Getting creative: Strategies for turning around a poor performing fund

LPAs are designed to give GPs the means to stabilise, restructure or exit underperforming assets, to protect the reputation of the manager and value for the funds LPs. Tools in the GP toolbox include:

a. Portfolio management

As a first step, GPs might look to effect an operational turnaround of a fund’s underperforming portfolio companies (which in the context of a credit fund is of most relevance where it has taken equity control of an underperforming borrower), whether that be by installing new leadership at portfolio level, streamline operations, and/or inject additional capital to drive growth and correct inefficiencies. When doing so GPs will be keen to maintain, and improve the transparency of, communication with LPs about a fund’s performance, any changes made to the investment strategy, and challenges. This could enable GPs to better manage expectations and build support for proposed changes, improving investor confidence and reducing the likelihood of investors selling on the secondary market.

b. Working collaboratively to bring in a third party

If LPs are unhappy (perhaps because they have been asked to agree to an extension of the fund or a continuation vehicle), the GP could appoint an independent third-party nominee to provide governance oversight. Indeed that might be of particular interest to LPs where the third party has particular turnaround expertise, and for the GP it might offer a means of freeing up their management time, affording them the opportunity to engage with other new projects whilst maintaining their rights to carried interest.

LPAs commonly allow the GP to appoint third-party advisers on an ad-hoc basis and for the fund to bear the costs of those appointments. However this is predicated on the (unspoken) assumption that the GP is in charge and is running the show (and for which it is paid a management fee).

Where a GP does bring in a third party, GPs and LPs will want to consider:

• the regulatory impact of such appointment: as the Alternative Investment Fund Manager (AIFM) of the fund, the GP will be (and must be) responsible for portfolio and risk management, so the third party’s appointment cannot upset that analysis;
• the duties (if any) owed by the third party to the fund / LPs as a whole. The GP owes fiduciary duties to the fund and must act in good faith. Would the third party owe similar duties? Would it be engaged by the fund? Or would it just be a service provider to the GP?;
• the impact of the appointment on any continuing “key person” requirements of the GP;
• fee arrangements to ensure that the LPs are not double charged (i.e. that they won’t want to be paying both the GP and the third party to do the job that the GP initially signed up to do on its own); and
• carried interest arrangements: if substantive investment related decision making is now in the hands of the third party, existing GP incentives may no longer be properly aligned. 

In all likelihood, bringing a third party on board to help will likely require a recut of the LPA to address some or all of these points, and may well involve a resetting of the financial incentives to align the third party’s interests with those of LPs.
 

As a general rule, LPAs weigh towards being more GP friendly than LP friendly and there are therefore limited remedies available to an LP. However whilst the LPA might offer limited levers for LPs, the impact of those levers once pulled is often dramatic.

a. LP rights to terminate the investment period for no fault

An LP remedy often negotiated into an LPA, and one typically only triggered if things unravel quickly after the fund has been raised, is the right afforded to LPs to terminate the investment period for no fault, usually after a grace period, provided that such termination is approved by LPs whose aggregate fund commitments represent a supermajority of total fund commitments. While this route would successfully prevent a GP from making further “poor” investment decisions in the future, where the fund has its own financing in place with a third-party lender such termination might well give that lender the option of cancellation under the finance documents, meaning amounts owed to the lender become immediately due and payable after a short grace period.

b. LP-led GP removal

A conventional feature of an LPA is the ability afforded to LPs to remove a GP. Traditionally these provisions have rarely been exercised and instead have been considered as behavioural levers, to make sure that a GP does not behave badly by providing LPs with an ultimate sanction where a GP does. However, as liquidity has become constrained and exit options for LPs limited accordingly, there is an increasing focus on how LPs might exercise their GP removal rights to improve the fortunes of a fund that has a portfolio of assets that are worth holding onto, or which they cannot for whatever reason exit.

In Europe, LPAs commonly offer LPs two routes to remove a GP: “for cause” removal and “no fault” removal. However both mechanics purposefully come with both a heavy evidential and cost burden for LPs as well as a significant reputational impact for GPs and LPs alike.

• Removal of a GP for cause: Where LPs are keen to replace a GP for its inadequate performance, they might remove a GP – without compensation – for gross negligence, wilful misconduct, wilful or reckless disregard, fraud or relevant criminal conviction (in each case as determined by a final unappealable court judgment). The approval threshold would usually be LPs whose aggregate fund commitments represent a simple majority of total fund commitments. For the GP, the consequences of “for cause” removal include loss or reduction of carried interest entitlement, immediate suspension of investment powers, and the appointment of a replacement GP or a liquidating trustee.

  “For cause” removal is a high bar and the route is not frequently used. While LPs are reputationally aware and hypersensitive to the potential impact that the bad publicity triggered by their association with a “failing” GP might have, they do not often have the time or resources to invest in the lengthy court process required to satisfy the necessary conditions. LPs will likely also be concerned about the impact of a court process on the appetite of the GP to continue managing the fund whilst such process is ongoing.

• Removal of a GP without cause: An alternative route that might be employed where LPs cannot, or would rather not, exercise a “for cause” removal right, is that of “no fault” removal. “No fault” removal allows a GP to be removed, usually after a grace period, with the approval of LPs whose aggregate fund commitments represent a simple majority of total fund commitments. Whilst more straightforward from a process perspective than “for cause” removal, “no fault” removal does not come cheap for LPs. A GP removed in this way would typically retain rights to receive carried interest and receive a compensatory payment for early termination, generally a year’s worth of management fee.

  It would be advisable for an LP to look to remove a GP without cause on a discrete basis and where there is no other viable option available to it, rather than employing this as a strategy across multiple funds on their investment book. GPs talk: the removal of a GP is likely to have a significant detrimental impact on the ability of that GP to raise future funds and as such the removal of GPs by an LP as a coordinated strategy would likely have a limiting effect upon the ability of that LP to invest in new funds with new GPs.

• Wait it out:  Some LPs will simply choose to wait it out knowing that, while they are ultimately prepared to write off their investment in a “zombie” fund (a fund considered to have no prospect of a successful outcome) and address the consequences that come with that, the passage of time may have a positive effect on the performance of, and returns available from, that fund.

When LPs do decide to pull the trigger for GP removal, what comes next? What support might an LP need?

Where an LP is considering the exercise of its GP removal rights, it should ensure that it is clear about the legal, commercial, economic and practical consequences of doing so:

1.  What do the LPA documents say? 

In the first instance LPs should look to the fund documents (e.g. the LPA, side letters, subscription agreements, LP advisory committee (LPAC) terms of reference and management agreements) as to how they might remove their GP. It will be important to confirm relevant governing law, any elected dispute resolution forum, relevant notice mechanics, voting thresholds, and cure periods.

Practically, LPs ought to tie each of their concerns about GP performance to specific LPA provisions or standards (e.g. missed audits, valuation policy deviations, key person breaches, expense misallocation, investment restriction breaches, etc.). They should also be able to provide evidence, dates and (if applicable) correspondence to substantiate their concerns. For “for cause” removal, it is not enough to simply be of the view that another GP might do better.

2. Does the fund have financing in place?

In addition to mapping out GP removal rights and related obligations under the fund document, LPs should ascertain whether a fund has financing in place and if so, consider the impact of GP removal under the fund’s financing documents.

In the context of both subline and NAV facilities, the identity of the fund’s management team will likely be critical in a lender’s assessment of the risk of providing a facility to that fund. For that reason a change of GP and/or manager, whether direct or indirect, will invariably trigger a “Change of Control” under the relevant facility agreement which typically gives any lender the option of cancellation in relation to their commitment, meaning amounts owed to the lender become immediately due and payable after a short grace period.

It is also likely that an “Event of Default” would be triggered by GP removal unless a replacement GP is appointed who is a relevant affiliate of the existing GP and/or approved by all the lenders. Practically, such new GP will need to satisfy lender KYC, enter the finance documents, and grant replacement transaction security (e.g. capital call assignments and bank account charges etc.). This requirement to replace security is likely to be a cost-intensive process. Elsewhere, the change of GP may trigger key person provisions, which often result in a mandatory prepayment event. It may also have a knock-on impact to underlying loan portfolio company facilities constituting a Change of Control at that level.

Ultimately LPs should be aware that where financing is in place, exercising their “investor protection” rights to remove a GP could have a knock on effect on the entire fund structure and portfolio, and they will want to do thorough due diligence of the impact of exercising these options before doing so. In practice, we have seen subline facilities being repaid before any replacement is effected not least on the basis that calling capital is the expected means of repayment for a subline.

3. Is there sufficient LP support for removal of the GP? 

Given the high LP approval threshold for both “for cause” and “no fault” removal of a GP, any LP tabling GP removal ought to first canvass other LP support to determine whether there are enough likeminded LPs who are prepared to bear the costs of the removal process.

The LPAC terms of reference often allow the LPAC to meet “in camera” without any GP representatives present, which can provide a forum for the larger LPs to coalesce around a course of action. Alternatively the LPA generally affords a right to requisition a meeting of the LPAC to a minority of LPs (perhaps 20% of total fund commitments) and in such forum they might outline their plans and give the GP the opportunity to put forward its side of the story.

In all cases it will be important for LPs to ensure that they do not do anything that strays into the operation or management of the fund or the conduct of its business, and that any steps they do take do not breach any of the fiduciary obligations to which they may be subject as partners.

4. How will the LPs manage an uncooperative GP?

It is fair to say that any attempt by LPs to remove a GP will likely be considered hostile and that the GP may be uncooperative beyond the provision of the minimum amount of engagement consistent with its fiduciary duties. It is therefore important that LPs do everything by the book and follow the LPA (e.g. processes, thresholds, notice periods, etc.) to the letter. Given the significant consequences and reputational impact for all when removing a GP, LPs will also want to demonstrate from a practical perspective that removal is not their first resort, and that they have already tried other courses of action (e.g. talking with the GP about their dissatisfaction, trying to understand the issues, affording the GP opportunity to remedy, etc.).

5. Has a replacement GP been found and the terms of management agreed?

Removing a GP is only part of the equation, as funds require a GP to be in place at all times. LPAs usually require that a new GP is elected and appointed within 20 business days, so it will be important to have identified, and agreed principal terms (e.g. remuneration) with, a new GP before the incumbent GP is removed.

6. Are any regulatory filings required to be made by the outgoing GP to replace the GP

Removal of a GP would typically require regulatory filings. For a UK GP, it would be the obligation of the outgoing GP to notify the FCA of the change of GP. There may also be other filings needed in other jurisdictions where the fund may be registered (e.g. if it has assets in other jurisdictions or if it has filed for tax exemptions, etc.).