Private equity real estate is a business based on personalities. The industry consists mainly of small, specialist firms, set up by two or three partners with nothing but a PPM and a dream; and as investors rarely get a chance to inspect the assets their money is going to buy in advance, the only guide they have to the security of their investment is the talent and experience of the people investing it.
So having invested with a firm on the basis of its senior partner's well known ability to provide triple-digit IRRs, an investor would understandably be a little upset to find that said partner had defected to a rival and that the fund is now managed by a previously unknown junior executive whose face appears never to have encountered a razor blade.
Key man provisions are the limited partners' defense against that kind of eventuality. And while an investor's influence in shaping the final clause is likely to be dependent on the size of its investment, fund formation lawyers suggest that getting the provision right should be a priority for all investors – because all stand to lose equally from the departure of a key executive.
“I can think of examples where the top guys spend more time on the golf course than on investments.”
“Every investor should be asking ‘Who's investing my money, and how do I know this team will continue to work on this fund?’” explains Kent Richey, a New York-based real estate partner with law firm Jones Day. “Institutional investors tend to focus more on this area, because they're investing more money. But even for smaller investors it's important to think hard about what would happen if the people you thought would be running the fund were no longer there.”
Key man clauses originated in the world of private equity, and generally take a similar form in private equity real estate fund documents as they do in their sister asset class. However, they can prove to be an even more important discussion point where opportunity funds are concerned, simply due to the relative immaturity of the industry. While a private equity firm may have dozens of investment professionals, it is relatively unusual to find such large staffs manning an opportunity fund; and the smaller an investment team is, the more important specific members will be to its success.
You see key man clauses most in true private equity funds, but real estate funds are beginning to put them in too,” says Bridget Barker, a London-based corporate partner with Mac-Farlanes. “The industry is becoming more like private equity. Smaller teams are coming out of bigger institutions, so they're very dependent on the talent of individuals.”
Larger funds may prefer to take advantage of the fact they employ larger investment teams to either push for a less onerous provision, or even scrap it altogether. John Noell, a Chicago-based partner at Mayer, Brown, Rowe & Maw, notes: “One trend I've seen is that large organizations which had a key man provision in Fund I may not have one in Fund II, as their investors are comfortable with their good performance.” And since key man clauses shift the balance of power to a fund's investor base, most fund managers have little love for a provision that shifts power to their individual staff as well. “They don't like the clause as it gives their employees more leverage against their employer,” says Noell.
For this reason, many investment professionals employed by large organizations would jump at the chance of being named key man. Another attraction, however, applies equally to such employees and to those managing their own funds. It is, essentially, flattering: the status of key man not only demonstrates a manager's importance to the fund, but also singles them out as a leader. For those who have not quite reached the top, being named key man is a recognition that they are on their way.
The main points for negotiation in key man clauses are easily summarized: who is key, how much time must they spend on the fund, and what happens if the provision is triggered. But differences on these points can produce a wide range of clauses. As Blair Thompson, a London-based private equity partner at SJ Berwin, notes, “It's fair to say there are no fixed rules. Different organizations and different investors will have different views.”
Much of the discussion will be concerned with who the key men are and how many have to leave in order to trigger the provision. Although the documents of some smaller funds will name a single key man – the so-called “super key man” – many funds will include several. Thus, instead of the loss of a single, irreplaceable staff member setting off the provision, they will instead be triggered by the loss of, for example, three professionals from a list of five. That way, not only are investors reassured that they know who is managing their money, managers can also feel confident that, in the absence of a mass walk-out, they will have a chance to prevent the provision from being triggered.
Richey notes that a key man clause may divide those named into different levels of importance: an important but not critical group, who can be replaced by others of comparable experience; and the top flight, the loss of whom gives investors leave to initiate more serious measures such as terminating the investment period. (Others suggest that the figures named by a clause may not always be as vital as investors think. One lawyer, who declined to be named, said, “I can think of examples where the top guys spend more time on the golf course than on investments” – making it all the more important to consider the next group down.)
Once the key men are chosen – “It's usually fairly obvious who they are,” Barker suggests – identifying them in the clause is normally a matter of a straightforward list. How much time key men are required to spend working on a fund is rather harder to describe; among larger firms at which several funds share investment staff, this can also become a key area for debate.
Some fund documents require that the key men spend “substantially all their time” on a fund; others will specify a percentage. The problem is that's not an easy thing to quantify. As Noell says: “If someone isn't devoting substantial time to a fund, how do you prove it? The LP may ask for substantially all of their business time, or sufficient attention to manage a fund properly, but it's a tough concept to articulate. Sometimes they just have to live with the ambiguous language.” He adds that some firms get around this by requiring the most senior guys to do no more than sit on the fund's investment monitoring committee.
The other question that will take up much of the negotiating time is this: what will happen when the key man provision is triggered? Here opinions unsurprisingly diverge: investors want the emergency measures to have real effect, while fund managers prefer to keep them as light as possible.
The most extreme options – that a fund would be terminated or its GP fired – are considered somewhat draconian, and seen only rarely. More often, if an employee leaves, as long as they aren't from the top rank, a sponsor will be given a chance to find a replacement acceptable to investors. In some cases, investors may demand that such a loss is followed by a sixty-day suspension of investment activity; during this time, the firm will nominate potential replacements on which investors can vote.
If the lost employee is one of the most senior partners, or if a replacement cannot be agreed upon, capital calls for new investment activity are likely to be suspended altogether – although some limited funds are likely to be available for asset management. “As a fund sponsor, the consequence of losing key personnel should at most be an early termination of the investment period,” says Richey. “This shouldn't be cause for removal of the sponsor as general partner or investment manager, and shouldn't be cause for an accelerated disposition of investments. The key personnel are there principally to direct the investment decisions, and the fund should be able to continue executing its asset management and disposition functions without them.”
This issue generally remains academic, however. As Barker notes, seeing such provisions take effect is “deeply shocking. It's very much a protective measure – no one expects it to be triggered.” The one example that any of the fund lawyers could cite did not involve a real estate fund at all. The key man clause at Morgan Grenfell Private Equity, which required the loss of chief executive Graham Hutton and any six other executives to be triggered, came into play in July 2001 after Hutton was fired following a string of departures. A 90-day suspension of all investment activity followed, before the fund was folded into DB Capital, owner Deutsche Bank's other private equity operation.
This was, however, an extreme case. “It generally happens behind the scenes,” says Barker. “The firm tells their investors, ‘We've fallen out with Mr X, how about Mr Y to replace him?’ If they have a good relationship with their investors they'll say, ‘Fine’.”
The fact key man provisions are rarely seen to be triggered does not mean they are unimportant. Indeed, some argue that it demonstrates their effectiveness. “They're more talked about than actually triggered,” says Thompson. “But if I were an investor, I'd say that the reason for that is because there's a key man provision there – it's doing its job, and people are staying. It's a clause investors do really want to get right – I have seen investors choose not to invest if they think it doesn't provide adequate protection.”