Investor Protections In Private Equity: What We Are Seeing Now And What You Should Expect In 2019

Every year, MJ Hudson surveys the terms of a large, diverse sample of in-market private equity, venture capital, growth capital, infrastructure, real estate and private debt funds, where we have advised either the fund manager or a prospective investor. In this article, we examine what's happening to key investor protections in fund documents, and we'll wrap up by looking at how the market might move in 2019.

Removal for cause

GP removal is the "nuclear option" of investor protection. There are two types. "Removal for cause" allows investors to vote out the management team in the event that they commit some serious error, such as fraud, gross negligence, material breach of the fund documents, bad faith, wilful default or violation of securities laws.

Removal for cause is almost universal in fund documentation: 93% of the funds in our 2018 survey provide for it. In our survey, 44% of funds allow removal for cause by investors representing a majority of committed capital, with a two-thirds majority being the next most popular (favoured by 33% of sampled funds).

Investors do not take removal decisions lightly, and removal for cause provisions are often hedged with conditions that make them less trigger-prone:

The GP may only be removed for cause if its liability is determined by a court - often, in a non-appealable final verdict.

Investors may have to show that there has been a materially adverse financial effect on the fund.

The procedure may be made more cumbrous, for instance by requiring removal to be voted on at an in-person meeting of LPs, in contrast to most LP consents, which can be obtained fairly quickly via written resolutions circulated by email.

Management often gets to keep a portion of carried interest post-removal. Only a quarter of funds in our sample imposed a 100% haircut, whereas the remainder allow the former GP to retain at least 50% of its carried interest.

Removal without cause

The second type of GP termination is removal without cause, also known as "no fault divorce", i.e., regardless of whether the GP has done anything wrong. It is more restrictive than removal for cause:

Investors who want a no fault divorce will invariably need to command the support of an even bigger majority than is needed to remove the GP for cause - generally, somewhere between 75% and 90% of committed capital.

Many funds also institute a grace period of one to three years, during which investors cannot trigger removal without cause.

No fault...