How to Negotiate Key Person Provisions – A Lawyer’s Guide

Introduction

The key person clause is one of the most important instruments of governance and discipline for investment funds. At its core, the key person provision helps to ensure that individuals who are identified as being critical to the prospects of the fund are focused on the investments of the fund, failing which the fund will usually be precluded from making further investments.

In this piece, we introduce the broad elements of the key person provision and closely examine some of the key aspects to keep in mind when drafting and negotiating key person provisions for private funds.

Top Considerations

We have compiled below a list of some of the significant issues that tend to arise during negotiations relating to key person provisions:

A. Who are the key persons?

Where a sponsor is attempting a new investment strategy, investors may wish to secure the time and attention of relatively senior executives of the sponsor by naming them as key persons. On the other hand, a sponsor will want to minimize the scope for interruption in the investment activities of its funds. Where a sponsor is operating multiple investment strategies, it would not want the exit of an executive who was responsible for implementing one strategy to result in investment activity for another strategy being brought to a stand-still.

B. What is the obligation on key persons?

There is scarcely any dispute about the general requirement for key persons to devote time and attention to the affairs of a fund. However, differences arise with respect to the precise formulation of the obligation i.e. just how much time and attention needs to be devoted to the affairs of the fund and during which stage of the life of the fund. Investors will want key persons to devote ‘substantially all of their time and attention to the affairs of the fund’ and this is generally the position agreed with relatively newer funds.

Where the sponsor is more experienced, it is in a position to bifurcate the obligation between different classes of key individuals. For instance, the key investment team members may be required to devote substantially all (or a majority) of their time and attention to the affairs of the fund whereas the obligation for the senior-most executives may be spread across all funds, vehicles and accounts managed by the sponsor. Increasingly, some version of the key person obligation is made applicable following the end of the commitment period. This is mainly to ensure that the sponsor is not entirely distracted by a successor fund and continues to pay attention to the portfolio of the existing fund after its corpus has been deployed.

C. When does a key person event occur?

The answer to this question may seem straightforward – if the obligation is to devote time and attention to the affairs of the fund, then it should follow that a key person event occurs when a key person fails to devote time and attention to the affairs of the fund. However, the devil really is in the detail of the key person framework. In some cases, it is clear when a key person event occurs e.g. the death, disability, retirement or resignation of a key person. But what happens where none of these events has occurred but investors nevertheless feel that key persons are not devoting adequate time and attention to the affairs of the fund? Some documents are entirely silent on the point, in which case the dispute resolution process may kick in. Other documents may provide for a bespoke determination (say by an expert whose decision will be final and binding). In extraordinary cases, investors reserve the discretion to make such a determination through a vote representing a certain percentage of commitments.

D. How will investors know that a key person event has occurred?

From an investor’s perspective, the key person provision would be toothless unless the investor is aware of the occurrence of a key person event. Therefore, there must be some obligation on the sponsor to report / notify the occurrence of a key person event. Given the importance of the key person clause, investors will often seek to attach some penalty to non-compliance with this obligation (e.g. non-compliance within a stipulated timeline may be deemed to be a bad act for the purposes of the removal provisions). Other than this, investors may look to tailor the contents of the quarterly and annual reports so that they can make an informed decision on whether or not key individuals are devoting adequate time and attention to the fund. Sponsors are likely to resist requests for bespoke reporting on the basis that it is simply not practical to prepare tailored reports for multiple investors in the fund.

E. What are the consequences of a key person event for the fund?

To recap, the occurrence of a key person event generally means that there is a material alteration in the composition of the fund’s investment team (on account of one or more individuals ceasing to be involved in the affairs of the fund). Therefore, it should stand to reason that the occurrence of a key person event should put a pause on further investments by the fund. This is usually drafted in terms of a suspension of the commitment period (or investment period). A suspension of the commitment period does not result in a complete freeze on the drawdown of commitments – the period does not result in a complete freeze on the drawdown of commitments – the sponsor is still able to call capital to complete existing investments, meet expenses and liabilities and even make follow-on investments.

Moreover, it may not necessarily be in the best interests of either the sponsor or the investors to pass up fresh investment opportunities that arise during a suspension period. Consequently, it is increasingly common for a halfway house to be agreed whereby the sponsor retains the ability to make fresh investments subject to enhanced investor oversight, which usually takes the form of prior approval by the advisory committee or a requisite percentage of investors.

F. What are the consequences of a key person event for the sponsor?

The occurrence of a key person event is materially disruptive to the operations and activities of a sponsor. For starters, the sponsor will find itself in a hugely frustrating position where it has a huge quantum of dry powder but no ability to make investments. It is worth taking a moment to understand the full import of this. An individual who is named a key person for one fund is likely to also be a key person for other funds or vehicles managed by the sponsor. The departure of such an individual is therefore likely to stymie investment activity across these funds and vehicles.

The other major economic consequence to the sponsor is a potential step-down in the management fees. Investors may require that the management fee computation during a period of suspension should operate as if the commitment period has expired i.e. management fee will be calculated as a percentage of the aggregate acquisition cost of investments that have been made rather than as a percentage of capital commitments. This could have a significant impact on the sponsor’s cash flows particularly when the cascading effect across multiple funds is considered. Sponsors are alert to the economic consequences of a key person event and actively resist the management fee cut during a period of suspension. After all, an unremedied key person event will in any event result in the termination of the commitment period.

G. What are the implications of the key person clause for the key persons?

The obvious implication is for a key person to devote the stipulated time and attention to the affairs of the fund. Given the significant consequences to the sponsor, key persons are likely to be regulated by robust employment contracts that disincentivize departures. This could take several forms including long periods of gardening leave, financial penalties and indemnity arrangements. A less talked-about aspect of key person provisions is that some executives actually push to have themselves named as key persons as a bulwark against being terminated – the idea being that a sponsor would not be minded to go through the hassle of a key person event caused by their termination.

H. Can a key person event be remedied? If so, how?

The answer to this question really depends on how the key person event was triggered. Though there is some ambiguity in the industry on how to remedy a key person event caused due insufficient attention paid by a key person, if the trigger was the death, resignation, retirement or termination of a key person, then it could be argued that the situation can be remedied through a suitable replacement. This raises two related questions: first, how is a candidate certified to be a ‘suitable’ replacement; and second, how long does the sponsor have to find a suitable replacement?

As regards the first question, it is important to remember that the identities of the key persons have a significant influence on the decision of investors to commit capital to the fund. In light of this, investors usually insist on some oversight with respect to the replacement of key persons. This takes the form of subjecting prospective key person replacements to approval by the advisory committee or, alternatively, a full-fledged investor vote

As regards the second question, the fund documents generally stipulate a specific timeline within which suitable replacements must be identified following the occurrence of a key person event – not only does this convey a degree of urgency to the task of identifying replacements but also it helps to avoid an unnecessarily long suspension period (where investors may continue to suffer management fee on an enhanced base (i.e. where there is no step-down in fees). Investors usually require an automatic termination of the commitment period in circumstances where a suitable replacement cannot be found.

Conclusion

The private equity fund model contemplates somewhat long investment holding periods during which investor capital is essentially locked in. It is therefore important that investors have confidence in the individuals charged with stewardship of investor capital during the life of the fund. The discussion in the foregoing paragraphs underscores the importance of the key person provision for various stakeholders. Given the multiple factors that may come into play in the context of a key person event, a robust key person provision could serve the interests of the investors as well as those of the sponsor.