The purpose of the removal of the general partner provision is to give limited partners the ability to remove and replace the GP for certain bad acts (a ‘for-cause’ removal) and/or for any other reason (a ‘no-fault’ removal). Removal rights are generally implemented by an LP vote (by commitment). The percentage of LP commitments required to remove the GP experienced a downward trend as a result of the economic downturn and has largely held at those levels: a ‘for-cause’ removal generally requires a vote of between 50 percent and two-thirds; and a ‘no-fault’ removal generally requires a vote of between 70 percent and 85 percent.
There is a noticeable difference between European and US approaches to GP-removal provisions. In Europe, it is common for the limited partnership agreement to contain both a ‘for-cause’ and a ‘no- fault’ removal provision. In contrast, these provisions have, historically, been less common in US funds; instead there is a bias toward an LP right to terminate the fund and/or suspend the fund’s investment period. However, as a result of the establishment by the Institutional Limited Partners Association of the Private Equity Principles, which outline a number of key partnership terms that ILPA feels GPs should consider including in their LPAs, GP-removal provisions are now being requested and, in some cases, given more frequently in US funds. Nevertheless, many established US fund managers are still able to avoid inserting these provisions in their LPAs, especially ‘no-fault’ removal provisions, due to the much longer term relationships these GPs have established with many of their LPs.
Removal provisions are detailed and complex, and there are numerous decisions that must be made, including what type of removal provision, if any, should be included in the LPA. Some GPs simply do not agree to the inclusion of a removal provision and instead provide LPs with the ability to terminate the fund and/or suspend the fund’s investment period.
If GPs are comfortable with the inclusion of a ‘for-cause’ removal provision, the principal areas for negotiation typically include:
• How ‘cause’ should be defined (for example, fraud, gross negligence, willful misconduct, breach of fiduciary duties, violation of securities laws, breach of relevant documentation).
• Whether a cause event must have an adverse effect on the fund.
• How the occurrence of a cause event is to be determined (for example, is a court decision required and, if so, must this be a final and non-appealable decision, which can present significant timing delays?).
• Whether a cause event can be cured and, if so, how (by firing, for example, the person whose conduct resulted in ‘cause’ and/or requiring restitution to the fund of any economic harm).
• Which parties will be subject to the provision (the GP itself plus one or more of the manager/adviser/management company, key principals and/or employees).
• The LP vote required to effect the removal (50 percent or two-thirds).
If a no-fault removal is included, the areas for negotiation include:
• The requisite vote for removal (from 70 percent to 85 percent).
• Whether there is a period of time during which the right cannot be used (for example, during the fund’s first few years).
• Whether any ‘alimony’ is to be paid to the GP on its removal. In Europe, it is quite common for the GP to receive a fixed payment reflective of between one and two years’ management fee if it is removed without cause. In the US, however, this type of arrangement may be problematic under the Investment Advisers Act of 1940 where the Securities and Exchange Commission has taken the position that a client (the fund) in an advisory relationship (under the management agreement) has the right to terminate that advisory relationship without penalty.
Further, in negotiations for both types of removal, there is a focus on the impact of the fund economics including:
• Whether the GP forfeits any carried interest (this is more common in a ‘for-cause’ removal).
• The timing of when the GP will receive its carried interest.
• The treatment of the GP’s investment in the fund
GP/LP tensions and alignment
The negotiation complexities listed above highlight some of the tensions and alignments arising from GP removal provisions. Ultimately, it is important to a GP to be able to continue to manage the portfolio it has built. Consequently, GPs often seek to define ‘cause’ narrowly and precisely, to require a higher LP vote before removal can be effected by LPs, sometimes to require such a vote to be held at a fund meeting where the GP can present and make representations, and to ensure that the condition has been adjudicated by either a court or an arbitrator, as required under the LPA. In contrast, LPs seek to have a reasonable ability to remove and replace the GP if they are materially unhappy with it. In addition, with the increased level of scrutiny of GPs by the SEC, a breach of securities laws is now sometimes included as a ‘cause’ event.
A primary concern for any GP in a removal scenario is the change in its economics, as future management fees will be forfeited. Even if the GP can negotiate a continuation of fees for some period of time, eventually the fee will end. In addition, there is the potential for the GP to forfeit all, or a portion, of its carried interest in the fund, especially in the case of a removal for cause. In removal provisions where the GP forfeits carry, some options are:
• For the GP to lose all of its carry.
• For the portfolio to be valued at the removal date and the GP to be paid its carry at that time (but no future carry), potentially at a reduced rate.
• To simply reduce the carry percentage to which the GP is entitled (for example, from 20 percent to 10 percent) and allow the GP to continue to be paid carry at the reduced rate throughout the remainder of the fund’s life on all the fund’s investments.
• To provide that the GP will be paid carry on the investments made before its removal (and any follow-ons in those investment) as if those investments comprised a separate portfolio with its own economics.
LPs, on the other hand, are concerned with replacing the removed GP and being able to provide an economic incentive to the new GP. By reducing the removed GP’s carry, the LPs have such an incentive to grant to the new GP without giving up any of its own profit share from the fund.
In European funds — but not typically in US funds — a haircut in the case of a no-fault removal is also seen, but this would be a significantly smaller reduction than when the removal is ‘for cause’.
Finally, the GP’s investment in the fund is often a point of negotiation. On removal, a GP may wish to be bought out at fair market value and, in any event, often seeks an option to curtail its funding obligation going forward.
Kate Simpson is a partner in the private funds group of Proskauer. Malcolm Nicholls was a partner at Proskauer until June. He is now a partner at Gunderson Dettmer.
This is an extract from The LPA Anatomised, available at the PEI bookstore.