How the crisis could affect fund T&Cs

Exits in the European private equity market plummeted in Q2 2020, reflecting a reluctance from buyers and sellers alike to engage in such transactions in an uncertain market: 155 exits were completed, with an aggregate value of €8.45bn, according to Unquote Data. In Q2 2019, 274 exits totalling €50.2bn were recorded. The last time the market saw an aggregate value of exits of less than €10bn was in Q3 2009, when 202 deals were completed totalling €8.7m.

Amos Veith, a partner in law firm P+P Pöllath + Partners' funds advisory team, explains the difficulties that many LPs are facing against this backdrop. "We have seen some clients who are investing in PE funds and other investment programmes who hold hundreds of fund positions and base their liquidity plans and forecasts partially on returned capital: say they are holding 100 old funds in their harvesting period that are making distributions, and at the same time another 100 in their investment period, and they are using the money returned by the older funds to meet their capital commitments to the new ones. But they can see that there are no exits going on in the current market; buyers often want 30-40% purchase price reductions, whereas the seller can wait another year."

Karl Adam, a partner at placement agent Monument Group, notes that it is not just the M&A market that might be causing problems for LPs. "Some US university endowments, for example, are having issues as they are having to provide refunds for students and not getting course fees, so their programmes are taking a hit. And there are hospitals that are no longer doing elective surgeries and need money for Covid-19."

However, he notes that LPs have not put commitments on hold as a whole: "Some LPs are very conservative and want to wait and see. But they are in the minority; the majority of LPs are still maintaining their programmes – they don't want to miss out on the good vintages by sitting on their hands."

In a correspondingly tough fundraising environment that will see LPs think long and hard about where to deploy capital (if at all), GPs will be looking for all the incentives they can possibly provide.

There are a handful of funds that have reduced the hurdle to 6% instead of 8%, but these are exceptions" – Britta Lindhorst, HQ Capital

An obvious one would be to offer lower management fees combined with a lower carried interest for the GP, so that terms are more favourable to potential LPs, who would therefore have to pay less and might see returns on their investments sooner. "The traditional discount is on the management fee and/or carry – GPs generally don't touch the hurdle rate," says Karl Adam, a partner at placement agent Monument Group.

Britta Lindhorst, a managing director and the head of European investments at HQ Capital, concurs: "There are a handful of funds that have reduced the hurdle to 6% instead of 8%, but these are exceptions."

Adam does not expect such changes to be widespread. "Generally, there would just be a modest discount to drive the closing and differentiate from other funds. The problem is that this is so specific to the GP – if they are for example on their third fund with a loyal LP base, the chances are that they will be able to close without an incentive."

Lindhorst says LPs are likely to be reluctant to agree to a 2% management fee on capital that might not be deployed for some time. "We always make sure that we don't pay management fees on funds where there is still dry powder in the predecessor fund. But now this is even more important."

Learning from a crisis
The consensus from market players with whom Unquote spoke was that the market standard hurdle rate 8% is unlikely to change due to the impact of the coronavirus crisis. However, the way in which returns are calculated, including the use of fund financing and draw-downs, are also something to consider. Edyta Brozyniak, a partner at MJ Hudson, says managers are instead getting creative in other ways: "We have seen some adopting hybrid waterfalls (part distribution going through the whole of the fund waterfall and the remainder through a deal-by-deal waterfall)."

In addition, Brozyniak notes that changing a hurdle rate is complex. "Such change would usually involve a unanimous consent of all investors under the terms of the limited partnership agreements. This can be – and has been – done, but it is a relatively rare occurrence as the GP should have a good rationale for lowering the hurdle rate, as the investors who have already been admitted to the fund would be required to consent."

There are some parallels to be drawn between how fund terms are likely to change in the wake of the coronavirus crisis, and what was seen during the global financial crisis (GFC). "As fundraising will be more difficult, GPs might adapt certain terms, as they did during the 2008 crisis," says Isabel Rodríguez, a partner in the fund team at King & Wood Mallesons (KWM). "The background of the GPs is very relevant; the LPs are still thinking of keeping up allocations to PE, but given the uncertainty of the market at this moment, it is safer to bet on the sponsors you already know, whose funds you have invested in for years, as it is difficult to predict right now what the impact will be on the portfolio in the long term. But in the middle of fundraising, the question is what you can do to move things forward and compensate for the effect of Covid-19."

A for-cause removal provision is never applicable in practice; typically you require a court decision which takes years" – Amos Veith, P+P Pöllath + Partners

When a vehicle is beyond its fundraising period, in crisis situations, GP removals could be contemplated, the precedent and provision for which can be set out in an LPA as a means for LPs to react to challenging circumstances. In theory, no-fault removals can allow a majority of LPs to remove a fund manager without alleging any "fault"; for-cause removals can be used when misconduct or mismanagement is alleged on the part of the GP.

Veith says the implementation of for-cause removals are a rarity, even if they are in theory possible and could be favourable to LPs: "A for-cause removal provision is never applicable in practice; typically you require a court decision, which takes years. As an LP, you want to be able to act or react, and this is what this right provides. If the vast majority want to remove the GP, they can do that for no reason; there is compensation in respect of lost management fees and carried interest and you are in a position to remove the GP."

The inclusion of provisions for no-fault removals, on the other hand, and indeed the implementation of such terms, might play a greater role than in previous years if LPs are seeking more control and security amid financial uncertainty, suggests Veith. "I would expect that no-fault investor protection rights, removal or termination will have more practical impact as a means of putting leverage on the GP. If that happens, we might see changes to those terms in the future. We have very limited experience so far in those provisions: in 20 years, I have only seen three or four cases where the no-fault removal right has been exercised or threatened to be exercised to put on leverage. It has almost no practical relevance, which will make GPs quite relaxed; but if LPs use this in this crisis, where it's not down to GP mismanagement or the investor's fault, then there might have a different view on those provisions in the future."

Long-term commitment
However, the consequences of GP removals can be dire for GP and LP relationships, and the market players with whom Unquote spoke do not expect these to be used extensively. In fact, LP and GP communication will be key as the market recovers from the crisis. Coller Capital's latest private equity barometer provided an early indicator that the market is doing well in this regard. It revealed that four fifths of LPs are currently satisfied with GP transparency, compared with 39% in the same period in 2012 and 40% in 2009.

"Most GPs have really been making an effort to manage communications much better in this crisis, to speak to LPs a lot more and to increase transparency and trust," says Monument's Adam. "In the last downturn, it seemed there was a lot less transparency, and GPs wanted to be left alone to fix and sort it out. But communication improves the relationship with the LP and it makes them less likely to panic if they know what's going on."

Communication will also be vital in the expected wave of fund restructurings, continuity vehicles and extensions that could come in the wake of the crisis, although longer holding periods were already an emerging trend pre-crisis. Says Brozyniak: "We can expect a lot more restructuring and stapled transactions, and fund mergers. It is important for the managers to consider if any such restructuring or merger would require an adequately high level of investor consent."

"Some GPs have already requested consent from their investors to extend the investment period, and in one way or another this has happened in the past, including in the crisis in 2008," says KWM's Rodríguez, noting that this will affect management fees. "It's normal for LPs to accept this, but with a reduction in management fee; for example, the fee will no longer be calculated on total commitments, but with a different formula. If a GP is asking for an extension as they need liquidity for the portfolio, they are putting on the table that they are in a bit of trouble and need more time, and there the LPs can ask to have an adjustment for everyone and reduce management fees."

Brozyniak says LPs will also step up their due diligence process, not only if a fund's investment period is extended due to complications arising from the coronavirus crisis, but also due to the significant impact of the coronavirus crisis on the GP's portfolio companies. "There is more scrutiny on the terms of the investments, including financial, operational and legal due diligence, and the investors are more sophisticated and more vocal. There is more debate on the GP/LP balance and focus on real alignment of interests."

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• coronavirus