Why LPs Could Have Greater Fund Governing Power after COVID-19

Historical trends in non-economic fund terms suggest that investors could regain some control from fund managers in the wake of the pandemic

In the LP-GP relationship, fund managers have been able to set more favorable fund terms in recent years. The use of key governance provisions in fund agreements which are designed to protect investor interests – namely the no-fault divorce clause and the key-man clause – have declined over time. If we look back at vintages 2009-2010, these averages are much higher among funds that began investing in the aftermath of the Global Financial Crisis (GFC). 

During the tough GFC-era fundraising environment, some LPs found themselves in a stronger position to negotiate fund terms and conditions. In fact, 43% of respondents to our 2009 survey of private equity investors told us that the balance of power had tipped in their favor. Several months on from the outbreak of COVID-19 and the IMF has projected a 4.9% fall in global real GDP for the rest of 2020. With fund managers struggling to raise capital in these bleak conditions, the pendulum could once again swing in favor of LPs, who will be closely examining how their funds are being governed. 

To understand how COVID-19 could affect fund governance, we analyzed GFC-era fund terms data ahead of the launch of The 2020 Preqin Private Capital Fund Terms Advisor this week.

Governance in a Downturn 
A no-fault divorce clause is one provision by which investors can influence fund governance. If a situation arises that is not covered by the terms laid out in the limited partner agreement (LPA), invoking the clause could allow investors to suspend the investment period until the situation is resolved, terminate it entirely, or even replace the GP. 

The use of a no-fault divorce clause has generally declined since the GFC. Among private equity funds raising capital in 2009, 95% included a no-fault divorce clause in their terms and conditions. But for private capital funds of vintage 2020 and those currently raising, only 50% of funds include a no-fault divorce clause in the LPA, as shown in the chart above. This is the joint-lowest proportion in recent years, and suggests that as demand for alternatives has grown LPs have been willing to accept less favorable terms in a more competitive fundraising market.

A key-man clause is another governance measure typically observed by a majority of private capital funds. The clause protects LP interests by ensuring that those professionals that are crucial to the fund’s investment strategy devote enough of their time and resources to a partnership. The clause serves not only to identify the ‘key’ professionals, but also specifies when the clause can be invoked and what actions may be taken. 

In a similar trend to the no-fault divorce clause, Preqin data shows that the use of a key-man clause has declined over time. Among private equity funds raising capital in 2009, 98% included a key-man clause in their fund agreements. In contrast, Preqin’s upcoming 2020 edition of the Fund Terms Advisor shows that 74% of recent private capital funds (funds in market or with a 2019/2020 vintage) have the clause written into their terms. 

In both cases, usage figures could well begin to rise closer to post-GFC levels as the impact of COVID-19 plays out in the coming months. Indeed, among investor respondents to our most recent survey, 40% believe the balance of power will shift toward the LP when negotiating fund terms in the aftermath of the pandemic.

Why Governance Matters to Investors
Greater LP involvement in governance seems particularly likely when we consider the rapid rise of sustainable investing as a whole. Among investors surveyed by Preqin at the end of 2019, 61% said that environmental, social, and governance (ESG) factors will become more integral to the alternative assets industry in the next 36 months. What’s more, according to a recent study conducted by S&P there is substantial empirical evidence to suggest that good governance ultimately yields better corporate returns.

With the resulting economic downturn from the COVID-19 pandemic, we expect to see LPs regaining some influence in the governance arena in the coming months – as we saw in the aftermath of the GFC. For investors looking for greater involvement in fund governance, now might be the time to act.

For more information on governance and the broader fund terms arena, order your copy of The 2020 Preqin Private Capital Fund Terms Advisor, the definitive guide to fund terms & conditions in the private capital industry.

For more insights and analysis on the impact of the pandemic on alternative assets, take a look at our COVID-19 Knowledge Hub.