By Christopher M. Schelling
Nearly all private-equity-style closed-end draw-down funds have a clause ensuring that the general partner remains focused on deploying the commitments of an existing fund prior to turning substantial business efforts toward raising a successor fund.
The reason is clear. Limited partners want to ensure that their money is nearly fully invested – prudently, of course – before the GP races off to raise more money.
Often enough, however, the legal language to ensure this process is far less clear.
This language must incorporate several important considerations, including:
- How deployed should a fund be (70%, 75%, 80%) before the GP is permitted to raise funds?
- What is included in the percentage deployed (portfolio company investments, partnership costs and expenses, management fees)?
- And which activities define the initiation of actually raising the successor fund (forming the partnership or filing partnership formation documents with a state, issuing a private-placement memorandum, holding a close, etc.)?
Negotiations regarding the first two elements are generally clear. More deployment as opposed to less is always favorable to LPs in the existing fund. Exclusion of fees, costs and expenses in the calculation has the effect of higher actual investment deployment and is again LP-favorable.
But the third element — which activities constitute fundraising — is more subtle and creates the potential for perverse incentives and unintended consequences for limited partners.
Let’s first investigate a typical successor clause with a formation trigger:
The Managing Directors may form any successor private equity fund with objectives substantially similar to the Partnership ( a “ Successor Fund”) on or after the earliest to occur of (i) such time as at least 75% of the Partnership’s Committed Capital has been invested, committed or reserved for investment in Portfolio Companies, or applied, committed or reserved for Partnership working capital or expenses or (ii) the expiration or permanent suspension of the Investment Period.
First, we note a standard of 75% invested, committed or reserved, which is market and generally acceptable. Second, partnership expenses and working capital are included in the deployment calculation, which has the effect of reducing that 75% actually invested to 60% or so. Therefore, removing the expenses could be a request. (I stress “could be,” since the manager’s natural deployment pace is important to consider. What is relevant from the manager’s perspective is how much callable commitment remains in the existing fund.)
Finally, turning to the trigger, we can see the language states simply “may form any successor fund.” Again, the objective is to ensure that an acceptable amount of the business time of the general partners and/or investment professionals is devoted to investing the assets of the current fund before they dedicate substantial time and effort toward raising a successor fund. This is the business intention.
The language in Example 1 accomplishes this objective. But it is also indeterminate in terms of what defines “forming” the successor fund. Does this mean starting to talk to investors and creating decks, or actually filing the partnership documents and getting a limited-partnership certificate of formation? I would argue that it permits the former and prohibits the latter, which is an entirely reasonable compromise.
Lawyers hate ambiguity, however, so other versions of this clause offer more clear and specific triggers for what constitutes raising a successor fund. Consider Example 2, which references a fund closing as a trigger.
Unless consented to by (i) the Advisory Board, or (ii) at least 66 2/3% in Interest of the Limited Partners, from the Initial Closing Date through the earlier of (a) the expiration or termination of the Commitment Period, or (b) the date on which at least 75% of the aggregate Commitments of the non‐defaulting Partners has been invested, committed to be invested (or reserved for investment in Follow‐On Investments) or reserved for payment of Fund Expenses, including, without limitation, the Management Fee, none of the General Partner, the Management Company or any of their respective Affiliates will close on any new investment fund vehicle controlled or managed by the General Partner, the Management Company or any of their respective Affiliates and which has substantially similar investment objectives as the Fund.
In this example, the prohibited action is to close on a new fund with similar investment objectives. While this is very explicit, holding a closing will come well after the real formation and fundraising activities have already occurred. Hence, this language is more GP-favorable in this regard than Example 1. The manager can essentially devote as much time toward fundraising as he or she desires, so long as a closing is not held. This violates the spirit or the intent of the clause to begin with.
Frankly, we might as well not even have a clause in this case, as the GP can still do whatever he wants, including simply delaying the ink on the initial close until he hits the deployment threshold despite having all the heavy lifting done. (In fact, I’ve seen docs with the trigger being a capital call on the successor fund. At that point, it’s a conflict of interest or an allocation consideration, not a business activity limitation.)
A third example of a trigger is the issuance of the PPM. Example 3 provides this language below.
None of the General Partner, the Ultimate General Partner, the Management Company, the Sponsor or any Approved Executive Officer may issue an offering memorandum for a new investment fund (a) with objectives, strategy and scope substantially similar to those of the Fund, unless the Advisory Board consents in writing, until the earliest of (i) the time at which an amount equal to at least 75% of the Partners’ aggregate Commitments have been invested, committed or allocated for investment, used for Partnership Expenses or Organizational Expenses or reserved for follow‐on Investments or reasonably anticipated expenses of the Fund or (ii) the date the Investment Period expires or terminates.
This clause prohibits the issuance of the PPM until the prior fund is 75% invested or committed, which at first blush seems like a good compromise. Issuing the PPM comes after fund formation and some actual sales but well before holding a close — or at least it should in theory.
In reality, what happens is that the general partner can still engage in all the activities of raising a successor fund — establishing the legal entity, creating a pitchbook and engaging in roadshows with potential limited partners — so long as a PPM has not been disseminated.
Functionally, this has the effect of allowing the manager to complete all the work associated with both forming and raising the fund simply without a PPM, which comes along at the last minute just prior to a first close. This allows the manager to technically remain in compliance with the terms of the original partnership agreement, but creates significant problems for (often slower moving) institutional investors that require the PPM to complete certain parts of their due diligence process.
Limited partners should ask ourselves what is the point of having a clause that doesn’t limit actual business activities or time but simply prevents dissemination of information.
This is not the original intent of this item.
It’s time to return to the objective of the successor-fund clause: ensuring that the general partner dedicates appropriate time to investing the assets of one fund before turning substantial business efforts toward raising the next, acknowledging that the GP cannot endure a gap of time without callable assets for portfolio company investments, since a stale pipeline or, worse, actual missed or broken deals because of an inability to close can damage their brand and hurt future performance.
An honest discussion between GPs and LPs — partners, both — and a return to simple triggers such as “may not raise” are in order because it is a partnership. How much time do we need and how much time do they need?
Actual business needs should drive the language to prevent perverse incentives and technical gamesmanship.
Christopher M. Schelling is director of private equity at Texas Municipal Retirement System.
Photo courtesy of Texas Municipal Retirement System