As established managers and mega funds increasingly dominate the private capital industry, certain investor protections may be becoming less common.
This includes no-fault divorce clauses, according to Preqin’s 2020 report on private capital fund terms. These provisions allow limited partners to remove and replace their general partner or terminate their limited partner agreement, even if the situation is not covered in the terms of the agreement.
Such clauses are considered “critical” by many limited partners, according to a recent survey by the Institutional Limited Partners Association. “While only 25 percent of respondents have experienced a GP removal within the last five years, ILPA members consider no-fault removal provisions to be an essential investor protection worth fighting for,” the group said in a report on the findings. “Whereas for-cause removal provisions can only be triggered by an unattainably high bar, no-fault provisions are more straightforward to execute and serve as a guaranteed forcing mechanism in cases of egregious mismanagement or behavior.”
According to the ILPA survey, 62 percent of group members had these provisions in place for at least half of the funds they invested with last year, while 37 percent had no-divorce clauses in more than 75 percent of the funds they allocated to.
But among private capital funds tracked by Preqin, these clauses appear to be on the decline: While 77 percent of funds raised in 2011 allowed for no-fault removals, that proportion has fallen to 58 percent for funds raised in 2019 and 2020.
Even where funds allow for GP dismissals, ILPA reported that voting thresholds for removals are trending “unattainably high.” No-fault divorce clauses now generally require a vote of 75 percent or more LPs, which ILPA said is “difficult to achieve when information about the other investors in the fund is lacking or outdated.”
According to Preqin, limited partners “may have become more willing to accept less favorable fund terms in a more competitive fundraising market in recent years, tipping the balance of power toward GPs.” But the trend may also be driven by the types of funds that are raising the most capital: Large pools run by established managers.
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“Anecdotally, I would concur that it is happening, but it’s happening in follow-on funds where there are existing relationships with LPs,” said Mark DiSalvo, CEO of Semaphore, in phone interview Friday. Semaphore, founded in 2001, is an advisory firm that limited partners hire to step in as a replacement GP when they want to terminate their relationship with their existing manager — either through a no-fault divorce or for-cause removal.
“Based on the relative power dynamics of successful follow-on funds and general partners with proven successes, it’s not at all unusual to see terms around the edges become more modest or modified a little bit,” DiSalvo said. He added that he has seen more no-fault divorce clauses and easier for-cause separation terms among first-time managers that have not yet proven themselves.
While fund terms may have shifted in favor of general partners over the last few years, the coronavirus pandemic could help even the playing field for limited partners. Among investors surveyed by Preqin, 40 percent suggested the balance of power would shift toward LPs, while only 8 percent thought general partners would have more leverage in negotiating.
“It would be unsurprising in this environment to see a small tilt toward more LP-friendly terms,” DiSalvo said. “I think there’s going to be a pendulum swing — how much will depend on how global and deep the post-Covid recession will be.”