How binding is a binding commitment?

Author: | Published: 7 Jan 2003
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This article will deal with an emerging legal issue associated with private equity funds such as venture capital and leveraged buyout funds. The issue relates to what extent an investor is bound to its commitment to invest in such funds under various conditions. Both current agreement practice as well as general principles of contract law will be reviewed.

In this article, the investor's position will at times be compared to that of a lender. This does not mean that the authors feel that the investment agreement should necessarily emulate loan agreements on the right of commitment cancellation. However, the general principles developed in loan agreements might be useful when comparing investment agreements and their relative lack of cancellation clauses. The observations are limited to Finnish law, but certain issues and solutions herein may have applications elsewhere.

The basic structure in a lender's commitment to the borrower and in an investor's commitment to the fund is the same: a commitment to provide funds to be used for agreed purposes in the future. In both cases, it is possible that once the commitment is made grounds may arise on which the committed entity is obligated or would prefer to withdraw from its commitment. One alternative is the ability to sell the partnership interest. This would only be possible with the manager's consent and would perhaps not release the investor from its commitment to make further capital contributions.

Investor's investment commitments to private equity funds are normally unconditional and irrevocable. The partnership agreements generally do not include terms or conditions that would allow the investor to cancel or reduce his commitment during the term of the fund.

On the other hand, committed loan facilities include numerous covenants and other conditions, which may trigger the lender's right to cancel his commitment. Material adverse change clauses, in their broadest of terms, protect lenders from any unexpected event impacting on a borrower's business.

Loan agreements have evolved over a long time period to their current comprehensive state. Furthermore, lenders, by the nature of their position, have had strong bargaining power in dictating terms and conditions to prospective borrowers. Taken together, both conditions have resulted in a variety of terms and conditions in loan agreements that allow lenders to withdraw from future disbursements under various sets of circumstances.

The private equity industry is much younger, and the evolution of similarly complex and more exacting agreement language has at least not yet occurred. Few disputes have been adjudicated in court, and as a result, case law is rather limited. Furthermore, potential investors have evaluated their possible participation in funds more on the basis of fund manager evaluation and performance than on the terms and conditions of the agreements.

Another reason for the lack of language dealing with the termination of commitment is the assumed alignment of interests of the parties. All hope to realize and benefit from future investment gains. This alignment of interest is a fundamental feature of private equity funds. However, due to the large management fees in big funds and possible fee income from the portfolio companies, fund manager income from investment gains might not be as compelling in some cases.

Furthermore, it is often in the interest of the individual investors that other investors be compelled to fulfill their obligations to make further capital contributions. Therefore, current partnership agreements often include very severe sanctions, the enforceability of which may even be questionable, against defaulting limited partners. (The agreements do, however, allow investors not to participate in individual investments, when changed legislation or regulations prevent the investor from investing. In this case the other investors have to cover any resulting shortfall.)

During any long investment period, the manager's and investors' interests and opinions may come into conflict. The reasons can be caused for a variety of reasons such as fundamental changes in the market situation, different opinions with respect to future expectations or simply lack of confidence in the investment skills of the manager. In some cases, agreement language may address some of these changes in conditions.

The private equity investor's choice of a certain fund is usually based upon the investment acumen of certain individual managers. As a result, Key Man Clauses have been developed so that an essential manager is committed to use his primary working capacity in the fund in question or in other permitted prior or future funds. This commitment can be made for the commitment period or for the term of the fund and if violated, the investors may suspend additional investments or even change the general partner or terminate the fund.

Considering the strong emphasis on track record and skills of certain managers at the time when the commitment is made, it may seem somewhat peculiar that there are no consequences from the loss of confidence in the manager during the term of the fund addressed in a typical current investment agreement. Clauses enabling the removal of the general partner require cause: breach of the agreement, negligence or criminal act. A mere loss of confidence or a failure to display adequate investment skills is not sufficient for the applicability of these clauses.

In sharp contrast to the unconditional always-binding commitment is the so-called no fault divorce clause, which has become more common in the partnership agreements for private equity funds. It gives the qualified majority of investors the right, at its discretion, to suspend investments, change the general partner or even terminate the fund. The voting thresholds, however, are high and calculated on the basis of a number of limited partners or the amount of their commitments.

Despite its apparent sweeping language, it has sometimes been argued that the exercise of the no fault divorce-clause nevertheless requires cause. It has been argued by some that the inclusion of the clause would only be helpful when there is not total certainty whether the requirements in with-cause-clauses are met and whether the evidence is sufficient.

In the opinion of the authors, this argument is flawed. We believe that a qualified majority has the ability to exercise this right if it so wishes. The right is exercisable - if the language is so written - "for any reason whatsoever or without any reason", as one columnist noted when making fun of the Anglo-Saxon way of drafting agreements. Even change of mind is adequate.

The discussion of the possible inclusion of the no-fault divorce clause has resulted in a debate for and against unconditional and in all circumstances binding commitments to invest.

It is argued by some that the general partner must be able to plan its resources for the long term and to attract skillful personnel. This might not be possible if the continuation of the arrangement would be constantly at risk. The possible premature termination of the fund would affect the investor appeal of future funds, which also would have an impact on the motivation and commitment of key personnel. Furthermore, the decrease in the amount of total commitment would directly affect the management fee, but without a corresponding decrease in fixed expenses.

The service role of the fund managers may not, however, be considered that different from other service providers and so the arguments for exceptionally long and unconditional investor commitment may not be completely convincing.

When compared to a lender-borrower relationship, the investor-fund manager relationship is somewhat different. In a lending situation, full financing as originally planned is often a requisite for the successful completion of a project. However, with respect to capital contribution commitments, investments are usually self-contained and mutually exclusive and do not depend on the outcome of one another.

When entering into an agreement, the parties have expectations that certain preconditions will remain valid or be fulfilled during the term of the agreement. These preconditions are not specific terms or conditions set out explicitly in the agreement but are more essential circumstances which one party has deemed to be necessary to be able to enter into the agreement.

For example, when an investor makes his investment decision, he has certain expectations about the future development of the industry or market relating to the investment strategy of the fund. If materially adverse market conditions then occur, then the investor may deem that his precondition for the investment has failed or has ceased to exist. According to Finnish law, under certain circumstances a material failure of a precondition may give a party the right to request a subsequent adjustment of his obligation under the agreement. Such a right is always subject to the condition that the other party knew or should have known of such a precondition already at the time when the agreement was executed

Under certain provisions of Finnish Contract Act, it could also be argued that materially-altered market changes might enable the investor to have the right to request adjustment of the extent of his commitment. However, in the kind of multi-party arrangement among professional entities such as between investors and fund managers, it is very unlikely that unconditional clauses could be set aside based on these provisions. The controlling idea is always that the investor, being a sophisticated entity, should have anticipated the possibility of unexpected downturns in the market and must accept the risk that results from such downturns, unless specifically otherwise agreed.

Considering the long term nature of many funds, the importance of investors' trust in the managers and need for a stable partnership arrangement to fulfill investment goals, it is surprising that wider variations in practice have not occurred between the two basic alternatives: the unconditionally binding commitment on the one hand; and the availability of the termination clause without any cause on the other.

Investors have often been successful in reducing their commitments in private equity funds due to shared interests with fund managers to do so when fund performance is poor or prerequisites for successful investments do not exist. This occurs as a result of the parties shared commercial interest, and not as a result of any legal argument, which in and by itself does not support investors' wish to reduce their commitments.

The past practices and experiences of the parties have, however, raised the question whether their agreements should be amended so that they would better address the investors' often justified need to reconsider the size of their commitment and thus the size of the whole fund under certain conditions. As discussed briefly above, some inference and possible partial remedies to this issue might be derived from conditions found in typical loan agreements that protect lenders' interests under committed facilities.

Peltonen, Ruokonen & Itäinen
Fredrikinkatu 48A
00100 Helsinki
Tel: +358 9 417 60 30
Fax: +358 9 417 60 417