Removing a fund’s manager: what investors can learn from a PE Fund in Turmoil

This article is produced by CMS Holborn Asia, a Formal Law Alliance between CMS Singapore and Holborn Law LLC.

It is extremely rare for investors in a private investment fund to terminate the fund manager. Yet, in the past few weeks it has been reported that LPs in Novalpina Capital Partners I SCSp, Novalpina Capital’s €1bn fund, voted by an overwhelming 99.6% to strip Novalpina of control of the fund, and are expected to appoint a third party in its place. The episode is a good reminder of how it is helpful for LPs to understand how and when their powers to remove a fund manager can be exercised. In some instances the removal provisions may be heavily negotiated, and in this note we set out below some general pointers that LPs may wish to take note of.

LPs in private investment funds are typically passive, having little say in how the fund is run provided that it sticks to the investment strategy and restrictions. However, most fund documents will give LPs some powers to remove the manager, and the implosion at Novalpina is a good reminder of how it is helpful for LPs to understand how and when these powers can be exercised. In some instances the removal provisions may be heavily negotiated and we have set out below some general pointers that LPs may wish to take note of:

• When can a manager be removed? A fund’s governing documents will often allow a majority of LPs to remove a manager or general partner for ‘cause’, that is, for certain reasons specified in the governing documents. These are usually limited to a manager’s insolvency, fraud, gross negligence, wilful misconduct, material breach of its obligations or criminal conduct that has a material adverse effect on the fund. A removal for cause often sees the manager forfeit some or all of its carried interest.
• Can a manager be removed without ‘cause’? There may be other circumstances apart from the specified cause events under which LPs may wish to remove a manager, and LPs should thus consider whether they have the right to remove the manager without cause. Such a right may need to be negotiated for, and will likely require the election of a supermajority of LPs. Removal without cause will typically see the manager retain most (if not all) of its carried interest and receive a compensatory payment of up to two years’ management fees. This is often a bitter pill for LPs to swallow, especially when there may be good reasons for removing the manager, which don’t amount to cause (yet).
• Who determines when a ‘cause’ event has occurred? It is insufficient for LPs to simply allege that a cause event has occurred. Fund documents generally specify that a determination of cause must be by a decision-making body, such as a court or arbitration tribunal, and may further specify that such a decision must be one that cannot be appealed against.
• What happens to the fund when the manager is removed? This is often the least well-defined aspect of the manager removal provisions as the potential circumstances of the manager’s removal are impossible to predict when the fund is launched. Whilst it is impossible to cover every possible scenario, it is preferable to specify who takes charge of the appointment of a replacement manager (either to manage the assets going forward or to liquidate the portfolio). Typically the LP advisory committee would take on this role, being smaller and nimbler than the entire LP base and, hopefully, having had more visibility on fund operations prior to the removal. A pressing issue will be how any replacement manager should be remunerated, especially for a ‘no cause’ removal where the outgoing manager will retain carry and fees.

The old adage ‘hope for the best, plan for the worst’ applies as much to a fund’s governing documents as it does to a pre-nup. Whilst LPs cannot predict what the ‘worst’ may look like, the episode at Novalpina demonstrates why it is important for LPs to have the option to remove the manager without cause, especially since cause events tend to be narrowly defined. LPs should also ensure that the fund documents set out a clear process and assign clear responsibility for kicking one fund manager to the curb and finding, appointing and remunerating their replacement.