Back to School: No-fault GP-removal provisions yet to go mainstream in U.S.

LPs in Europe have latched on to no-fault provisions that make it easier to boot a GP from a fund, but such terms remain rare in the U.S.

No-fault divorce clauses, while rarely used, offer limited partners some protection if a GP severely underperforms or behaves irresponsibly. Such provisions enable LPs to appoint a new GP or dissolve a fund rather than be stuck in a bad investment for years, a recent study by consultant MJ Hudson shows.

While most funds will allow a GP to be removed for cause, proving that a GP deserves to be removed can be expensive and time-consuming to litigate, making no-fault removal a more attainable option, MJ Hudson Managing Partner Eamon Devlin says.

“Without fault removal of a GP is a relatively rare occurrence, owing to the high consent threshold often set and the compensation typically payable even when this threshold is reached,” Devlin said in a statement. “Nevertheless, in cases where the outcome of court action to demonstrate cause is uncertain, or the process itself too expensive or time consuming, it may be the only option.”

Such provisions are more common in funds managed by European firms, the survey says. While 52.5 percent of funds surveyed included a no-fault removal provision, only 18.2 percent of U.S. funds allowed for a no fault divorce, compared with 73 percent of European funds.

Large funds are also less likely to have no-fault removal provisions, and the 52.5 percent of funds that have them represent just 39 percent of the total capital in MJ Hudson’s survey. Of the funds with target sizes of $5 billion or more — which are also more likely to be found in the U.S. — only 14 percent offered a no-fault-removal right.

While U.S. managers have resisted adding no-fault-removal provisions to their contracts, they often offer a no-fault-suspension of the investment period instead, something that’s relatively rare in European funds, according to MJ Hudson.

A no-fault suspension period, however, doesn’t allow for a new GP to come in and rescue a struggling fund, and doesn’t protect LPs in funds that have already invested much of their capital.

“The inclusion of a no-fault suspension of the investment period is, of course, no help once the investment period has ended,” MJ Hudson Partner Edyta Brozyniak said. “Depending on the reason for the suspension, an LP’s interest in the fund may be an unattractive secondary proposition to other LPs; ditto the portfolio assets to secondary direct investors.”

To actually trigger a no-fault removal provision, LPs typically face many obstacles, including a grace period during which a manager cannot be removed, a high voting threshold among a fund’s LPs, and financial concerns, such as continued management fee payments.

Three-quarters of no-fault removal clauses provide for continued management fee payments, and only one-quarter of the surveyed funds offered fewer than 12 months’ management fee as compensation for removal, indicating a slight shift to a more GP-friendly terms, MJ Hudson found.

Action Item: Check out MJ Hudson’s earlier report on fund terms, focused on economics, here https://bit.ly/2QRk6vK