Management Fee – You Are Always on My Mind
This Q&A attempts to answer some questions that may be on the mind of private equity sponsors who are nervous about the reactions of their LPs to the current crisis.
Can our LPs terminate our fund?
You need to check your fund agreement. According to the most recent MJ Hudson survey, 58% of private equity funds permit a majority or supermajority of LPs to terminate the fund. In most cases, though, the termination right may only be exercised after a standstill period (e.g., two years) following the final fund closing. If the fund has already made investments, it would be unwise for the LPs to force a liquidation of the portfolio at depressed values.
Can our LPs terminate or suspend the investment period?
You need to check your fund agreement. According to the same MJ Hudson survey, only 26% of private equity funds permit a majority or supermajority of LPs to terminate or suspend the investment period. Any termination or suspension would result in a step-down of the management fee. If your LPs do have this right and you are concerned that they may organize to exercise it, we recommend that you are proactive and consider the options we outline below.
Can LPs refuse to fund capital calls? Can they invoke force majeure?
Generally no. Fund agreements typically excuse LPs from participation in specific investments based on regulatory, tax, or ERISA prohibitions or limitations, but not for general economic or financial reasons. In any event, the excuse would not apply to capital calls for management fees.
We are not aware of fund agreements ever containing a force majeure clause. However, you should confirm in your fund agreement. Force majeure is a contractual concept that can only be invoked if provided for in an agreement.
We have a subscription facility in place to bridge capital calls. Can our lenders refuse to fund?
You need to check your credit agreement. Many subscription facilities include material adverse change clauses or similar borrowing conditions that may incorporate general economic circumstances. However, anecdotal evidence suggests that so far lenders have not refused to lend. We believe that funds will continue to be able to draw down under their subscription facilities so long as their right to call capital from their LPs is not questioned.
What are some of my options if, for relationship reasons, we want to accommodate LPs who have liquidity constraints or are simply concerned about funding the management fee?
Whatever you propose, you should propose to all LPs.
Under a standard fund agreement, the GP cannot excuse individual LPs from capital calls except for regulatory, tax or ERISA reasons. Strategic concerns also speak against granting individual relief.
If you do not expect to make an investment for some time, you could propose a suspension of the investment period until reactivated by you. This is likely to require LP consent. The management fee would step down during the suspension, but you would have the full remaining investment period (and the regular management fee) available once your investment activity gears up again.
Another option is to stop the clock on all fund economics: suspension of investment period and fund term, no management fee, but no ticking of the preferred return either. This would undoubtedly require LP consent. Stopping the clock makes sense only in specific situations – primarily fully or mostly invested predecessor funds with a healthy portfolio where the benefits of suspending the preferred return outweigh the foregone management fee and the PE sponsor is not relying on it to support its operations. Even if the cost-benefit analysis favors the PE sponsor, the proposal could appear attractive to LPs who dislike capital calls for management fees in the current environment.
Any other advice?
If you are towards the end of your investment period but you are not fully invested, consider asking your LPs for an extension now. They will still expect you to step down the management fee at the regular expiration date. However, the extension will give you additional time to invest remaining commitments once valuations stabilize.
Please visit our Coronavirus: Preparation & Response series for additional resources we hope will be helpful.
This information is provided by Vinson & Elkins LLP for educational and informational purposes only and is not intended, nor should it be construed, as legal advice.