Investors haven’t been in the driver’s seat for some time when it comes to negotiating terms of their LBO partnerships. Nevertheless, over the last few years they have succeeded in winning tougher key-person provisions, which are designed to protect investors in cases where key people abscond from a firm.
Several years ago, a typical key-person provision would require an automatic 90-day suspension of investments after a certain number of senior professionals named “key” in the partnership agreement left or, for some other reason, stopped devoting substantially all of their business time to the enterprise.
During the suspension the buyout shop would be expected to develop a plan to deal with the departures, and share it with backers. Once the 90 days was up, the firm would have the green light to return to investing unless, dissatisfied with the plan, limited partners voted to again suspend investments.
But key-person provisions written this way have at least two flaws, from a limited partner’s perspective. First, they don’t guard against a mass walkout of professionals below the senior level, which can be just as detrimental. And second, it is very difficult, as a practical matter, to get a majority or two-thirds of limited partners (as often required) to agree to a suspension—even if it seems clearly in their interests.Thanks to pressure from public pensions and others, many key-person provisions today address these two flaws. According to John P. Beals, a partner at Nixon Peabody LLP who often represents funds of funds and large public pension plans, the first flaw gets addressed by the addition of a second tier in the key-person provision for professionals below the senior level. One term sheet that Beals is working on, for example, calls for a 90-day suspension should either of two top partners leave (or fail to devote substantially all of their business time to the firm). However, the suspension also gets triggered should a majority of seven named principals (including the top two) leave.
In addition, said Beals, the suspension becomes permanent after 90 days unless two-thirds of the limited partners vote to lift it. This is much more desirable for LPs than an automatic lifting of the suspension, given the difficulty of obtaining an LP vote to suspend investments. In about half the partnership Beals works on today the suspension becomes permanent after 90 days unless lifted by the limited partners; in the other half, LPs must still vote to continue the suspension.
Investors have been smart to pay attention to the key-person clause. In the past decade, a number of senior professionals have left buyout shops to form their own firms. And while they often wait until the end of investment periods to do so, they don’t always. With so much money available for funds today, and a growing appetite by investors for new managers to back, the temptation to set up new shops has probably never been greater. Buyout firms have also lost top people to mishandled succession plans.
Perhaps buyout pros have been feeling in a generous mood on the key-person provision, particularly since it’s not a term that impacts fees or profit-share. That said, LPs show more muscle at the negotiating table than they generally get credit for. The request for stronger key-person language, said Beals, came “not just from isolated LPs, but from many of the biggest public pension plans, who were in any given fund making the largest commitment.”
Buyout firms have discovered the virtues of clubbing up on deals. Maybe it’s time for more LPs to do the same.
Look for this and other insights into the buyout market in the January 22 edition of Buyouts Magazine (subscription required). Highlights:
* Plans by top limited partners for 2007 buyout fund commitments
* List of LBO shops expected to launch funds this year;
* Analysis of a proposed SEC rule that would make it more difficult for buyout pros to let friends and families invest in their funds;
* In-depth look at why 2006 was a year Cypress Group would probably like to forget;
* Look into growing appetite for infrastructure investments at California State Teachers’ Retirement System;
* Rundown on the dangers of working with unregistered broker-dealers.