This article considers both fund documents and management documents, analysing the topics that are typically covered in each set of documents. The key terms negotiated between the fund manager and the fund investors are examined, and practical guidance is provided on how each set of documents should be drafted to ensure that the key terms agreed are correctly translated at both the fund level and the management level.
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During the fund formation process, finalisation of the fund terms and fund documentation often receives priority over any ancillary documentation. However, it is also crucial to determine both the management documentation and how relationships are governed at the management level before the fund launch. Of course, this is important not only for the individuals who are behind the fund manager, but also for the fund investors, who usually wish to sign off on management documentation. Fund investors take an interest in the arrangements between the key individuals running the management entity of their fund, and the interaction between the fund documents and the management documents is of significant importance for both fund managers and investors. Not only do the key terms governed by both sets of documents become the crux of the negotiations between fund managers and fund investors, on a practical level it is imperative that the agreed terms are properly drafted so that, even though they are separate documents, there are no discrepancies between them when both sets of documents are viewed together. This is vital, as in order to be effective certain terms must be considered and ensured at management level before they will be effective and provide protection for the investors at fund level.
While most of the topics covered in this article are important and affect the documentation at both the fund level and the management level, the intention is to focus on the management side of things. The article will cover the following matters:
A short description of the documents that comprise fund documents and those that comprise management documents, with an overview of which topics would typically be covered where.
The key terms that are the commercial drivers for the negotiations between the fund manager and the fund investors. The article will briefly introduce these key terms and current market trends, while providing more practical guidance on how the outcome of these negotiations is dealt with in practice and translated by drafting those terms at both the fund level and fund management level, as appropriate.
A few key tax issues that are of principal concern to the individuals running the fund management and some structuring tips to ensure taxes are minimised at the management level.
At this point it is worth considering some typical fund structures before embarking on a more detailed discussion regarding fund documents and management documents and their contents. If the fund is a partnership, then the fund manager will typically be the general partner. In most jurisdictions, the partnership does not have separate legal personality, meaning that a fund that is a partnership cannot hold assets and liabilities in its own name. The general partner (the fund manager) is entrusted with representing the partnership in regard to its business activities, and the general partner's liability is unlimited. The investors of the fund would be limited partners of the partnership and, barring exceptional circumstances, the liability of the limited partners is limited to their partnership contribution (in other words, the amount of capital contributed, or agreed to be contributed, by the limited partners to the partnership). In a fund with a partnership structure, it is not uncommon to also use a separate limited partner vehicle as the recipient of the carried interest. This avoids having the carried interest flow into the general partner with unlimited liability, thus making the carried interest amounts susceptible to any creditors of the general partner and the partnership. This carried interest vehicle is often called the special limited partner, and it enjoys the benefits of limited liability like all other limited partners, protecting the carried interest.
If the fund is a limited liability corporate entity, the fund entity itself will enjoy the benefit of limited liability. In this structure, the management entity can be the recipient of the carried interest as board member.
In most cases, the key persons and senior members of the team are the shareholders of the fund manager/general partner and the carried interest vehicle. This article uses the term "key persons" to cover all such individuals.
It is important to remember that both the fund documents and the management documents each govern a separate set of relationships. The fund documents regulate the relationships between the fund, the fund manager and the fund investors. The relationship between the fund manager and a third party investment manager assisting with the running of the fund is also covered at this level. The management documents, on the other hand, establish the understanding between the fund manager's shareholders and, where necessary, the carried interest recipient.
Documents that typically comprise fund documents are:
The fund agreement (a limited partnership agreement, if the fund is a partnership, or a shareholders agreement or membership agreement, if the fund is a corporate entity).
The fund's articles of association (if the fund is a corporate entity).
If desired (since this is not always necessary), an investment management agreement with the fund manager (usually if the fund is a corporate entity engaging a third party fund manager).
Investment advisory agreements with any third party advisors hired to assist the fund manager/general partner.
Subscription agreements with the fund investors.
Depending on the fund structure, there may be more ancillary documentation at the fund level, but these are the documents that one would typically see.
Documents that typically comprise management documents are:
The fund manager's shareholders' agreement (if the fund is a partnership, the fund manager is the general partner of the fund and the document would be the general partner's shareholders' agreement).
The fund manager/general partner's articles of association (if that entity is a corporate entity).
The carried interest vehicle's shareholders' agreement (if the fund is a partnership, the carried interest vehicle is usually a special limited partner and the document is a special limited partner shareholders' agreement).
The carried interest vehicle's articles of association (if that entity is a corporate entity).
Again, depending on the fund structure, there may be more ancillary documentation at the management level, but these are the most typical and recognisable documents in any structure.
Terms affecting both the fund documents and the management documents tend to be key points, which are negotiated between the fund managers and the investors because they are commercially important for both parties. Coming to an agreement on these terms is the first step, but they must be properly translated into the documentation (often both at the fund level and management level) to ensure they provide adequate protection. We will now discuss some of these terms, providing practical guidance on how these terms are reflected both at management and fund level.
Types of removal. Terms governing fund manager/general partner removal are often heavily negotiated. It is in the fund manager/general partner's interest to ensure that it cannot be easily or unjustifiably removed, whereas it is in the fund investors' interest to remove fund managers/general partners who are detrimental to the business and/or the fund's reputation. Removal provisions are also controversial, as the categorisation of a removal has an impact on the compensation that the leaving fund manager/general partner (and/or its affiliates) is entitled to. Removal provisions are usually categorised in the following ways:
A cause removal. This is where the fund manager/general partner has committed an act that warrants removal, such as fraud, gross negligence or a breach of law. In this scenario, the fund manager/general partner typically forfeits all unpaid and accrued carried interest and management fees.
A no-fault removal. This is where the fund manager/general partner has not committed an act to warrant removal, but can still be removed with a sufficiently high percentage of fund investor votes. In this scenario, the fund manager/general partner is entitled to some remaining management fee payments, and there is a compensation scheme negotiated for the carried interest (see below, Carried interest).
Note that actions committed by the fund manager/general partner's affiliate can also give rise to the application of these provisions.
In addition to removal of the fund manager/general partner, the fund document will usually contain provisions on the removal of key persons (the individuals who are often behind the fund manager). These provisions are usually categorised in the following ways:
A bad leaver removal. This is where a key person has committed an act that warrants removal, such as fraud, gross negligence or a breach of law. In essence, this is the same as a cause removal of the fund manager/general partner.
A good leaver removal. This is where due to events that are not deemed cause events (for example, death or disability), the key person is removed as a key person of the fund. Note that some fund documents do not have a good leaver removal provision, but instead have a "key person trigger event provision". In this instance, certain consequences apply if a sufficient number of key persons do not devote an agreed amount of time (usually substantial business time) to the fund, due to any number of reasons (for example, death, disability, voluntary departure, and so on). If these types of provisions are included, it is usually superfluous to include other similar provisions (such as good leaver provisions).
Note that the removal of a key person, particularly if that key person is a bad leaver, can give rise to a fund manager cause removal. If the fund investors are especially demanding, they could even argue that a key person trigger event should give rise to a fund manager cause removal. This is most likely to happen if a succession plan or rectifying arrangement has failed. This kind of detail is at the forefront of removal provision negotiations.
The definitions for "cause removal", "bad leaver", "good leaver" or "trigger event" are often negotiated at the fund level (for example, should the bankruptcy of the fund manager/general partner warrant a cause removal?). However, unavoidably the outcomes of these negotiations have an effect on the management documents.
A breaching key person. The management team will usually insist that appropriate consequences apply to both:
A key person(s) who commits an act that leads to their bad leaver/good leaver removal that the fund level (the "breaching" key person(s)).
A key person(s) that causes the cause removal of the fund manager/general partner entity as a result of their actions.
Similar provisions are usually applied in the case of a key person trigger event, since these actions have an effect on the whole management team.
As the actions of a breaching key person have consequences for the amount of compensation payable to the fund manager/general partner at the fund level, the management usually seek to penalise a breaching key person at management level. For example, a breaching key person may be forced to forfeit their share options in the fund manager/general partner and carried interest vehicle to other non-breaching key persons (see below, Important topics in a fund manager/general partner shareholders' agreement).
To ensure that both the concepts and definitions of "cause removal", "bad leaver", "good leaver" and "trigger event" are consistently dealt with in both sets of documents, it it advisable to make cross-references in the management documents to the relevant removal provisions contained in the fund documents when describing the consequences that will apply to a key person triggering those provisions.
In cases where the triggering event is not caused through the fault of a key person, it is usually good practice to divide any compensation due according to the fund manager/general partner's shareholding (or the shareholding of the carried interest vehicle, where applicable)
No-fault removal. At the fund level, it is becoming more and more common to see a no-fault removal provision, where the fund investors (usually with a supermajority consent threshold) can elect to remove the fund manager/general partner. Since no event constituting cause is required, this provision is usually applied where the fund manager/general partner is simply not doing a good job (for example, on the business side).
In this scenario, the management documents usually remain unaffected, since no one key person is penalised. Compensation is usually divided according to the designated shareholding of the entity receiving the carried interest at management level.
However, there is potentially an area of concern that needs highlighting here. Where a no-fault removal occurs after the end of the investment period, this means that all investments have been made, and the replacement fund manager/general partner will not make any new investments. Since the carried interest that will come in is only attributable to the investment made by the removed fund manager/general partner, how can the replacement fund manager/general partner be incentivised? Consideration should therefore be given to whether it is wise, in these circumstances, to allow a removed fund manager/general partner to remain entitled to all carried interest from all investments made prior to their removal. Examples of various compensation schemes that can be applied in the event of a no-fault removal are discussed below, seeCarried interest provisions.
It is important to keep in mind that removal provisions are generally tailored to suit each particular fund. However, care should be taken to ensure that the terms concerning removal provisions are adequately translated at the management level.
Carried interest provisions are in addition to, and connected with, removal provisions. These provisions are also at the forefront of any negotiation, since the carried interest compensation is the fund manager/general partner's bread and butter. While fund investors understand that fact, they also want to ensure that the fund manager/general partner is sufficiently incentivised to act in a manner that is acceptable from the fund investors' point of view.
A notable provision concerning carried interest is the clawback. The clawback is designed to ensure that the fund manager/general partner does not receive more carried interest than it is entitled to. A clawback obligation represents the fund manager's promise that, over the life of the fund, the fund manager will not receive a greater share of the fund's distributions than agreed (this amount is typically 20% of the fund's cumulative profits). Since the cumulative profits of the fund are variable until the end of the life of the fund, if carried interest has been paid during the life of the fund, a final calculation of the cumulative profits will be made at the end and the fund manager will be required to return to the fund's investors any amount considered to be "excess" distributions.
Another notable provision is the clawback escrow. This adds another layer of protection for fund investors, ensuring that in addition to the clawback provision itself, there are sufficient funds available to fulfil that clawback obligation. Clawback provisions by themselves provide no absolute guarantee that the money due under them will be returned, since the fund manager may have already spent that money before the clawback provision is applied. To protect themselves from this credit risk, some fund investors demand an escrow account where the carried interest, when accrued and payable, must be paid into. Heavy negotiations often surround the details of the escrow (for example, whether the escrow should be the fund manager's separate account or that of a third party custodian, when the escrow should be released making the carried interest payable to the fund manager, what percentage of the carried interest should be paid into the escrow account, and so on).
The final provision that should be considered concerns what happens to the carried interest entitlement in the event that a fund manager is removed. Since a cause removal usually results in the forfeiture of any entitlement to carried interest, it is necessary to consider what happens in the event of both a no-fault removal and a removal that occurs as a result of a key person triggering event (where that is not treated as a cause removal). There are several compensation schemes that can be put in place, including:
A linear vesting arrangement (sui temporis), with more carried interest payable where the fund manager has been working with the fund for a longer time period.
Fair value compensation at the time of removal.
The entitlement to carried interest is attributable only to those investments made prior to removal.
Provisions concerning carried interest compensation tend to be fund specific, but in all cases care should be taken to ensure that any replacement fund manager is properly incentivised.
While the fundamentals concerning carried interest terms are negotiated at the fund level (from both the fund manager and the fund investors' viewpoints), it is important to ensure that any terms agreed are properly translated at management level. For example, there is no point having a clawback provision unless the management documents also ensure that in the event of that clawback, the shareholders of the carried interest vehicle (effectively the individual key persons themselves, as the ultimate beneficiaries of the carried interest) are also obliged to to clawback their portion of the carried interest, in order to enforce the clawback provision at fund level.
Similar care should be taken if there is an escrow arrangement. It would be unwise to promise the shareholders of the carried interest vehicle payment of their portion of allocated carried interest every year, if in reality that carried interest is sitting in an escrow account until the end of the life of the fund. The provisions that govern what happens to carried interest must be documented clearly to ensure that no inconsistencies or conflicts arise when the fund documents and management documents are viewed together.
This article has focused on the key terms that affect management at the fund level, and how those terms should be dealt with at the management level, but it is also important to consider how terms agreed at management level can be drafted to ensure that they comply with the fund documentation. We will now consider some of the key provisions contained in the management shareholders' agreement, providing practical guidance on how to ensure that the terms contained in that agreement are consistent with the contents of the fund documents.
The fund manager/general partner shareholders' agreement can contain an involuntary removal section, if the parties wish. This is not to be confused with the involuntary removal (that is, the no-fault removal) provision at the fund level, where the fund investors can remove the fund manager/general partner without cause. In this scenario, the fund manager/general partner's shareholders can remove another shareholder using an agreed percentage of votes. In effect, a majority of the key persons can elect to remove another key person. This type of provision can be qualified to avoid the situation where a few key persons effectively "gang up" on another key person (for example, by limiting the application of the provision to certain circumstances, such as the key person's failure to perform their duties).
There are various ways in which the fund manager/general partner shareholders' agreement can deal with this type of removal. One possible arrangement is one where the remaining key persons have the option to purchase the removed key person's shares in the fund manager/general partner. These provisions should be clearly expressed in writing and provide details on the following matters:
The purchase price of the option shares.
Whether each key person can only purchase an amount of shares that is pro rata to their shareholding, or whether certain key persons (or all key persons) can purchase shares in excess of their shareholding.
What happens if a key person fails to exercise their option rights.
This article assumes that all key persons are treated equally, but further complications can arise where arrangements differ among senior key persons and more junior key persons, or "real" key persons and seed investors who happen to have a share of the general partner/fund manager.
At the fund level, investors will often require the fund manager/general partner shareholding and the carried interest entitlement to remain with a certain percentage of the management team (for example, 80%). Therefore, option rights for remaining members of the team can work very well in practice, since this kind of provision can help avoid a change of control scenario, which could in turn trigger a removal provision.
Transfer provisions are important provisions in any shareholders' agreement. The fund manager/general partner shareholders' agreement will usually contain restrictions on how shares can be transferred. This is natural, since the shareholders (as key persons of the fund) are active managers of the fund and not passive players. It is not unusual to have a very high percentage of votes (or even unanimity) as a requirement in approving a transfer of shares and a new shareholder.
Some limited exceptions can be incorporated into the general provisions on the transfer of shares to cover, for example, the death of a shareholder (and terms can be included to ensure that the heirs of that shareholder retain the relevant shareholding). Again, these arrangements must be carefully incorporated to ensure continued compliance with the agreements made with fund investors at the fund level. Fund investors will be keen to know transfer details at the management level, since they have entrusted their money in the belief that certain individuals will run their fund.
It is also not uncommon for the existing shareholders of the fund manager/general partner to have an option to purchase shares before they are offered to third parties. Again, the options procedure must be clear in the management documents. Care should also be taken to ensure that, in any event, no transfer can take place which would result in a breach of the fund documents. It is common for fund investors to insist that a certain percentage of the fund manager/general partner entity's shareholding (and, if separate, the carried interest vehicle) must remain with key members of the team (perhaps with some limited allowances to transfer shares to incentivise senior employees, without approval). Since a breach of these provisions can potentially result in fund manager removal, it is important that the share transfer and new shareholder provisions at the management level do not create such a situation.
A final point to consider concerning additional shareholders is that the fund documents will often contain terms requiring the fund investors' approval of a new or replacement key person, in the event that either:
A key person is removed.
The team want to add an additional key person.
It is a good idea to ensure at the management level that all shareholders must approve any new key person as an additional shareholder of the fund manager/general partner (and the carried interest vehicle). In addition, it should be agreed at the management level that all shareholders will do whatever is necessary to transfer both shares and the carried interest entitlement to any new key person, ensuring that they are recognised as a key person at the fund level.
Provisions governing how removal and trigger event consequences at the fund level should be translated at the management level should also be incorporated into the fund manager/general partner shareholders' agreement.
If the occurrence of particular event causing detrimental consequences for the fund and its management can be attributed to a particular key person, then arrangements can be contained in the shareholders' agreement to penalise the key person causing that breach.
Options can be incorporated into the shareholders' agreement giving non-breaching key persons the right to purchase a breaching key person's shares where the breaching key person either:
Breaches the fund agreement.
Breaches the shareholders' agreement.
Triggers a removal or a trigger event under the fund agreement.
Effectively, this would exclude a breaching key person from receiving their entitlement to any carried interest that would flow in, even in the instances where any entitlement to carried interest would be forfeited at the fund level anyway.
The carried interest recipient can be a separate vehicle from the fund manager/general partner vehicle, particularly where the fund is a partnership. A few key points should be made about this entity and its shareholders' agreement.
Naturally, the shareholders of a carried interest vehicle usually closely correlate with the shareholders of the fund manager/general partner, as the individuals managing the fund usually receive the carried interest as compensation. If a separate carried interest vehicle is used, then any arrangements concerning the payment of carried interest at the management level (for example, clawback from the individual ultimate beneficiaries of the carried interest) are contained in the carried interest vehicle's shareholders' agreement, rather than in the fund manager/general partner shareholders' agreement.
The relationship between the fund manager/general partner shareholders' agreement and the carried interest vehicle shareholders' agreement is important. The two documents should be viewed as one document, and should closely mirror each other in most respects. Since one vehicle is being compensated for the work of the other, it would not make much sense if the two were not closely linked. The same provisions concerning breaching key persons, and any options on their shares, should be contained in both documents. In practice, it is commercially and logically sound for a loss of fund manager/general partner entity shares to result in a loss of the shares in the carried interest vehicle. There is little point in removing a key person from management but letting them retain their carried interest entitlement. Similarly, no manager would agree to retain the risks associated with holding the fund manager/general partner shares whilst receiving no benefits from the carried interest vehicle's shares.
At the fund level, it is worth considering whether the carried interest vehicle should be automatically removed in the event that the fund manager/general partner is removed. If the carried interest vehicle is also investing the management team's own money as a passive investor, then it may be reasonable to leave that entity as it is, since that entity is not part of the active management of the fund (unlike affiliated investment managers and advisors, who are usually removed alongside the fund manager/general partner).
As the balance of power continues to shift between the fund managers and the fund investors, as has been the case for the past few years, the provisions in the fund documentation with respect to management removal and compensation will continue to be the most important areas where fund managers will try to position themselves in the most favourable way possible. Once a mutually acceptable commercial position has been reached by both sides, they must not fail to think through how the commercial terms will affect, and how the execution of those commercial terms as envisioned is dependent on, the arrangements that have been agreed at both the fund level and the management level.
Qualified. The Netherlands, 1994
Areas of practice. Cross-border private equity investments; legal and tax aspects of pan-European fund structuring.
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Qualified. The Netherlands, 1994
Areas of practice. Investment funds; M&A; general corporate.
Qualified. New York State, US, 2007
Areas of practice. Investment funds; private equity; general corporate.