Three key trends for private equity lawyers

Covid-19 is having an effect on approaches to some LPA terms, while foreign investment regimes are affecting transactions in ‘sensitive’ sectors.

1 New thinking around terms

It has been more than a year since private equity firms first grappled with the fallout from the covid-19 outbreak and national lockdowns on their portfolio companies. To deal with the immediate impact of the crisis, particularly support for affected portfolio companies, and to take advantage of opportunities created by the disruption, some managers sought additional flexibility from investors.

According to Private Equity International’s May 2020 Covid-19 Study, more than half of LPs received requests from managers to extend fund terms and investment periods due to the pandemic, 37 percent were asked about the expansion of investment mandates and the use of fund-level credit, and 49 percent fielded fund amendment requests relating to recycling provisions.

While vaccine rollouts now provide hope of a return to at least some semblance of normality in the not-too-distant future, it seems the push for greater flexibility around certain fund terms may be one outcome of the pandemic that is here to stay.

Geoffrey Kittredge, partner and chair of the European funds and investment management group at Debevoise & Plimpton, says: “We have seen, and expect to continue to see, more tolerance of recycling and reinvestment across various strategies. That is likely to manifest itself in a longer period during which reinvestment is permitted. There was a time when it was limited to quick-flips, but that is now extending out.”

LPs may have been supportive of fund managers’ requests at the height of the crisis, but that does not mean they will all be fully accommodating when it comes to embedding some of these changes into fund terms going forward.

“Certain investors – typically the larger fund of funds platforms – are very keen on recycling to make the funds they are investing into as efficient as possible and reduce the drag. Others don’t like it because it reduces certainty as to when cash that is returned to them is actually theirs,” says Travers Smith partner Sam Kay. “There has always been that tension in place, but I think this period has highlighted the benefits of being able to recycle to maximise efficiency within a fund. We are seeing increasing acceptance of recycling as a concept, but with restrictions placed on that.”

2 Key-person clauses cause contention

One aspect of the limited partnership agreement that appears be an increasing source of friction between GPs and LPs is the key-person clause. In PEI’s LP Perspectives 2021 Study, 50 percent of investors list unsatisfactory key-person clauses among the three LPA terms that cause the most disagreement during fund due diligence. The proportion of investors listing key-person clauses as the main cause of LP-GP disagreements has increased by 12 percentage points since 2020, placing it above management fees as the most significant bone of contention.

Greater scrutiny of this clause may be linked in part to growing concerns around talent management and succession planning in the wake of covid. “I think periods of uncertainty often lead to people re-evaluating life’s priorities and whether they wish to roll the dice again for a new fund,” Peter Linthwaite, head of private equity at Royal London Asset Management, told PEI last year. “Senior retirements are not a new phenomenon in times such as this. We have seen it before in 2001 and 2008.”

Some LPs are seeking tougher key-person provisions, such as a reduction in management fees. John Rife, a partner at Debevoise & Plimpton, says: “The most frequent economic consequence I see investors pushing for is, once a key-person event triggers a suspension of the investment period, an immediate step-down in the management fee calculation to the post-investment period rate, rather than that step-down only happening if the key-person event is not remedied and the suspension becomes permanent.”

As the PE industry has matured, key-person clauses have increasingly been drafted to cover more people. “Key-person clauses started off with just one or two people but, as firms develop, the key-person triggers become more complex and more about teams or combinations of senior and mid-level executives and investment professionals,” says Debevoise & Plimpton’s Kittredge.

As Jennifer Choi, managing director of industry affairs at the Institutional Limited Partners Association, told PEI in December: “LPs have to balance the need that GPs have for flexibility in managing these leadership transitions with the governance risks posed by material turnover within the firm’s leadership.”

3 Governments scrutinise foreign investments

In February 2020, regulations expanding the authority of the Committee on Foreign Investments in the US came into effect. A similar foreign investment regime change is in the works in the UK in the form of the National Security and Investment Bill. The proposed reforms will give the government greater powers to screen transactions on national security grounds. This will include a mandatory notification system for transactions in “sensitive” sectors, which must be authorised by the government.

“What you are going to have is a lot of disclosure to government of deals, with the government now acting as gatekeeper on all these transactions,” Caroline Hobson, a partner and co-lead of the competition team at law firm CMS, told PEI in January. “Not only is the bill politically motivated but also quite intrusive, especially for a lot of PE owners, as to deals they are doing and how they are structured, who the investors are and who they are affiliated with. That is going to cause some discomfort.”

The new regime is expected to result in an additional layer of due diligence for private equity firms and lengthier transaction timelines. “The processes people like are the ones that move quickly and efficiently – this is going to hamper that,” says Simon Lyell, a private equity partner at Weil, Gotshal & Manges.

The US and UK are among a number of countries that have stepped up efforts to scrutinise foreign investment in sectors deemed critical to national interests.

In March 2020, for example, the Spanish government placed additional restrictions on foreign investment as part of emergency measures to address the social and economic impact of covid. This included widening the scope of foreign investment transactions that require prior authorisation from the Spanish government.

“Government approaches to foreign investment during covid-19 have varied significantly,” says Hogan Lovells partner James Wood. “GPs/LPs need to keep a watchful eye on how government policy may impact their activities.”