Do key-man provisions do what they are supposed to?

Private equity is a people business. As such, key-person provisions – or key-man clauses – have historically been among the most important sections in a limited partnership agreement.

“For the LP clients that we represent, it is near the top of their diligence and terms lists for funds that they are considering investing with,” says Heather Stone, a funds lawyer at Locke Lord in Boston. “It is the starting point for the LP’s diligence on team, incentives, track record and succession planning.”

Key-person clauses come in various forms. What they have in common is that they identify a person or group of people who, were a prescribed number of them to leave, trigger a suspension of the investment period and allow the limited partners to decide whether the fund should have a future.

With Vista Equity Partners’ recent $10.5 billion fund, for example, an event is triggered if either of the two co-founders, Robert Smith and Brian Sheth, “cease to devote substantially all their time” to the business, or if a proportion of a wider group of nine top execs were to do the same thing, according to documents prepared by StepStone for a US public pension client.

So it is a perfectly sensible investor protection, right? Not everyone thinks so. To an outsider coming into the industry, they can seem unnecessary or even counterproductive.
Private Equity International recently interviewed the leadership team at Italy’s largest domestic private equity firm Clessidra, chairman Carlo Pesenti and the chief executive Mario Fera.

Both men arrived at the firm from outside private equity, having previously been part of Italmobiliare, the investment holding company that bought Clessidra following the death of the firm’s founder and leader Claudio Sposito.

Both criticised key-man provisions. Sposito’s death had led to nine months of uncertainty as the firm was sold and new leadership established. “That would have almost certainly destroyed most firms of that size,” says Fera.

While private equity is clearly a people business, says Pesenti, “there are systems you can put in place to moderate the risk this poses to the business”. In other words, have a credible succession plan in place and the key-person provision should be unnecessary.
Someone with direct experience of the key-man clause is UK investor Jon Moulton, who left the firm he founded – Alchemy Partners – in 2009, triggering a key-person event. These provisions are “mostly stupid”, he tells PEI.

“If the key man takes to the bottle or the secretaries, or gets a criminal investigation, or simply stops trying, the key-man clause becomes a major obstacle to sorting things out.”

In the case of Clessidra, the story had a happy ending: the firm survived and is today investing its €607 million third fund. Alchemy Partners, likewise, is still investing.
So is the key-person provision outdated? Unnecessary? No, but it does need to be thought through carefully before fundraising begins and “before third parties – ie, LPs – become involved in the conversation”, says Stone.

Some clauses are better drafted than others. “There are as many key-men clauses structured with nuances as there are GPs with nuanced investment strategies,” says Klaus Bjorn Ruhne, a partner at ATP Private Equity Partners, which invests on behalf of a $113 billion Danish pension fund.

The jury may be out on key-person clauses – investors have differing and strong views – but they are here to stay. In the words of one LP: “It’s definitely a case of better to have one and not need it versus the other way around.”