In a private equity fund arena, where I have lived and worked for the past 40 years in several capacities (counsel, advisory board member, limited partner, fund-nominated director), the focus of negotiations, as a fund is organized, has historically been the bargain between the investors (the limited partners or LPs), and the managers.
Once upon a time the managers were individual general partners of the limited partnership; they are now members of the limited liability company which is the general partner (the "GP") and shareholders (again usually members) of the entity which comprises the management company. There are highly experienced professionals who have concentrated their professional careers on representing the GPs or the LPs. The limited partnership agreement (the LP Agreement) continues to be intensively negotiated. Certain "market" or "industry standard" provisions have emerged from years of negotiations amongst the elite professionals but the LP Agreement represents a complicated set of provisions. There is still ample room for differences of opinion and various ways of expressing the bargain between the investors and the managers, a bargain which has changed over time as the market for portfolio company securities (and, therefore, the ultimate outcome of the LPs) has changed.
The meltdown, however, has served as a wake up call, if you will, for professionals in this space, exposing a prominent series of issues which should have been addressed long ago but which were often (indeed largely) ignored in certain important respects, as the rising tide of portfolio values floated all boats.
By that clich, I mean that a consistent pattern of good news for the managers of LPs of private equity funds generally meant little or no attention needed to be paid to the specifics of the agreements amongst the managers, inter sese if you will. As long as everyone was making a bundle, arguments amongst the managers were few and far between. When the agreement constituting the LLC as general partner (the "GP agreement") was tabled for discussion, not much in the way of hard negotiation took place because the parties simply assumed that there would be enough profit to go around and that phenomenon would subsume all differences.
Well, as I have said before, 'the times they are a-changing.' While (based on my personal experience) new fund organization is beginning slowly to pick up, nonetheless I am spending an unusual (unusual by historical standards) amount of time attempting to sort out disputes and differences of opinion amongst the individuals I will call the general partners. I will not, of course, go into any of the details of my assignments; the idea is to avoid open warfare, predictably a lose/lose situation for all concerned, and settle disagreements amicably. But, human nature being what it is, the meltdown has produced acrimony, as one time partners attempt to sort out the blame (if blame is in fact the right word). As differences of opinion and disagreements surface, we (the professionals in this field) have gone back to the GP agreement, to see if there were specific provisions governing the issues raised. And, we were often disappointed to find that the GP agreements simply did not take into account the contingency at hand; not many of the contingencies were, in fact, anticipated in the typical GP agreement.
I and others will be talking about the issues in new GP agreements in this and future Buzzes. I would be happy to hear from potential contributors . ideas, war stories, interesting new language; all will be welcome and cheerfully attributed to the commentator as this important arena of negotiation and careful drafting receives the attention it clearly deserves.
Let me set the stage for these discussions by outlining some of the fundamental considerations which the sponsors of private equity funds (whether new or, say, sixth generation) should take into account.
First, the principal reason the LP agreement is so intensively negotiated is that (a) it is complicated and involves large sums of money; and (b) more importantly, it involves a lock up of the investors' capital for as long as 12 years and in some cases longer. As we know from the inefficient state of the secondary market, investors who want to retrieve their unspent capital, cancel their commitments and exit, in effect, the investment are often left without any practical remedies. It becomes, therefore, of paramount importance that as many contingencies be anticipated as possible, including the contingency that some investors will either want, or be compelled, to exit prematurely, before the fund's positions are monetized. The instant point is that the same imperative applies in negotiating the agreement amongst the managers: Circumstances change, stuff happens, and one or more of the individuals (and there are usually only a handful) will want to go do something else.
It is important, therefore, to discuss in advance how a disaffected member or general partner will be able to withdraw; and that, in turn, brings into focus a number of important questions: Is the withdrawal involuntary, for example, triggered by death, disability, maybe even divorce or personal bankruptcy? Does the withdrawing member want simply to retire or does he or she plan to join a competitor. or to start up a competitive fund? Is the withdrawing member so important that his or her withdrawal triggers consequences with the LPs . the so-called 'key man' issue, entitling the LPs, upon the individual's withdrawal, to liquidate the fund or, less dramatically, to close down the investment period. Many of the current agreements simply provide that none of the general partners may voluntarily withdraw. Is this a constructive provision, to hold somebody in the partnership against his or her will? Obviously, since any party can withdraw de facto if not de jure, what consequences should that entail? Big damages? The lockup phenomenon is worth dwelling on, if only because its length (10 to 12 years, mimicking the LP lockup) lends a high probability to the contingency that (a) someone's plans will change; and (b) the contributions of the various parties will become, both as perceived and in fact, divergent over time.
Let's assume a general partnership with three senior managers putting the deal amongst themselves down on paper. At the time the enterprise starts off, the parties are full of positive expectations, including the notion that the three of them will be equally productive throughout the entire term of the enterprise. The odds, obviously, are against that eventuality. Thus, let's say one of partners was instrumental in bringing in a disproportionate share of the capital commitments required to get the fund off the ground. Maybe that partner feels that he or she is entitled to somewhat of a free ride because of vital importance of the initial fund raising. Query: The success of the deals each brings to the party is also bound to be varied. While all three partners typically vote on important actions, including the decision to invest and/or to harvest, each deal is generally acknowledged to be the responsibility of one and only one of the individuals. What happens if the deals one individual brings to the fund are uniformly disappointing, which in turn raises the question whether two of the three partners should have the ability to replace the third whose star has dimmed. Most current agreements talk about replacement for "cause" but that term is so narrowly defined, it is rarely of any use. If, on the other hand, two of the three could gang up on the third, what is to prevent them from greedily and unfairly expropriating the third partner's share, ignoring his or her important intangible contributions? As in many of these cases, there is no specific "right" answer. The point is that the issues should be discussed and negotiated in advance, rather than after the fact . when emotions are high and the chance of unproductive warfare breaking out are equally high.
Further to this point, if there is machinery for expelling a partner who turns out to be non-contributor and the threshold is set high enough to prevent simple bullying, a very intricate set of issues concern the appropriate payout. And, in this connection, an important point is often ignored. The way private equity funds are structured, each general partner is required to enjoy only a single material asset . the "carried" profits interests in the limited partnership's portfolio. The limited partnership makes the investments, with capital committed and contributed by the partners . including (to a minor extent) the general partner (in turn using contributions from the three members we talked about) and the investors themselves. The general partner (meaning the members of the general partner, of course), controls the timing of profit realization and of proceeds distribution; to that extent, the GP is in control of its own destiny. However, it is important to understand that the profits and/or losses booked by the GP are derivative. They, first, depend on a realization event (a sale of a portfolio company or the distribution of securities in kind) and, in such a case, calculation of gain or loss on the sale, the amount of expenses charged to the limited partnership, including the management fee, potential income from other sources (temporary cash balances, for example), and accruals for reserves. In most but not all partnerships, these calculations are made on a periodic basis (and the period is usually an annual period), taking into account all the relevant events and items occurring during the period in question. In other words profits and losses are not calculated on a portfolio position-by-position basis. Everything gets thrown into the pot and netted out and then, as of the year end, allocated to the capital accounts of the various partners, including the general partner. Further complications arise from the fact that the methods of allocating profits at the LP level can be quite complex. Thus, most LP agreements contain a 'true up' mechanism, whereby profit or loss in one year is used, first, to counteract prior and opposite cumulative postings. I will save a discussion of some of these issues for later Buzzes; I will simply point out there may be a handsome net profit for tax purposes in a given year but the GP, for one reason or another, may not see any of that profit in terms of actual cash or liquid securities.
Accordingly, when one goes to rearrange and recalculate the interest of the members of the GP, occasioned by withdrawal for one reason or another or a new partner joining the partnership in mid-stream, the derivative nature of the profits and losses at the GP level can be the occasion of some quite tricky and complex drafting. Once the language is circulated, the use of examples is highly recommended so as to flush out eccentric results due to the inherent difficulty in expressing numeric formulae in words.
Another complicating factor is the existence of the so-called clawback which, post the meltdown, has real teeth in it. The clawback is described in The Encyclopedia of Venture Capital, Section 10.1.8.a; suffice it to say at this point that the operation of the clawback is a distinct possibility, as the pre-2001, often generous distributions of profits to the GPs have to be trued up, because of significant subsequent losses in the portfolio, in order to realign interests of the parties to the proportions they bargained for. The clawback is at least the responsibility of the members of the GP collectively; the LPs often insist the responsibility be joint and several since they do not want to have to chase a defaulting member. This question then is: Who does have the responsibility to chase a defaulter, and how does one do it? Should there, at the GP level, be some kind of escrow of distributions, to guard against the possibility that one of the members will be stuck with someone else's clawback liability.
Two more issues and this installment is done:
The way most private equity funds are structured is as follows: The best funds are sequential . Acme Partners I, Acme Partners II, Acme Partners III, etc. As each Acme fund is organized and capital raised, a separate LLC is organized to act as the general partner. This allows the sponsors in overall control to make changes on a fund-by-fund basis; it may not be possible and/or feasible to remove a given partner from, say, Acme Fund II, but it is usually a rather simple matter to leave the individual in question out of any participation in Acme III, IV, V, etc. Alternatively, if a partner is beginning to slow down, his or her interest in Acme III and successor funds can be reduced at some agreed-on rate; he or she becomes in effect a nonvoting member, a limited partner if you will, of the successor GPs. The problem is that, in most funds, the management company is a single institution which endures immortally. The GP entity enjoys the carried interest, where the big money is assumed to lie; however, with the mega-funds formed in recent years, the management fee is by no means trivial. The law of numbers requires that a little number (2%) multiplied by a big number ($1 billion in commitments) is a big, not a little, number. And if two or three funds are still in business each drawing down fees for the management company at any one point in time, the management company can enjoy significant surplus value. And, of course, the question is, who should own that surplus value? All the members of the GP? Some of them? Or perhaps, only a very few? There is no requirement that a GP member also be a member of or a stockholder in the management company. The GP members are, in fact, almost always employees of the management company, drawing their salaries and fringe benefits there from. However, it can be a highly contentious negotiation whether a given individual gets an ownership share at the management company level, as well as his or her share in the carried interest through the GP.
In that connection, and again focusing on shifting the relationships of the members in mid-stream amongst themselves, there is not much guidance on the following issue. What the law governing the relationship of an individual who is a member (and therefore, for all intents and purposes a partner) in the GP but an employee of the management company . the law applicable to partnerships or to employer/employee relationships. Again, saving details for later installments, the question of how one looks at that relationship can have important, and quite different, practical consequences.