Venture capital funds are closed-ended, long duration blind pools. In the many years following closing, the fund manager is permitted to operate and invest the fund in its discretion as long as it stays within some limited guidelines codified at inception in the partnership agreement. But, what happens if circumstances change over time such that the investors become truly unsatisfied with the prospects for the fund, or the management of it?
The answer lies in a set of provisions that reside in the fund’s partnership agreement. We generally refer to these as “LP governance rights”. The common theme is that these LP governance rights represent ways in which LPs can take action if, in fact, they do become deeply concerned about the fund’s prospects or the conduct of the manager.
LP governance rights are best thought of as a suite of options. Not all of them will exist in every fund agreement, but usually some of them will. They can differ based on the duration of engagement between investors and the fund manager and the adherent level of trust that has developed over time amongst the parties, or for other reasons (including business leverage and precedence of prior funds). It is safe to say that where investors are very demanding of attaching unusually strong LP governance rights to a deal, they probably have a heightened level of concern about issues of team stability, trust or just generally a lack of familiarity with the manager. Certain investors may, internally and in light of their nature, be prone to requesting stronger than middle-market LP governance rights; for example managers of public pension or sovereign wealth assets may have strong legal or fiduciary reasons for such requests compared to private sources of capital.
So, what encompasses this suite of options comprising LP governance rights? At a high level, there are three broad categories to be aware of: (1) provisions which can lead to the fund’s investment period ending prior to its scheduled time; (2) provisions which can lead to the fund’s entire term culminating early and the fund being completely shut down; and (3) provisions which leave both the investment period and overall term of the fund intact but cause the existing fund manager to be replaced with a new fund manager of the investors’ choosing. Let’s examine each of these in turn.
Termination of the Investment Period
In a typical venture capital fund, an investment period will apply. This is the period of time after closing, usually four to six years in duration, that the fund may make investments in brand new portfolio companies. Beyond this time, only follow-on investments will be permitted. The goal is to ensure that the fund can liquidate reasonably on-time, say after ten to twelve years. That won’t be possible if investments in brand new portfolio companies, especially early stage ones, are made late in the fund’s lifecycle. The investment period duration regulates this.
An investment period may end early if a fund becomes fully invested ahead of schedule, but from an LP governance perspective, there are two ways it might end even earlier.
The first is in association with a key person event, in which a certain number or particular persons of a select group of the fund’s investment personnel are no longer meeting their time devotion to the fund (usually substantially all business time) or are no longer managers of the fund. For example, perhaps a fund is targeting 30 investments, and has five professionals expected to identify and nurture, on average, six deals each. It might be the case that investors would tolerate some level of departures and still be comfortable with the team’s ability to fulfill the investment mission, but what if a supermajority of the five investment professionals has left and replacements have not been found and approved? It may no longer be feasible to invest in 30 deals if these departures happen a couple of years into the investing cycle. In many agreements, this happenstance, called a “key person event,” may call for the suspension of the investment period either automatically or by LP / Advisory Committee vote. During this suspension period, the manager seeks to find replacement talent or otherwise formulate and propose some go-forward plan. After exhausting efforts to find suitable substitute talent over a period of time, the fund’s investment period will terminate under the fund’s governing documents. In this case, the remaining team will stay in place to guide the fund’s investments that have been made to fruition, but the investment period will terminate and opportunities in new portfolio companies cannot be pursued.
The second way an investment period may end earlier than scheduled is upon an investor vote. This term is present in only a minority of deals to begin with, but where it is seen, it will almost always require bad conduct on the part of the fund manager team (“cause”, in industry parlance), usually proven in court, arbitration or a similar tribunal to the stage of final adjudication. Very infrequently, it may be the case that a supermajority of investors may vote to terminate the investment period without any such cause. It’s worth careful emphasis to highlight that this is a very uncommon clause, and one that most venture capital managers will not agree to. The position is usually that such a punitive action should require wrongdoing and not be arbitrary, especially where venture fund managers by their lengthy mandate invest in and contract for long duration assets and obligations (offices leases, etc.) that can be difficult and costly to unwind.
Termination of the Fund
Whereas investment period termination is usually driven by a concern over the ability to make all of the contemplated investments, as reflected in a typical set of key person provisions, if concerns run deeper, the investors may in exceptional circumstances wish to completely terminate the fund. If this occurs, the fund is liquidated and the securities – marketable and nonmarketable – are simply distributed in kind to the investors in connection with the winding up of the fund.
This remedy is in fact truly exceptional inasmuch as investors typically do not desire to hold private venture-backed securities in their portfolios. This is what they hire fund managers to do, and they are often ill-prepared to take this on, especially if they are outside the domicile of the investments (like a UK pension fund trying to deal with U.S. portfolio securities). In addition, the diffused, small positions that each particular investor may receive are not likely to carry the weight of the position as a whole that was previously held by the fund (think of things like the leverage to obtain a board seat or major investor rights); and the act of seeing the positions to fruition through follow-ons or if not disposing of them privately, perhaps in a secondary transaction at a discount, are not terribly appealing either. So this remedy is reserved, in application, for the most serious situations. Reputable fund managers need not lose much if any sleep that such a provision will be acted on.
The flip side is, in light of this sort of “natural bias” on the part of investors to call for application of the termination right, it is in fact often able to be exercised without cause. In comparison to say a right to terminate the investment period or substitute a fund manager for no cause, the strong “downside” of enacting the fund termination serves as a natural check and balance. The result is that in the industry, a majority of venture deals have no-fault termination rights. These are usually on supermajority investor votes – perhaps as high as 85% in interest. Sometimes, the right to terminate the fund in entirety on a lesser vote is seen where there is adjudicated cause and/or after a key person event – perhaps in these cases, on a 66% vote.
Replacement of the Fund Manager
The final type of LP governance right we see in venture capital deals involves an option for investors to replace the fund manager (often referred to as “GP removal”). Where this happens, the fund will continue, but under the supervision of a new manager they choose. The former manager is likely to retain some carried interest and possibly some transitional management fees, but won’t be involved in the going-forward management of the fund and ultimately will be likely to cede some economics, perhaps to a significant degree, to the new manager.
Some deals, especially in the case of emerging managers or managers struggling in fund raising, have some sort of removal and replacement right, almost all of which run off adjudicated cause. In this case, following that sort of final determination in court of a serious bad act, a supermajority vote may lead to the right to remove and replace the fund manager; provided that in some deals where the bad conduct is resulting from a particular team member and that team member is terminated, the removal right may disappear (it being intended that an otherwise well-run organization shouldn’t be punished as a whole for basically “lone wolf” type conduct that isn’t pervasive in the firm). Investors may ask for no-fault removal and replacement rights on a high supermajority vote – 85% or north, for example. In reality, this type of provision is highly infrequent; a positive number yet approaching somewhere close to zero percent of deals we see today have this sort of provision. As with no-fault investment period termination, most managers are simply unwilling to concede that they can be put out of business where there is no adjudicated bad conduct.
In the case of a removal and replacement right, whether for cause or otherwise, the departing manager is almost always afforded carried interest in the prior deals (often up to 100% though in some cases less) and sometimes a transitional amount of management fees permitting the outgoing manager to gracefully wind down operations. These provisions are meant to be a deterrent to enacting the removal rights, such that those rights are invoked only where circumstances truly warrant it.
A Suite of Rights
In the end, most deals will have some collection of the above rights. Having no such LP governance rights is rare, as is having everything listed above in any particular deal. Fund managers and investors are well advised to cooperate to put in place a standard set of provisions encompassing some of the above and as the situational facts dictate. In deals where provisions are too favorable for LPs, team retention issues may result. That is to say, an excellent investment professional at the top of her game may not be satisfied to work at a firm where provisions can be enacted, especially on a no-fault basis, to effectively shut the company’s doors.