The majority of U.S. private equity fund documents allow some percentage of investors to remove the fund’s general partner in certain egregious cases of cause. Some U.S. and many non-U.S. private equity fund documents also allow for the general partner to be removed by a super-majority of investors without cause. Negotiating these non-cause general partner removal provisions requires investors and general partners to address a number of difficult legal and business issues. In respect of U.S. investment funds, all parties may be better off in many cases to avoid these issues by agreeing to a simple for-cause only removal scheme accompanied by the right of a super-majority of investors to terminate the fund at any time and for any reason. This is the approach taken by the majority of U.S. private equity funds.
Perhaps the most difficult issues in negotiating not-for-cause removal provisions are determining how the general partner should be compensated on removal for the loss of its management fee and carried interests, and what should happen to its investment interest. It is common for a general partner to be entitled to a “breakup fee” of six months to two years of management fees on its removal without cause. The point of these “breakup fees” is both to encourage the idea that removal should only be for very serious issues (even if they do not have to rise to the level of “cause”), and to reimburse the removed general partner for its efforts in raising the fund. While determining the precise amount of management fees that will be paid to the removed general partner as a “breakup fee” may require a difficult business negotiation between investors and the general partner, it is at least a simple concept to draft into the documents.
Determining what should happen to the carried interest in the event that a general partner is removed without cause, however, is more difficult. Assuming the general partner is removed after investments have been made, it seems fair to many people that the removed general partner should receive at least some part of any carry that is generated by those investments. But investors often insist that there be some “haircut” to allow them to give the appropriate incentives to a new fund manager. Adding to the complexity is the fact that private equity fund waterfalls almost never provide for true deal-by-deal distributions. Rather, the carry is always ultimately calculated based on the performance of the fund as a whole. This means that investors and the general partner can never simply agree for the general partner to receive carry with respect to the old investments and the new general partner to receive carry on the new investments. Instead, they must negotiate either a more complicated or a less satisfactory arrangement.
These issues get resolved in fund partnership agreements in various ways, none of which are completely satisfactory to all parties. In respect of the “haircut,” some funds have no haircut, some have a flat percentage haircut, some have schedules for the haircut based on the year of the fund when the removal occurs, and some even have formulas for the haircut based on the extent to which the fund is invested when the removal occurs.
With respect to the issue of investments made after the removal of the general partner, many partnership agreements provide for the general partner to receive carried interest on the basis of a hypothetical portfolio consisting only of the investments made prior to removal, and only taking into account partnership expenses incurred prior to the removal, but this could potentially be a very poor deal for investors. A similar approach is to “crystallize” the carried interest at the time of removal based on the fair market value of the portfolio at that time, but general partners often argue that an inherent characteristic of private investment strategies is that the full value of an investment may not be apparent for some time after it is made. After all, general partners are paid a management fee to find and purchase undervalued investments.
Other fund partnership agreements address this issue by providing for the general partner to simply be entitled to receive a reduced percentage of the carry for the entire fund, even including post-removal investments. There are even a few agreements that provide for no additional carry to be paid to a general partner that is removed without cause, but this is fairly rare.
Almost as difficult as determining the amount of the carry payments is determining how and when they will be paid. One common approach is to provide for the payments to be made over time generally as they would have been made had the removal not occurred. Another approach is to achieve basically the same result but through a purchase of the carried interest around the time of the removal by the issuance of a promissory note to the removed general partner. In either case a question arises as to what priority the removed general partner should have in these distributions, with fund managers often insisting that they should be paid the full amounts of their interests prior to any other distributions being made to investors. In a few cases fund partnership agreements even provide for the full amount of the consideration for the removed general partner’s carried interest to be paid by the fund soon after the removal. The practical effect of such a provision might be to require the dissolution of the fund on the general partner’s removal.
In addition to determining what should happen to the general partner’s right to receive management fees and the carried interest, the investment interests of the general partner and any members of fund management also have to be dealt with. Often it is the case that these investment interests were intended to be funded with management fees (and many times the documents provide for that to take place automatically). Additionally, these interests usually do not bear management fees or carried interest. Finally, general partners often complain that it is not fair that they continue to be required to fund their commitments for investments being selected by a new management team that they never agreed to. For all of these reasons, fund partnership agreements often provide for removed general partners to be released from their capital commitments. The question then is how to deal with their existing capital interests in the fund based on the capital contributions that have already been made. The issues here largely parallel the issues in respect of the purchased of the carried interest.
In contrast to these issues, for cause removal provisions are usually much simpler. While it is true that in some cases general partners with more bargaining power will negotiate for deals similar to what they would receive in respect of a not-for-cause removal, it is much more common for fund partnership agreements to provide simply that on removal for cause the removed general partner is no longer entitled to receive additional payments of management fees or carry, and that it is also not released from its commitment.
General partners are often able to get comfortable with such a one-sided provision because of the use of fairly tight definitions of “cause.” Usually, “cause” does not exist unless there is a final court determination – and often a non-appealable court determination – that the general partner or another member of fund management has committed a fairly egregious act such as a material and unremedied breach of the fund governing documents or a felony related to the investment management business. The negotiation of for cause removal provisions is usually mostly around the definition of precisely what constitutes “cause.” This negotiation can be more legal in nature and often does not take up the same amount of “partnership capital” as negotiations of not-for-cause removal provisions.
While the removal of a general partner of a private equity fund is very rare, the fact that investors are able to remove the general partner without cause does affect the subsequent relationship of a fund manager and its investors. Investors truly do gain something by requiring the inclusion of no-fault removal provisions in fund investment documents. On the other hand, those provisions can be expensive to negotiate, both in terms of legal expense and perhaps even more importantly in terms of relationship goodwill. Accordingly, both investors and general partners might be better served in many cases to agree to a simple for-cause removal provision coupled with the ability of a super-majority of investors to require the liquidation of the fund (and to control that liquidation through the appointment of the fund’s liquidator) at any time.
Henry Riffe practices corporate and commercial law at Robinson Bradshaw with an emphasis on private equity and venture capital transactions and mergers and acquisitions.