The covid-19 pandemic has impacted the ability of funds to exit investments, and it will leave behind a trail of funds with underperforming portfolios, little prospect of making carry and perhaps the inability to raise a further vehicle.
When it comes to the removal of a manager, it could be for ‘cause’ due to behaviours such as fraud, gross negligence, bad faith, wilful misconduct or a material breach of fund documents, and for ‘no-fault’, which is effected without triggering any act by way of a supermajority of investors.
Practically speaking, the threshold for a cause removal is set prohibitively high and the cost of a no-fault removal is not attractive in such a situation.
Even when there may be tentative evidence of bad acts, the time it takes to cross the threshold required under the LPA, let alone the cost, is not a realistic solution.
A no-fault removal is possible, assuming widespread investor sentiment. However, investors are liable for the full management fee rate on the acquisition cost of assets unlikely to sell before the end of the fund’s life. This fee, set by reference to the original acquisition cost, is now at an effective rate that is at a much higher percentage of the holding value.
What can LPs do?
Before embarking on any negotiated manager exit, parties must select appropriate legal and strategic advisers. Factors include experience negotiating with fund managers, an understanding of both fund-level and portfolio-level issues and a lack of conflicts with GP clients.
While it may appear self-serving, we find agreement of an appropriate outcome-driven incentive fee structure will ensure advisers are aligned with investors in seeking a cost-efficient outcome rather than accruing costly advisory fees. Subsequently, a strategic review of the fund and the portfolio, and a negotiation strategy, must be developed.
The strategic review
The strategic portfolio review is a critical step in determining the value of the underlying assets and the baseline of potential returns for investors.
Ideally, the incumbent manager is supportive of the introduction of a third party to carry out a strategic review on behalf of investors. We would review the terms of the LPA and, in particular, the investor advisory committee’s powers to appoint advisers to ensure the outside oversight can be instigated and the fund is responsible for such costs.
It is imperative investors choose an option that helps mitigate the impact of covid by creating enough runway for the underlying portfolio companies to recover. There is a potential upside in holding the assets and trying to execute a revised business plan for each portfolio asset.
At this point investors need to consider who would be the successor to the current manager. An obvious choice may be a replacement GP active in the same sector, or a fund-less sponsor (GP for hire), yet quality candidates are less available in the current fundraising climate.
Another option would be to establish an ‘interim manager’ structure with a subset of the current management team, which would include ongoing oversight from professional advisers acting on behalf of investors. This team would focus on effecting the removal of the current manager, the stabilisation of the portfolio and the management of an orderly transition.
Negotiated manager exit
The negotiation strategy will revolve around key levers:
- The contractual cost of removal
- Historical fund liabilities (tax, expenses, portfolio recharges)
- Reputational risk (where applicable)
- Combined legal and commercial advisory costs
With respect to costs, the cost-benefit analysis should consider all categories of recurring savings and one-offs:
- Cost of removal including adviser costs
- Staff restructuring costs such as severance, redundancy or payments
- One-off setup costs including IT, property or infrastructure for new GP
- Rationalised selling, general and administrative cost base that ‘best fits’ the needs of the portfolio in the context of the overall value of the fund
The cost-benefit analysis of a GP removal showcases an alternative that could significantly lower costs. In most cases, the savings can help cover some or all one-off costs.
Critical success factors
From the outset, it is important to understand the competing objectives of the investor base in the fund. In widely held funds, the need to create an LP subcommittee and chair to represent the broader LP base will be helpful in streamlining decision-making and setting the primary objectives of the upcoming negotiation.
The spirit of the process can be collaborative and cordial despite any preceding friction between the manager and its investors; at this stage the parties are well aligned in seeking a quick and clean outcome.
In our experience, maintaining lock-tight confidentiality throughout the process and avoiding any negative press are central to ensuring negotiations are not derailed and ultimately lead to a successful outcome.
In the same vein, it is best to ensure all communications are centrally coordinated, as individual discussions with larger investors risk hampering the process. Balanced with the need for confidentiality is the requirement to update the wider investor base regularly.
Aside from any legal rights, the key driver to ascertaining the best route for investors will be the upside recovery potential of the portfolio assets.
Gabriel Boghossian and Sarah De Ste Croix are partners at law firm Stephenson Harwood. Stelios Fragkos is a managing director at AlixPartners.