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May 16, 2016 | BUYOUTS | 9

INSIDE THE DEAL

Successor Funds and the

Problem with PPM Triggers
By Christopher M. Schelling
fund (forming the partnership or filing
partnership formation documents with a
state, issuing a private-placement memorandum, holding a close, etc.)?

Christopher M. Schelling

learly all private-equity-style

closed-end draw-down funds
have a clause ensuring that
the general partner remains
focused on deploy ing the
commitments of an existing fund prior
to turning substantial business efforts
toward raising a successor fund.
The reason is clear. Limited partners
want to ensure that their money is nearly fully invested prudently, of course
before the GP races off to raise more
money.
Often enough, however, the legal language to ensure this process is far less
clear.
This language must incorporate several important considerations, including:
How deployed should a fund be (70%,
75%, 80%) before the GP is permitted to
raise funds?
What is included in the percentage deployed (portfolio company investments, partnership costs and expenses,
management fees)?
And which activities define the initiation of actually raising the successor

Negotiations regarding the first two

elements a re generally clea r. More
deployment as opposed to less is always
favorable to LPs in the existing fund.
Exclusion of fees, costs and expenses in
the calculation has the effect of higher
actual investment deployment and is
again LP-favorable.
But the third element which activities constitute fundraising is more
subtle and creates the potential for perverse incentives and unintended consequences for limited partners.
Lets first investigate a typical successor clause with a formation trigger:

Example 1.
T he Managing Directors may form any
successor private equity fund with objectives substantially similar to the Partnership ( a Successor Fund) on or after the
earliest to occur of (i) such time as at least
75% of the Partnerships Committed Capital
has been invested, committed or reserved
for investment in Portfolio Companies, or
applied, committed or reserved for Partnership working capital or expenses or (ii) the
expiration or permanent suspension of the
Investment Period.
First, we note a standard of 75% invested, committed or reserved, which is market and generally acceptable. Second,
partnership expenses and working capital are included in the deployment calculation, which has the effect of reducing
that 75% actually invested to 60% or so.
Therefore, removing the expenses could
be a request. (I stress could be, since
the managers natural deployment pace
is important to consider. What is relevant from the managers perspective is
how much callable commitment remains
in the existing fund.)
Finally, turning to the trigger, we can
see the language states simply may form

any successor fund. Again, the objective

is to ensure that an acceptable amount of
the business time of the general partners
and/or investment professionals is devoted to investing the assets of the current
fund before they dedicate substantial
time and effort toward raising a successor fund. This is the business intention.
The language in Example 1 accomplishes this objective. But it is also
indeterminate in terms of what defines
forming the successor fund. Does this
mean starting to talk to investors and
creating decks, or actually filing the
partnership documents and getting a
limited-partnership certificate of formation? I would argue that it permits the
former and prohibits the latter, which is
an entirely reasonable compromise.
Lawyers hate ambiguity, however, so
other versions of this clause offer more
clear and specific triggers for what constitutes raising a successor fund. Consider Example 2, which references a fund
closing as a trigger.

Example 2.
Unless consented to by (i) the Advisory
Board, or (ii) at least 66 2/3% in Interest of
theLimited Partners, from the Initial Closing
Date through the earlier of (a) the expiration
ortermination of the Commitment Period, or
(b) the date on which at least 75% of theaggregate Commitments of the nondefaulting
Partners has been invested, committed to be
invested (or reserved for investment in FollowOn Investments) or reserved forpayment
of Fund Expenses, including, without limitation, the Management Fee, none ofthe General
Partner, the Management Company or any of
their respective Affiliates willclose on any new
investment fund vehicle controlled or managed
by the General Partner,the Management Company or any of their respective Affiliates and
which has substantially similar investment
objectives as the Fund.
In this example, the prohibited action
is to close on a new fund with similar
investment objectives. While this is very
explicit, holding a closing will come well

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after the real formation and fundraising
activities have already occurred. Hence,
this language is more GP-favorable in
this regard than Example 1. The manager can essentially devote as much time
toward fundraising as he or she desires,
so long as a closing is not held. This violates the spirit or the intent of the clause
to begin with.
Frankly, we might as well not even
have a clause in this case, as the GP
can still do whatever he wants, including simply delaying the ink on the initial close until he hits the deployment
threshold despite having all the heavy
lifting done. (In fact, Ive seen docs with
the trigger being a capital call on the
successor fund. At that point, its a conflict of interest or an allocation consideration, not a business activity limitation.)
A third example of a trigger is the
issuance of the PPM. Example 3 provides
this language below.

Example 3.
None of the General Partner, the Ultimate
General Partner, the Management Company, the Sponsor or any Approved Executive
Officer may issue an offering memorandum
for a new investment fund (a) with objectives, strategy and scope substantially similar
tothose of the Fund, unless the Advisory Board
consents in writing, until the earliest of (i)the
time at which an amount equal to at least 75%
of the Partners aggregate Commitmentshave
been invested, committed or allocated for
investment, used for Partnership Expenses or
Organizational Expenses or reserved for followon Investments or reasonably anticipated expenses of the Fund or (ii) the date the
Investment Period expires or terminates.
This clause prohibits the issuance
of the PPM until the prior fund is 75%
invested or committed, which at first
blush seems like a good compromise.
Issuing the PPM comes after fund formation and some actual sales but well
before holding a close or at least it
should in theory.

iStock/vm

In reality, what happens is that the

general partner can still engage in all
the activities of raising a successor fund
establishing the legal entity, creating
a pitchbook and engaging in roadshows
with potential limited partners so
long as a PPM has not been disseminated.
Functionally, this has the effect of
allowing the manager to complete all
the work associated with both forming
and raising the fund simply without a PPM,
which comes along at the last minute
just prior to a first close. This allows the
manager to technically remain in compliance with the terms of the original
partnership agreement, but creates significant problems for (often slower moving) institutional investors that require
the PPM to complete certain parts of
their due diligence process.
Limited partners should ask ourselves

Fund Raising Cycle with PPM Trigger

PP
M

ng

ui

Source: xx

Sales
Process

Iss

Filing LP
Agreement

Holding
closes

what is the point of having a clause that

doesnt limit actual business activities or
time but simply prevents dissemination
of information.
This is not the original intent of this
item.
Its time to return to the objective of
the successor-fund clause: ensuring that
the general partner dedicates appropriate time to investing the assets of one
fund before turning substantial business
efforts toward raising the next, acknowledging that the GP cannot endure a gap
of time without callable assets for portfolio company investments, since a stale
pipeline or, worse, actual missed or broken deals because of an inability to close
can damage their brand and hurt future
performance.
An honest discussion between GPs and
LPs partners, both and a return to
simple triggers such as may not raise
are in order because it is a partnership.
How much time do we need and how
much time do they need?
Actual business needs should drive
the language to prevent perverse incentives and technical gamesmanship.
Christopher M. Schelling is director of private equity at Texas Municipal Retirement
System.