What happens if you set up a key man rule in your fund and no one pays attention to it?
That question came up in a squabble between a fund-of-funds called Bay Hills Capital and Kentucky Retirement Systems, the single investor in four of its funds-of-funds.
Bay Hills sued KRS, claiming that the pension fund is trying to wrest control of Bay Hills’s funds using trumped-up charges of for-cause breaches of fund contracts.
Kentucky’s effort is part of a strategy to bring more investment management in-house, Bay Hills claimed in the lawsuit, filed earlier this month in Delaware Chancery Court.
Kentucky made various charges in seeking to oust the GP, including that Bay Hills collected a share of fund profits too early and that the firm manipulated expenses, among other things, the lawsuit said.
The firm answered that the early carried interest was due to an inadvertent error, and that the expense structure was agreed to by Kentucky, the filing said.
The issue I’m focused on here is the key-man provision in the third fund. Bay Hills’s third fund-of-funds tripped a key-man provision in October 2016 when “an important employee” left the firm, the lawsuit said.
I’m not clear on exactly who left, but a look back at Bay Hills’s history shows that at least three partners no longer work at the firm. The executive in question could be ex-partner Philip Godfrey, who left Bay Hills in September 2016 and went on to join Cliffwater, according to his LinkedIn profile.
The firm lost two other partners earlier: David Smith left in 2013 to become treasurer of Syracuse University and Albert Chiang left in late 2014 and joined Sobrato Capital, his LinkedIn profile said.
The key-man trigger in Fund III, like in most private equity funds, gave Kentucky, as sole LP, a few options. As usually happens, KRS could choose to negotiate with the GP to keep the fund going and maybe ask for some kind of fee break.
As per the fund contract, Kentucky could also ask to dissolve the partnership and either liquidate the assets or receive its shares in the fund to manage out itself. KRS wanted to take over the fund assets and manage them in-house, the lawsuit said.
Here’s where the problem arose for Kentucky. The pension system had the right to terminate the partnership and receive its shares in the assets, but a fund-of-funds structure is different than a straight-up buyout fund. In a buyout fund, the LP would receive shares in the private assets, which it would then have to figure out how to manage or sell.
In a fund-of-funds, Kentucky is simply receiving its LP stakes in underlying funds, which it could put into its portfolio of other LP stakes. But each underlying GP in the fund-of-funds must approve the transfer. In this case, only two out of 10 underlying funds gave Kentucky the nod, the lawsuit said.
“Most underlying funds are not going to want to partner with KRS directly for a variety of reasons, not the least of which is that KRS is plagued by mismanagement and one very public scandal after another,” the lawsuit said.
Bay Hills said it tried to work with KRS to simply sell its stakes in the funds on the secondary market, lined up a bid and offered to work to improve the offer, but was rejected by KRS, the lawsuit said.
Instead, KRS asked Bay Hills to help it get consent from the underlying funds, but later told Bay Hills to back off. While two of the underlying funds consented to the transfer, the others did not, and some complained about KRS’s allegedly “deceptive conduct,” the lawsuit said.
One GP allegedly complained that KRS falsely claimed or insinuated it was making better progress at getting consent than it really was, even allegedly using a blank transfer agreement from one underlying fund to suggest the GP had agreed in principle to consent.
All of these accusations are from Bay Hills; I don’t have KRS’s side of the story because the system has not yet filed a response. And a spokesman declined to comment. So I’m pretty excited to hear what they have to say (because LP/GP squabbles = fun).
Meanwhile, though, this is a pretty interesting fight over a key-man issue, which is one of those fund terms of grave importance to LPs.
Investors, like public pensions, that commit millions of dollars to PE funds want to ensure that the team they’re backing stays on board through the 10 years (lol) of a private equity fund’s life. They do this through key-man provisions that allow them to terminate the fund, or immediately end a fund’s investment period, when a key executive or executives leave.
But as Bay Hills said, I don’t recall ever seeing an LP actually go for the nuclear option of dissolving the partnership. I know it happens in bad situations with terribly performing funds, but in this case Bay Hills’s funds have been strong performers.
Overall, the four funds-of-funds invested $139 million and created more than $335 million of returns and investment value, including around $117 million of distributions to date, the lawsuit said.
It gives Bay Hills’s theory that this is a public pension land grab a bit more weight.