in its capital calls the names and details of the potential fund investments from the called capital.

GPs commonly negotiate restricting the right of anchor or large LPs to excuse themselves such that the excuse right may only be exercised to excuse the LP from investments that violate previously communicated investment guidelines or directions. This restriction aims at avoiding committing the fund into an investment it is unable to call meaningfully representative capital to fulfill, and at avoiding significant variations in fund returns.

Mechanically, being excused from an investment varies the fund returns of the excused investor from standard fund returns, and varies the investor’s capital account. This means that GPs and fund administrators should be prepared to maintain capital accounts by investor, rather than a single commingled partnership or fund capital account.

Institutional investors commonly use external third-party research agencies to find out whether a specific company complies with their preferred SRI or other investment restrictions. As many investors align their standards with the Ten Principles of Socially Responsible Investing established by the United Nations, fund managers also usually run (or outsource running) a UN PRI verification for the benefit of their LPs.

Investors also commonly undertake to re-evaluate fund portfolio companies periodically to determine whether their practices and impacts still align with their investment standards. If not, they may discuss with the GP how they may dispose of their investment. This, however, is not commonly a contracted right, and will be subject to discussion and agreement with the fund manager.

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.