EUROZONE: Option A, B or C?

Say for the sake of argument that a GP is out raising a euro-denominated opportunity fund. A potential investor demands there must be a term in the limited partnership agreement (LPA) stipulating that, if a certain country were to leave the European Union, the investment period of the fund should end. Should that fund manager: A) agree to the request – after all, the GP is probably desperate for the commitment, B) forget the LP – the investor is clearly cooking up this unreasonable request because he doesn’t really want to invest or C) welcome the LP into the fund but only go as far as to promise to talk about a possible suspension should the event in question happen.

With talks between Greek authorities and that nation’s private bondholders unsettled at press time, it is perhaps unsurprising that private equity real estate firms on that point-to-point endurance course otherwise known as the fundraising trail are experiencing scenarios similar to the one outlined above.

Lawyers that have worked on documentation for funds that closed in 2011, when Europe first entered troubled times, provide some examples of quite drastic terms that some jittery LPs have asked for. A few examples of recurring restrictive themes include: don’t invest in subprime mortgages; don’t make temporary investments (i.e. those made pending investment in assets or a distribution) in banks or government bonds of the PIIGS countries; and don’t invest in Greek real estate. 

Such restrictions certainly can be covered in side letter provisions if the LP is in effect asking for an exemption from participation in say a Greek property deal. However, on a number of occasions, the restrictions mentioned above have been incorporated into the main LPA. Although they tended not to be absolute prohibitions rather provisions requiring investor consent, including from the investor advisory board, some GPs that PERE has contacted said they would not entertain such clauses. They would take option B above.

The line of argument for those preferring option B goes something like this: “I am a seasoned, experienced GP and you are willing to pay fees for my skill and judgment, therefore I have full discretion to invest your capital to the best of my abilities. If you are coming up with a restriction like ‘Don’t invest in Greece’, then you cannot be thought of as seriously ready to invest in a pan-European fund. The discussion should forthwith terminate here.”

The effect of Eurozone disquiet is not limited to the examples above when it comes to fund terms, and it has led to unusual demands on the GP side as well. In one or two cases, a fund manager has said it should be open to him to change the denomination of a euro fund to dollars with either the consent of or in consultation with the advisory board. That seems quite drastic because people are investing in a euro fund and expect to continue to do so.

Nevertheless, I am told the clause did slip through for a fund with a significant number of US investors in it.
Even more drastic is the question of what should happen if an important country such as Germany or France should leave the euro to return to something like the deutschmark or franc. In normal times, a term requesting the investment period should end upon such an event wouldn’t even have occurred to an LP. Typically, serious events that might trigger investment suspension would include things like all the key men of a fund leaving. However, in one case, I am told that there were discussions about adding a stipulation that, if a certain country/countries left the euro, this would trigger an investor vote on suspending all further investments in that particular jurisdiction.

What finally went into the fund documentation was a watered-down version of the above. Essentially, everyone agreed to talk about it – option C above. If the GP in question had acceded to the demand, he felt it could have proved too rigid a term (and appear to be a knee-jerk reaction to events). After all, who is to say that some of the other LPs wouldn’t want to continue investing in that country?

At the end of the day, there are checks and balances within the GP-LP relationship that don’t really need to be spelled out in the LPA. Namely, if a GP does something that an LP doesn’t want him to do, he is unlikely to win support from the LP next time he raises a fund. At the same time, it should be acknowledged that the GP is the expert and is paid to make a call.

Consider this: if something quite radical should happen to the euro, like a country coming out of it, who is to say that there wouldn’t be more opportunity coming out of that event? In fact, this might be the very worst time to suspend investment because it actually could be the most opportune time to invest.

For that reason, there is merit in taking option B in the scenario above. The course of action for a GP should be to explain to the LP politely that he is the expert. If the LP doesn’t buy into that, then it is time to walk on by and find the next investor that does.