Key person clauses: Man overboard

Less than four years into the investment period of its third fund, Helion Venture Partners informed LPs that three of the six partners had decided to leave. This represented a seismic shift for a relatively small Indian VC firm, but deployment continued regardless. The three leaving partners were not covered by the key person clause, so LPs were unable to halt new investments and consider their options.

That was late 2015. Helion never raised a fourth fund and its principals have since moved on to new projects, with some simultaneously managing out the portfolio. But the split has not been forgotten by LPs that were involved because it represents a familiar story in Asia: the older generation holds on to the power and economics, prompting frustrated younger team members to flee the nest.

"It's the more mature funds where you are coming up against some form of generational transition or there are tensions between the senior and junior partners about carry or governance, which may result in junior partners – who are the ones at the coal face with investments – deciding to leave. Those are the situations where you need a structure in place to mitigate concerns," says Wen Tan, co-head of Asia Pacific private equity at Aberdeen Standard Investments.

The structure in question is a key person clause broad enough that an investment period is frozen if a meaningful number of the major contributors to a fund stop contributing. Whether triggered by departure, distraction or death, LPs want the ability to assess the GP's proposed remedy before either agreeing that activity can resume or winding down the fund, and likely the firm as well. 

Internal dynamics

Opinion is divided as to whether Asia sees a disproportionately high number of key person events relative to the number of funds active in the region. But the region certainly does have a reputation for spin-outs and general team instability, which makes some LPs highly protective of governance tools afforded to them under limited partnership agreements (LPAs).

Numerous industry participants link this volatility to the immaturity of the asset class in Asia and the youth of the operators. For Fund I, the key person clause covers the one or two founders of a firm; they are reluctant to include anyone else because the platform isn't yet established, and they don't know how different roles will play out or who they might need to recruit as they expand.

"As the business matures you still have a one-person trigger and that's not institutional because someone could get hit by the proverbial bus and suspend the whole platform," says Justin Dolling, a partner at Kirkland & Ellis. "The question is how, over time, do you move from that single-person trigger to a fully institutional clause which means introducing other key persons, whether it's a separate tier or a group of key persons with a super-key-person trigger on one individual."

This transition is not necessarily welcomed in markets like China that are known for their patriarchal business culture. PE firms that are dominated by individuals who take the lion's share of the fund economics are viewed as succession-planning crises waiting to happen if no attempt is made to incentivize mid-level talent to remain. These individuals might also be resistant to adding some of this talent to the key person clause because they see it as a matter of prestige rather than liability.

"From a liability perspective, you would want to bring in other team members to dilute a situation in which the founder departs," says Lorna Chen, a partner at Shearman & Sterling. "But sometimes people want to use the key person clause to showcase that they are the boss and no one else is in charge. It makes them hesitant to add other people. If that person is the founder and no one else comes close in terms of investment experience and seniority, it is hard to bring about change."

At the same time, there are few examples of founders being transitioned out from super-key-person status. This happens by reducing the amount of time they must spend on a fund – often in return for a commitment to devote more time to the entire platform – and ultimately absorbing them into a group of key people where a key person event is triggered by a certain number departing.

All the major indigenous pan-Asian buyout firms, such as Affinity Equity Partners and Baring Private Equity Asia, are said to have super-key-person provisions attached to their founders. One GP recalls a peer telling him that he tried to downgrade himself but faced tremendous pushback from LPs. "I recommended that he not waste time trying to change it," the manager says. "The more you try to change it the angrier LPs become. In most cases, these are fights you can never win."

This super-key-person provision is accompanied by another tier that covers a wider array of partners or managing directors. It is not necessarily as straightforward since the clause is triggered by at least four out of seven departing at the same time. Points might be allocated to individuals based on seniority and it is the cumulative score rather than the number of people that counts. There are also three-tier structures where a combination of different departures could constitute a trigger.

It is normal practice to name the individuals covered by the key person clause. But even here some of the larger firms are trying to be creative by emphasizing their scale, depth of talent across multiple strategies, and institutional credentials. 

"It is not usual to keep names out of the LPA, we see it occasionally. Some sponsors try to push for this to take away some of the politics of who is in and who is out," explains Gavin Anderson, a partner at Debevoise & Plimpton. "They say, ‘You should care that there are 10 managing directors, not who they are. You must trust us when we say that we will only elevate good people to managing director level.'"

Change agents

There are firms in Asia that have seen so much turnover the second-tier personnel for certain funds looks very different from the line-ups during fundraising. Key person events have been avoided, though, because departures are gradual and new people are brought in one by one. In addition, funds may have an automatic replacement rider, so even if the clause is triggered, a GP can introduce new talent, provided the individual meets qualification criteria based on experience. 

John Fadely, a partner at Gibson Dunn, notes that this mechanism can save a lot of bother when a key person event is automatically triggered. "It can be hard for a sponsor to convince LPs to vote to take the fund out of suspension," he says. "LPs may be averse to doing so unless there is a clean solution with few if any drawbacks. Therefore, if a key person event is triggered, it can be easier if someone on the sponsor's investment team from the next generation has been pre-ordained in the key person provision to be automatically promoted as a replacement unless LPs vote against that." 

Concern that smaller managers will not be able to draw on such a deep well of talent often prompts LPs to broach the subject of broadening the key person clause at a relatively early stage. According to Kirkland's Dolling, questions might be asked during the first fundraise, although the point is seldom intensely negotiated. By Fund II, assuming a platform has begun to scale up, it becomes a more involved discussion, and by Fund III, "If it's going to happen it will have happened by then."

Resistance to change from the GP might be driven by the same volatility that makes LPs push for including more people. In appointing someone a key person, a PE firm is giving them the power to freeze the investment period and create havoc. While there might be an acceptance that a broader key person clause is necessary to reflect the changing dynamics of a firm, there is a sensitivity around the people and process.

One LP recalls asking for a certain individual to be promoted to partner and included in the key person clause as a precondition for investing in a fund because it was felt this person would be a significant driver of value. However, the same LP also acknowledges that in a fair number of cases, no matter what efforts are made towards institutionalization, there remains a gulf in value contribution between the founder and key rainmaker and the rest. If he leaves, the firm is essentially finished.

"For a lot of internet deals in China, it is not a matter of how much time the founder spends on the fund, it comes down to his reputation and relationships," adds Shearman's Chen. "That's why one commonly seen clause requires this person to spend a substantial amount of time on managing the firm if not on managing the fund. LPs have to be comfortable that he's half retired, but still bringing deals to the team on the strength of his name."

The industry is evolving, with multi-level key person clauses becoming more commonplace among smaller country-focused GPs. For example, when one of the two founders of Ascendent Capital Partners – both of whom were designated super key persons – left the firm earlier this year, the remedy was said to have involved bringing some of the managing directors into a second-tier clause below the remaining founder. For some LPs, though, the provisions still don't go far enough.

Sting in the tail

Once an investment period has concluded, the powers granted under the key person clause vanish. Earlier this year, Australia's Archer Capital announced it would not raise a sixth fund but focus on managing the existing portfolio, while Peter Wiggs, the firm's founding partner and CEO, would retire. According to industry sources, Wiggs is a super key man on Fund V but even if his involvement falls below the required threshold, it makes no difference if there are no new investments to freeze.

From the perspective of an LP that wants to see portfolio companies managed through to successful exits, it does make a difference. They want stability in the team and pending carried interest payments might not be enough to secure it if the terms of the LPA allow investment professionals to walk away with their economics. In these situations, an LP would likely resort to other governance tools like no-fault removal of the GP or termination of the investment period if it has yet to expire. 

While Debevoise's Anderson is seeing more LPs focus on the steps they can take, it is generally acknowledged that options are limited. They are also more about the threat than the execution. Aberdeen Standard is among those investors seeking to maximize their leverage in certain instances by trying to push down the voting threshold required for GP removal from 75% or 80% to two-thirds of the LPs. 

Future fundraising prospects – whether with the current firm or using the track record as the basis for a spin-out – can sometimes incentivize team members to find a management structure that works for them and the LPs, but the lack of flexibility in terms of taking action can be frustrating for LPs. Short of introducing indentured servitude so investment professionals must remain with a fund for its full 10-year life, it is difficult to see what can be achieved beyond the current set of options.

"If you look at it globally, there has been limited language in LPAs to address the issue of what happens beyond the investment period, but there have also been proportionally fewer blow-ups elsewhere in the world than in Asia," Aberdeen Standard's Tan observes. "Maybe it's because the industry is not as evolved: this is often the first generation of GPs undergoing generational change and there aren't enough templates and good examples for others to follow."   

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• Topics
• Fundraising
• GPs
• LPs
• Advisory
• Greater China
• Australasia
• South Asia
• China
• India
• Australia
• Fund formation