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Private Equity Limited Partnership Agreements: Common Trigger Events and Limited Partner Remedies

Cameron Koziskie and Sam Ault, Torys LLP


The limited partnership agreement (LPA) for a private equity fund represents a road map for the fund. It embodies the fundamental interests and expectations of the parties. One of its objectives is to ensure that the incentives of all parties are well-aligned. Aside from the financial terms of the fund, the remedies (and associated triggers) available to the limited partners are the most intensely negotiated aspects of the LPA during the process of fund formation. Defining the remedies and triggers is vital to aligning the incentives of general partners (GPs), limited partners (LPs) and affiliates, and ensuring that extraordinary situations can be dealt with swiftly and successfully.

The purpose of this article is to discuss some of the issues surrounding common remedies and triggers. The remedies discussed include the suspension or termination of the commitment period; the removal and replacement of the GP; and the termination of the fund. The triggers discussed include key-person, no-fault and for-cause provisions.

Remedies

Suspending or Terminating the Commitment Period

The commitment period establishes the period of time within which the fund can make investments. It begins after the initial closing date and usually ranges from four to seven years, depending primarily on the type of fund and the term of the fund.

With regard to remedies, the commitment period can be either suspended or terminated. Suspensions of the commitment period typically prevent the GP from making capital calls to fund new investments (other than, sometimes, follow-on investments in existing portfolio companies). GPs are, however, allowed to make capital calls to fund partnership expenses or investments that were in progress when the suspension began - commonly defined as where a binding legal commitment to invest was made before the suspension took effect.

Most LPAs allow for suspensions that last between 30 and 180 days and are invoked automatically by trigger events such as a key-person event, a for-cause event or a sufficient no-fault vote by the LPs, all of which are discussed later. The automatic nature of the suspension favours LPs because it puts the onus on the GP to convince the LPs not to terminate the commitment period. A "pro-GP" suspension clause would not be automatic, instead requiring a majority vote by LPs to invoke the suspension of the commitment period following a trigger event.

Before the end of any suspension, most funds require a vote by LPs to continue the fund as before (i.e., to remove the suspension), otherwise the commitment period is automatically terminated at the end of the suspension. A termination of the commitment period ends the GP's ability to make any future capital calls to fund new investments (other than, sometimes, follow-on investments), but does not dissolve the fund. The role of the GP after the commitment period is terminated is to focus on building (and successfully exiting) current portfolio companies, and eventually winding down operations.

To move from suspension to termination of the commitment period, some LPAs require the support of a majority or supermajority in interest of the LPs. As mentioned above, other LPAs contain suspension clauses that automatically default to termination unless there is a vote to remove the suspension; thus they require only inaction by the LPs to terminate the commitment period. Clearly, the former situation is preferable from a GP's perspective.

Some LPAs allow individual LPs to decide whether to suspend or terminate the commitment period with respect to themselves (but not other LPs). This means that the GP would still be able to call upon the LPs who agree to continue the commitment period and all LPs who do not have the right to terminate the commitment period unilaterally. Only these LPs would receive future proceeds and returns from future investments. In general, whether the other LPs in the fund are made aware of such "individual suspension/termination" arrangements depends on the fund.

Removing/Replacing the GP

Another common remedy included in LPAs is the removal of the GP. Given the drastic consequences this would have on the GP (and its economic entitlements), GPs are particularly sensitive to the terms of this remedy.

Although the vast majority of LPAs require a for-cause event to trigger the removal of the GP, a "pro-LP" LPA would allow for no-fault removals. While a no-fault removal remedy is rare, where available, the minimum percentage in interest of LPs required to invoke it is usually in the 75% to 85% range, which is difficult to achieve.

The actual removal of the GP occurs very rarely. Rather than remove the GP, LPs generally prefer that the GP work diligently to correct any problems that it encounters and then return to the business of managing the fund. Dissatisfied LPs tend simply to "vote with their feet" and avoid investing in that GP's next fund.

Dealing with the Principals' Investment

In almost all funds, the principals have invested some of their own money. If the GP is removed, the LPA should outline the consequences of the removal to the principals' investment. The appropriate consequences are the subject of negotiation, but at least three broad options are available.

  • The first, and most common, is to leave the principals' investment as it is - that is, it would be treated just like the investments of other LPs.
  • The second option, which is seen occasionally, is to reduce any outstanding capital commitment while maintaining the current investments. For example, if the principals originally committed $10 million to the fund and $3 million of that commitment was drawn down for investments before the GP's removal, the principals would be relieved of their obligation to contribute the remaining $7 million to the fund for new investments, but would typically remain obligated to fund follow-on investments and fund expenses. The $3 million previously contributed and any further contributions would then be treated like any LP's investment. This second option is more appealing to most GPs than the first option.
  • A third option would enable the principals to put their interest in the fund back to the fund at fair market value. This third option is very rarely found in LPAs.

Dealing with the GP's Carried Interest

In negotiating for the remedy to remove or replace the GP, there is often disagreement over the amount of carried interest to which the former GP should be entitled after removal. A common approach is to limit the former GP to receiving carried interest only in relation to portfolio investments made before its removal (the pre-removal portfolio companies). An LP-favourable modification to the LPA would be to further reduce the carried interest owed to the former GP (or eliminate it altogether) if particular cause events occur - such as fraud or a breach of fiduciary duty (i.e., the GP's entitlement is "discounted").

In any case, the remaining portion of the former GP's carried interest is available to be paid to the new GP, on the theory that the new GP will be contributing to the existing portfolio investments and new investments as they mature and are exited. Where there is a discount, part of the carried interest from the existing portfolio companies is available to the new GP, which results in the new GP's interests being more closely aligned with the fund's interest in those portfolio companies. Where there is no discount, the new GP will inevitably need to receive incentives relating to existing portfolio companies to align its interest with the fund's interest in those portfolio companies, but the cost of those incentives will be borne solely by the LPs.

In most cases, the former GP's entitlement to carried interest on pre-removal portfolio companies will be determined only on the eventual exit of those portfolio companies. To increase certainty for all parties and to perhaps increase the accuracy of the true carried interest, some funds will use an agreed-upon valuation technique to value the current portfolio investments at the time of removal and pay the GP its carried interest according to that valuation. This method brings with it significant issues regarding payment timing that need to be covered in the LPA. At least three options are available for the timing of this payment.

  • The first option is for the fund to pay the former GP immediately at the time of removal, regardless of whether any portfolio companies have been exited at that time. This helps to completely terminate any relationship between the former GP and the fund.
  • The second option is to give the former GP priority on its entitlements as the pre-removal portfolio companies are exited. The former GP would receive all of its entitlements before the new GP receives any carried interest from the pre-removal portfolio companies. Again, however, this carried interest is paid only as the pre-removal portfolio companies are exited.
  • The third option is for the former GP and the new GP to share proportionately in the carried interest available from the pre-removal portfolio companies. This clearly is the most advantageous from the LPs' perspective because it allows for a more current and meaningful incentive to be available to the new GP.

Terminating the Fund

Terminating the fund is arguably the most extreme remedy for all parties involved. Upon dissolution, the affairs of the fund are wound up and its assets liquidated in an orderly manner or distributed in kind to the LPs. After a termination event, the GP cannot conduct any operations except those directly related to winding up the fund. Depending on the terms of the LPA, the GP can act as liquidator or, if the GP is unable to so (or the LPA so provides), the LPs can vote to appoint a liquidating trustee. The liquidator must use its best efforts to convert the assets to cash and cash equivalents, and dispose of the assets on commercially reasonable terms. This often means exiting investments at fairly low valuations compared to their likely value at maturity. The liquidator does have some discretion to avoid selling assets if it deems the sale inadvisable. Similarly, the GP can distribute some of these assets to partners in kind.

After liquidation, the fund is dissolved as the GP makes the final distribution of proceeds. This distribution is generally performed in the following order of priority: (1) to creditors of the fund, including partners who are creditors; and (2) to the partners according to the distribution priorities set out in the LPA.

Triggers and Associated Remedies

Each fund's situation is unique, so there is no standard package of remedies and triggers; nor is there a requirement for any particular remedy/trigger combination. The remedy and trigger provisions are therefore tailored to fit each situation, and the package is generally negotiated in its entirety, not as individual clauses. The negotiating leverage of either the GP or the LPs has a major effect on the ultimate package of triggers and remedies.

Note that in the discussion below of trigger events and the common remedies associated with them, the percentage of interest votes required in each case typically excludes any LP interests held by the GP or its affiliates, since their desired outcome for certain votes is often contrary to those of the unaffiliated LPs. Thus, when reference is made to a vote by a particular percentage of interest, the vote required is that percentage of the total interest of only the unaffiliated LPs. Even though this makes it easier for LPs to trigger remedies against GPs, many consider 75% or more votes among LPs to be almost unachievable under any circumstances.

For Cause or Fault

Defining and Negotiating For-Cause Clauses

The specific activities or occurrences that constitute cause should be explicitly defined in the LPA. Sources of tension between the GP and LPs include not only the activities or occurrences themselves, but also whether or not they need to be material or intentional. Frequently, the definition of cause in LPAs encompasses some or all of the following:

  • criminal conviction for or admission by consent of
    • a violation of securities laws, including of any related rule or regulation, with certain de minimis exceptions, and
    • a criminal felony (or its equivalent in any non-U.S. jurisdiction);
  • determination by any civil or criminal court or governmental body of competent jurisdiction or an admission of
    • gross negligence/negligence,[1]
    • willful misconduct, and
    • breach of fiduciary duty toward the fund or the LPs
  • commission by the GP of fraud, embezzlement or a similar crime;
  • reckless disregard of duties regarding the fund;
  • issuance of an order by any court or body of competent jurisdiction permanently enjoining the GP from fulfilling its obligations under the LPA;
  • knowing, intentional or material breach by the GP of any of its obligations under the LPA; and

If the GP has sufficient leverage during negotiations, many of these clauses might be qualified as needing to be intentional or material, or to have a material effect on the fund before they would constitute cause. On the other hand, a pro-LP variation to the for-cause remedy is to expand the remedy to apply to the activities of the principals, the manager and their affiliates rather than only the GP.

Another point of negotiation is the existence of "cures" to these events. Some LPAs allow for certain cures (such as firing an offending individual) to automatically cancel the for-cause trigger. Other cures must be voted upon by the LPs, especially if curing the for-cause event requires a reworked business plan or triggers a key-person event (discussed below). If a cure is available, the GP is given a specified period after the initial notification of the for-cause event (often between 30 and 60 days) to implement that cure.

There is a debate over exactly how important some of these for-cause triggers are, given the low likelihood that they would occur and the practical difficulty of proving their occurrence. Some LPs have taken the position of avoiding negotiations related to the definition of the cause events and focusing instead on other important areas for discussion in the LPA.

Common Remedies

Given the nature of most for-cause events, it is not surprising that it is relatively common to see several remedies available to the LPs following a for-cause event. Removal of the GP generally requires between 50.1% and 66.7% of LP support. Suspending or terminating the commitment period or dissolving the fund generally requires a 66.7% vote, if the remedies are available.

No Fault

No-fault provisions have become standard in LPAs for private equity. No-fault provisions are generally designed to provide LPs with a remedy in the event that an unexpected issue arises relating to the fund, and in many cases allow LPs to pursue remedies that are not available under cause or key-person events.

Triggering No-Fault Clauses

To trigger a no-fault provision requires only that a certain percentage in interest of LPs vote to exercise this clause. No-fault remedies typically require an LP voting threshold that is higher than that required for for-cause remedies, generally in the range of 66.7% to 80% in interest of LPs.

Common Remedies

The choice of remedies available to LPs after invoking a no-fault provision is the subject of much negotiation during the process of fund formation. The GP and the LPs tend to have divergent perspectives on which remedies are the most appropriate. GPs prefer no-fault trigger provisions to have only extreme consequences (e.g., dissolution of the fund), because they believe that the severity of the consequences will make it less likely that LPs will actually implement the remedy. LPs, on the other hand, prefer less draconian remedies such as terminating the commitment period or removing the GP.

In the current environment it is fairly typical for the LPs to be able to terminate the commitment period on a no-fault basis. The theory is that if a significant percentage of LPs have lost confidence in the GP, all further investments should stop. More LP-favourable LPAs also provide for the replacement of the GP; if that remedy is available, however, the GP would typically be entitled to receive all carried interest relating to "pre-removal portfolio companies" (i.e., no discount) and often will receive its distribution on a priority basis.

Key-Person Provisions

Defining and Negotiating Key-Person Clauses

Two important factors in an LP's decision to invest are the experience and the track record of a fund's principals. The goal of key-person provisions is to establish the expectations of investors and management regarding the time that those principals (and possibly other individuals) must commit to the fund. Key-person provisions can also help keep LPs informed of departures, even if the provision is not triggered. The fact that there is a trigger makes it more likely that the GP will move quickly to rectify any situation and satisfy LPs.

Key-person provisions are generally accepted as standard components of an LPA. The contentious aspect of key-person provisions involves deciding the precise content of those provisions. Some of the controversial decisions that need to be made include

  • which individuals should be considered key persons?
  • how many key-person losses would be required to trigger the key-person clause?
  • what is the requisite time commitment for each key person or each group of key persons?

Depending on the nature and size of the fund, it is not unusual to have key-person clauses that extend beyond the principals to the next level of management. The most important individuals in a fund (the principals) are often listed individually by name with specific time requirements. Other individuals who are considered "important executives" are generally grouped together. For example, an LPA might require that all the principals and/or "x number" of the "y number" of important executives remain engaged full time by the fund throughout the entire term of the fund. The combination of commitments and key persons can vary significantly, allowing for countless possible definitions of key-person events.

In outlining the expected time commitment, most LPs request that key persons devote "substantially all of their business time" to the fund or related entities. Some LPAs use specific figures for time, such as "75% of business time," although this is less common. The principals, on the other hand, might argue for a softer requirement, preferring terms such as a "substantial amount of time" or even "such time as deemed necessary."

Key-person provisions are, from the LPs' perspective, an important complement to for-cause provisions, giving the LPs the power to ensure that any problems caused by the removal of key people (for any reason) are addressed quickly. At the same time, the significance of key-person remedies is arguably reduced if the LPA includes adequate no-fault remedies.

Cures and Common Remedies

Most LPAs stipulate that the GP must notify the LPs when a key-person event occurs. When this happens, there is usually an automatic suspension of the commitment period, followed by a vote on whether to remove the suspension or to terminate the commitment period. During the time between the automatic suspension of the commitment period and the vote, the GP usually attempts to persuade the LPs not to terminate the commitment period. A more LP-favourable LPA would stipulate that the commitment period is automatically terminated unless the LPs vote otherwise. Furthermore, in some funds, the LPs can vote to completely dissolve the fund.

Convincing LPs to reinstate the commitment period after a key-person event might require a plan to either replace the departed executive(s) or continue the fund as is. Any such plan generally needs approval from either the fund's Advisory Committee or a majority or supermajority in interest of LPs.

Conclusion

Negotiating the appropriate suite of trigger rights and remedies is a key component of every discussion regarding the formation of private equity funds. Every effort must be expended on the development of an appropriate package of triggers and remedies to impose the necessary discipline on the activities of the GPs. This package must be balanced so as not to erode the natural incentives for GPs to achieve the best possible results for the fund and, by extension, for the LPs. By developing a suite of trigger rights and remedies, the GP and LPs will have a clear road map available them to address significant issues in the fund and resolve them in a timely and orderly manner.


Cameron Koziskie (ckoziskie@torys.com) practises corporate and commercial law with an emphasis on private equity, mergers and acquisitions and securities law.

Sam Ault is a summer student at Torys LLP.

[1] The standard of negligence required is usually a topic of significant discussion. For U.S. funds, "gross negligence" is the most common standard, and it is occasionally used in Canadian funds. "Negligence" often refers to exercising the care that a "reasonably prudent person would have exercised in a similar situation." Gross negligence, as the name suggests, implies a higher standard to breach than simple negligence, although the extent of the difference under Canadian law is not well-defined.