While we advise on this topic daily, hopefully most of our fund clients will only have to think about matters related to the departure of senior investment professionals, i.e. managing directors (MD’s) a small handful of times in their organizational lives. Having an MD depart your firm is not a “blip on the radar screen” moment, as such occasions can have wide ranging structural, economic, strategic and even emotional impacts on the entirety of the firm.
In order to navigate these potentially choppy waters, a firm should prepare well in advance for – or at least educate itself as to – the various issues and considerations than can arise in such a situation. This education and preparation process should begin at the inception of the firm, with thoughtful consideration of the terms of the governing agreements of the management company and first general partner (GP) entity, which will become a critical base of support for the firm’s long term health. The analysis should not stop there, however, as a firm should re-visit these issues throughout its life based on the particular circumstances it faces and experiences it may have. The approach here must be dynamic and flexible, as if you simply analyzed and drafted a form of these agreements 20 years ago and continue to simply “clone” them over time, you may be missing out on capturing more recent market practices which can serve to better protect the organization in the face of MD departures. Our most mindful clients regularly engage with us to strive to have the most company favorable terms in their documents, with a view of organizational health and stability.
While each MD departure situation has its own unique attributes, when counseling clients in these circumstances we generally cover the same basic list of issues and considerations as a starting point for helping our clients find the best way forward. Most often, the resolution of these issues between the firm and the departing MD is encapsulated in some form of separation and transition agreement that is drafted by us, as fund counsel, in conjunction with our employment lawyers to assist with the employment-related considerations. What goes into such an agreement and what are those core issues that a firm can expect to deal with an manage around when an MD departs? Let’s tackle them in turn.
What do existing governing agreements provide?
The starting place for analysis in the face of an MD departure is to look at the “upper tier” organizational documents referenced above. As stated, these set up the basic set of ground rules for the departure. These agreements may differentiate treatment of a departing MD based on whether the MD is departing voluntarily or involuntarily, and in the latter scenario whether such departure is “for cause” or “not for cause.” The governing agreement for management company entity, if drafted with a company viewpoint in mind, is likely to have a “buy back” provision where the management company can repurchase a departing MD’s interest therein for some price (e.g, the relative capital account balance of the departing MD as of the departure date), though in some cases there may be more complex pre-negotiated severance terms in the agreement that have to be considered and complied with.
For GP entities, the underlying agreements very likely will have: (1) a set of vesting rules in place that apply to the departing MD’s carried interest therein; (2) rules about the MD’s capital commitment to the GP entity on a going forward basis, which may call for full contribution or may scale back the commitment to allow others to take up the corresponding investment; and (3) many other smaller rules, for example regarding potential future dilution for admission of additional members, ongoing obligations, etc. Importantly, some agreements that are very company favorable may have complete buyout provisions at the GP level (including of all vested components, like vested carry) to permit the GP entity to “entirely rid itself” of a difficult departee, such as one that leaves amidst a lawsuit or goes to work at a competitor. In the case of both management company and GP entities, the departing MD also almost invariably loses his or her future right to vote and any other management authority with respect to matters related to these entities.
Timing of departure
While most often not an agreement driven issue, from an organizational perspective the timing of when an MD departs can be crucially important and should be carefully planned in advance, if possible. For instance, the timing of when an MD departs can potentially disrupt fund raising, raise securities laws issues (e.g., if the departure occurs soon after a fund has closed and the firm knew of the departure before the closing happened), implicate key person clauses in underlying fund partnership agreements (see more on this below), give rise to potential tax implications to a departing MD and the firm, and so forth.
In addition, if the departing MD is going to stay on as a consultant or serve in a lesser role than the historical one, thought needs to be given to the time periods for this type of multi-step transition and what it may mean for other issues, such as vesting.
Circumstances do sometimes mitigate that someone be immediately removed from employment with the firm (e.g., the departing GP has died, committed a crime or engaged in other salacious behavior), and in these cases timing is a triage matter as opposed to part of a dutifully considered transition plan. In any event, as you can see, the timing of when an MD departs can in certain circumstances be almost as important as the terms negotiated around such departure.
Compensation and equity interests
Depending on the circumstances and negotiated terms, the departing MD may receive severance payments or some form of transition period compensation if his or her level of engagement with the firm is scheduled to sunset over a negotiated time. As mentioned above, in a minority of cases the management company governing agreement may have pre-negotiated severance terms that must be complied with as well. A benefit of a firm paying additional compensation (i.e., compensation the departing MD is not already entitled to) is the firm’s ability to demand a release of claims in connection with the granting of such additional compensation. In addition to the separation agreement setting forth any residual equity and similar interests that the departing MD will obtain in the relevant upper tier entities (as mentioned above), it will also cover treatment of any parallel or side fund interests retained by the departing MD.
Messaging of departure
One of the most fundamentally important items to fully set forth with any departing MD is how, when and to whom either the firm or its personnel on the one hand and the departing MD on the other will communicate with the outside world regarding the MD’s departure. Most often, a full set of negotiated talking points are mutually drafted and a communications plan is put in place fully setting forth the details applicable to all parties about what they can and can’t say, to whom and when. The separation agreement will also often have a specific requirement for this communications plan and attach the talking points as an exhibit so all sides are on the same page regarding proper communications regarding the MD’s departure. This kind of concerted effort ultimately benefits everyone and provides a good playbook to follow.
The firm owns its track record but departing MDs will often seek to negotiate under what circumstances they will be allowed to use certain data for their future activities, particularly data surrounding the deals they have led or been involved in. Often the management company and GP entity governing agreements, if drafted properly, will have provision regarding ownership of track record and permit a departing MD to disclose a limited set of information in the future (and under what circumstances such disclosures may be made; for example, perhaps with advance consent as to form of disclosure by the fund manager). In absence of any such provisions, the negotiations on this issue can get a bit more muddied and contentious, but firms should be aware that this will likely be one of the key points up for negotiation in relation to an MD departure.
One of the most impactful legal provisions that a firm should be obtaining from a departing MD is a full release of claims against the firm, its personnel and affiliates. This is even more true in a contentious departure. Often the departing MD will ask for this to be a mutual release, which may or may not cause the firm heartburn depending on the circumstances surrounding the departure. The release question is a big one and should be fully considered with the input of counsel given the potential ramifications involved.
Key person test
Any potential or actual departure of an MD should cause the firm to look carefully at all applicable key person provisions in their fund partnership agreements. Triggering a key person provision can lead to whole host of consequences for the fund manager, from automatic suspension of a fund’s investment period to potential rights of the LPs to vote to terminate the fund (and other possibilities in between). Accordingly, as the timing of the departure is considered, the effect on the key person provisions should be considered and planned for carefully as well, to the extent feasible.
Other negotiated topics
Other considerations and issues that are often dealt with by firms facing a GP departure, typically housed in the separation agreement, are as follows:
- Continuation of health, dental and vision benefits
- Continuation of 401(k) and other similar retirement benefits
- Expense reimbursement
- Return of company property
- Continued use of office & secretarial support
- Future cooperation
- Non-solicitation (of employees and investors)
Final thoughts and takeaways
Having counseled over the years on hundreds, if not thousands, of MD departures, a fundamentally important observation we have about firms that have successfully navigated their way through these circumstances is that those firms that were well prepared in advance on the issues noted above were the ones that ultimately had the more satisfactory outcomes. While often times an MD departure will wind up in a big negotiation where there will be give and take on all sides, the successful firms know in advance where they have leverage (e.g., through the provisions in the management company and GP entity governing agreements, which hopefully are well set up with a company favorable view) and where they don’t (e.g., they may need a departing MD to stay on board for a certain amount of time and/or continue to fulfill certain duties). They also know how best to counterbalance those considerations and be amenable to going “off script” to achieve a good outcome. As the saying goes, one who fails to prepare has ultimately prepared to fail and we’ve seen that time and again in these MD departure scenarios.
One last note in relation to planning and MD departures is a word to the wise regarding generational planning at the upper tier level. Too many firms have either unartfully implemented or wholly ignored any plans regarding how best to introduce the next generation of great MDs within their own ranks. We have found that one of the most opportune times for firms to be thinking about potential promotion or managerial additions is often when an existing MD is leaving the firm. Economics may then already be shifting, voting concentration is being adjusted and team dynamics are changing. Accordingly, these are often the best of times to execute on generational planning matters, which our best managed clients are continually focused on.