Most young couples planning their wedding don’t think about the possibility of divorce. When blinded by love, negotiating a prenuptial agreement isn’t top of mind — perhaps rightfully so if “till death do us part” is to have any real meaning. Unfortunately, a bleaker reality often intrudes; roughly 45 percent of marriages in the U.S. end in divorce, according to often-cited statistics.
But hiring an investment manager isn’t really like getting married — indeed, an old trading adage is that one should never get married to a position. While it doesn’t make sense to enter into a transaction expecting to break up with your counterparty, you should always be prepared for it. After all, managing risk is quite literally about changing your mind, and changing positions as necessary, if macro or micro conditions warrant.
But sometimes — in relationships and in portfolio management — it’s complicated. Take private equity, where breaking up is hard to do because of the illiquid nature of the asset class, but also because of the structure of the limited partnership agreements, or LPAs.
At 150 to 200 pages of dense legalese, LPAs are nothing if not thorough, detailing every aspect of the strategy, costs, and governance of the fund. During negotiations, limited partners have the ability to opine on issues such as how long the fund’s investment period is, what authority the limited partner advisory committee has, and what fees should be charged — often with little effect.
It’s important to prioritize negotiating for the most critical items precisely because you can’t get everything you ask for. And while they’re all important to understand, perhaps no item is more critical to the governance of the partnership than that related to the removal of the general partner, otherwise known as the divorce clause.
There are two main types of GP removals. One clause is for removal upon what’s known as a cause event. This item usually defines a series of actions or behaviors which, if the GP is found to engage in, allow the limited partners to kick the GP out with a simple majority vote, either terminating the partnership or hiring a replacement general partner.
Seems reasonable enough, but the problem comes from how a cause event is defined. LPAs commonly define cause as “a final adjudication by a court or governmental body…of embezzlement, fraud…criminal conviction of a felony…material violation of securities laws,” and so on.
The challenge is that “final adjudication” qualifier. This often means a cause event cannot be found to have occurred until all venues for possible appeal have been exhausted.
Now, we all know how slowly the wheels of justice turn. Even if the GP is literally stealing from the fund, LPs may have to wait five, maybe ten years for the judicial process to inch forward, with virtually no recourse to stop the ongoing activity, until final adjudication in a court of law. Only then could a vote be brought to the partnership.
This essentially means there is no removal cause, because the fund could be done by then anyway.
On the other hand, a no-fault divorce clause permits limited partners to bring forward a vote to remove the general partner for no reason at all, subject to a super majority vote, often 75 percent to 90 percent. In practice, this is never done for spurious reasons, as limited partners all have return targets that must be met, and it is no trivial thing to consider an action that will almost certainly reduce potential gains. It is only with the near consensus of LPs — ostensibly all sophisticated investors — that drastic action is needed to maximize recovery of value that such a vote could pass.
Our investment team has first-hand experience at a previous employer of the importance of a no-fault removal clause. During the ongoing monitoring of a legacy fund in the portfolio some years ago, we encountered significant discrepancies in the calculation of the portfolio company valuations and our capital account balance. Some things just didn’t add up.
Other investors had similar concerns — and apparently, so did the FBI. Upon the arrest of the founding partner for embezzling funds from the partnership, we were able to lead a successful no-fault removal vote, ultimately putting a new restructuring-focused GP in place to manage the partnership through to liquidation. No small feat and not a great outcome, but one which would have been considerably worse if delayed by years of court proceedings before a removal vote.
Despite the infrequency of such occurrences — far less than the 45 percent of star-crossed lovers above — why would any reasonable GP resist such a term, as long as the supermajority threshold is high enough?
I’ve never heard a really good reason, but they almost all do.
According to the Private Equity Fund Terms Research report published by MJ Hudson, just 18 percent of U.S.-based private equity funds contain a no-fault divorce clause. Across the pond, however, a full 73 percent of Europe-domiciled PE vehicles do provide limited partners this important removal right. (And most of those that don’t are the European products of American general partners.)
Whether or not you think couples should consider a prenup before marrying, U.S. limited partners should be pushing our GPs a great deal harder on the inclusion of no-fault divorce clauses in LPAs. If something goes wrong during the relationship, it’s really the most meaningful lever we have to protect our assets during a messy breakup.
