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GP Removal Provisions in European Funds—Are They Used in Practice?December 9, 2020
One of the most negotiated provisions in fund documents is the GP removal provision. In Europe, most LPAs contain two types of removal clauses: “for cause” removal and “no fault” removal. The former, as the name suggests, is designed for removing GPs who have committed certain bad acts; the latter allows investors to remove a GP without the need to give any reasons. In contrast, no-fault removal provisions are less common in US funds. The alternative protection sought by US fund investors from a governance perspective is an early termination of the fund’s life or a no-fault suspension of the investment period.
For Cause Removal
The definition of “cause” is usually narrowly defined in European fund agreements and typically covers fraud, gross negligence, willful misconduct, and material violation of securities laws that results in a material adverse effect on the fund. How “cause” is determined is often hotly debated. For experienced fund managers who do not have difficulty raising funds, determination of “cause” is typically a final, non-appealable decision by a court of competent jurisdiction. For first-time fund managers or emerging market managers, a less lengthy and formal process such as arbitration or expert determination is usually pushed forward by investors. In terms of the consequences of a “for cause” removal, the outgoing GP is usually forced to forfeit its carried interest, and no compensation is payable to the GP.
In practice, the “for cause” removal provisions are scarcely invoked even where investors have good grounds to allege “cause” having occurred. There are a number of reasons for this. Firstly, LPs usually do not have the time or resources to invest in a lengthy court process. Will fund activities be put on suspension or will the GP continue managing the fund pending outcome of the judicial process? Even if “cause” is to be determined outside of court, the process would still require substantial time commitment by the investors group and fund activities will invariably be disrupted for a considerable period of time. Secondly, investors are sensitive to bad publicity. No-one wants to be seen to be associated with a misbehaved GP or have on their record an investment with a GP who was found to have committed “cause”. Thirdly, the drafting of the “cause” provisions may be too narrow or restrictive that it acts as a deterrent, or renders it commercially unappealing, for any reasonable investors to go down this path.
By contrast, the no-fault removal provisions are the provisions that do get exercised by investors in practice. We have acted on a number of no-fault removals over the years. Apart from one case where the investors were not impressed with the performance of the GP, the other cases involved some element of bad acts on the part of the GP involving suspicious accounting practices or misappropriation of funds. Whether investors are unhappy about their GP’s performance or whether the GP has committed an act that borderlines “cause”, investors who view such issues as serious enough to warrant action would want to sever ties with the GP sooner rather than later. If the fund still holds a portfolio of assets that are worth holding onto, replacing the GP might be a more attractive solution than terminating the fund if such rights are provided in the LPA.
A no-fault GP removal typically requires a vote of between 70% and 80% (by reference to LP commitments). The votes may be cast by written resolutions, although established PE houses may be able to limit such votes to be held at a fund meeting only. It is common for the out-going GP to be paid a compensation by reference to its management fees as well as some portion of carried interest with respect to investments already made by the fund. In negotiating the fund economics, GPs would seek to protect their entitlement to carry for the work they have already done while LPs would often seek a haircut on such payout so as to incentivise the replacement GP to achieve a meaningful return for the inherited portfolio.
Practical Difficulties in Executing A No-fault Removal
While a no-fault removal seems to be an easy option for removing a GP without having to confront them with the underlying reasons, investors do not exercise such rights lightly in practice. LPs wishing to exercise such rights should be clear about the legal and commercial consequences of activating a no-fault removal, as once the clause is triggered, there is no turning back. Some of the practical items that the LPs need to consider and work through thoughtfully include:
- is there a lead investor who is willing to lead the investors group in the removal process?
- how should the investors manage the GP if the GP turns hostile and un-cooperative?
- has a replacement GP been found and the terms of management agreed?
- is there any regulatory filing required to replace the GP and if so, does the investors group have a back-up plan if the out-going GP refuses to make the filing?
- are the investors prepared to bear the costs involved in the removal and replacement process?
Regardless of whether the GP agrees to walk away amicably or to make the transition difficult, each step of the removal process requires careful planning and substantial involvement by the LPs. There is always a significant reason behind the LPs’ decision in exercising such drastic measures, and LPs should be prepared to take on the risk that the outcome of the removal might not be as good as originally envisaged. Given the complexities associated with a GP removal, it is still a rare occurrence in the market. However, investors have demonstrated that they are willing and able to exercise their no-fault removal rights if serious GP conduct or misconduct justify the action.
This memorandum is a summary for general information and discussion only and may be considered an advertisement for certain purposes. It is not a full analysis of the matters presented, may not be relied upon as legal advice, and does not purport to represent the views of our clients or the Firm. James Ford, an O'Melveny partner licensed to practice law in England & Wales, UK, and Hong Kong, and Alicja Biskupska-Haas, an O'Melveny partner licensed to practice law in New York, Tracie Ingrasin, an O'Melveny partner licensed to practice law in New York, and Angela Yung, an O'Melveny counsel licensed to practice law in England & Wales, UK, and NSW, Australia, contributed to the content of this newsletter. The views expressed in this newsletter are the views of the authors except as otherwise noted.
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