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Fund Covenants

Fund Covenants. Cumming & Johan (2013, Chapter 5). 1. Chapter Objectives. Identify five main categories of covenants: investment decisions, investment powers, types of investments, fund operations, and limitations on liability

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Fund Covenants

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  1. Fund Covenants Cumming & Johan (2013, Chapter 5) 1

  2. Chapter Objectives • Identify five main categories of covenants: investment decisions, investment powers, types of investments, fund operations, and limitations on liability • Provide new international empirical data to evaluate the proposition that covenants are more likely to be observed when expected agency problems are more pronounced; • Specifically analyze factors that influence the frequency of use of investment covenants • Human capital of the fund managers • Legal and institutional conditions in which the funds operate • Fund characteristics (stage and industry focus) • Market conditions. 2

  3. Motivation • How VC & PE funds are structured is important for understanding most things associated with VC & PE investment, including • Investment selection • Financial contracting • Fund performance 3

  4. Issues • What are the covenants? • What affects their frequency of use? • Law quality? • Human capital? • Style focus of fund? 4

  5. LP Covenants Covenants – Frequency of use Data Empirics Five types of LP covenants: 1. Investment decisions 2. Investment powers 3. Types of investments 4. Fund operations 5. Limitations on liability 5

  6. LP Covenants Covenants – Frequency of use Data Empirics Investment Decisions Investment Powers Types of Investment Fund Operation Limitations on Liability Investment Decisions • Restrictions on size of investment (either in dollar value or percentage of fund capital) on any one investee firm or portfolio company • Why? • Failure to do so… unscrupulous VC could invest all committed capital in one or two projects… take a bet, and spend time doing something else. Collect management fee, increase risk of fund to potentially collect a larger performance fee (risk shifting agency problem) 6

  7. LP Covenants Covenants – Frequency of use Data Empirics Investment Decisions Investment Powers Types of Investment Fund Operation Limitations on Liability Investment Decisions • Restrictions on use of debt instruments • Why? • Scenario 1 (more common): Covenant prevents fund manager from borrowing from bank, prevents increasing leverage of fund, mitigate risk shifting • Scenario 2: Covenants prevent fund manager from investing in entrepreneurial firms with debt, mitigates problems with risk/return tradeoff associated with investment in PE 7

  8. LP Covenants Covenants – Frequency of use Data Empirics Investment Decisions Investment Powers Types of Investment Fund Operation Limitations on Liability Investment Decisions • Restrictions on co-investment by another fund managed by the fund manager • Why? • Fund 2 used to bail out bad investments of fund 1… bad for institutional investors in fund 2 8

  9. LP Covenants Covenants – Frequency of use Data Empirics Investment Decisions Investment Powers Types of Investment Fund Operation Limitations on Liability Investment Decisions • Restrictions on reinvestment of capital gains • Why? • Moral hazard… fund managers pursuing fame (building CV with lots of IPOs) as opposed to fortune 9

  10. LP Covenants Covenants – Frequency of use Data Empirics Investment Decisions Investment Powers Types of Investment Fund Operation Limitations on Liability Investment Decisions • Restrictions on the fund manager making investment decisions independently, without fund input. • Why? • New inexperienced fund, desire to mitigate adverse selection costs 10

  11. LP Covenants Covenants – Frequency of use Data Empirics Investment Decisions Investment Powers Types of Investment Fund Operation Limitations on Liability Investment Powers • Restrictions against the fund manager investing in any of the investee firms • Why? • Moral hazard… distorted effort towards investments personally invested in, at the expense of the others… bad for LPs 11

  12. LP Covenants Covenants – Frequency of use Data Empirics Investment Decisions Investment Powers Types of Investment Fund Operation Limitations on Liability Investment Powers • Restrictions on the sale of fund interest by the fund manager • Why? • Overall distortion of risk/return tradeoff of fund and contractual structure of the LP agreement 12

  13. LP Covenants Covenants – Frequency of use Data Empirics Investment Decisions Investment Powers Types of Investment Fund Operation Limitations on Liability Investment Powers • Restrictions on investment principal additions to the fund manager • Why? • LPs did not agree to invest with new unknown managers 13

  14. LP Covenants Covenants – Frequency of use Data Empirics Investment Decisions Investment Powers Types of Investment Fund Operation Limitations on Liability Investment Powers • Key person provisions regarding the fund manager • Why? • Don’t want key fund managers to leave the fund • Note: might have covenants for any other important restrictions governing the actions of the fund manager in his or her capacity as General partner or most active fund shareholder 14

  15. LP Covenants Covenants – Frequency of use Data Empirics Investment Decisions Investment Powers Types of Investment Fund Operation Limitations on Liability Types of Investment • Restrictions on making investments in other investment funds • Why? • Added layer of fees • Don’t give one fund manager capital and pay fees so that s/he can pass on the job of investment to another fund manager! 15

  16. LP Covenants Covenants – Frequency of use Data Empirics Investment Decisions Investment Powers Types of Investment Fund Operation Limitations on Liability Types of Investment • Restrictions on follow-on investments in an investee firm of which another fund managed by the fund manager has an interest • Why? • Analogous to co-investment restriction but more general to capture any possible affiliation with the fund manager to another fund 16

  17. LP Covenants Covenants – Frequency of use Data Empirics Investment Decisions Investment Powers Types of Investment Fund Operation Limitations on Liability Types of Investment • Restrictions on investments in public listed securities, restrictions on investments in leveraged buyouts • Why? • Inappropriate for the desired risk/return profile for the institutional investors • Particularly don’t want to pay fixed and performance fees (Chapter 6) to a fund manager to invest in publicly traded firms (that is what mutual funds do, and their fees are a lot lower!) 17

  18. LP Covenants Covenants – Frequency of use Data Empirics Investment Decisions Investment Powers Types of Investment Fund Operation Limitations on Liability Types of Investment • Restrictions on investments in foreign securities, and restrictions on bridge financing • Also possible to have a minimum percentage of domestic investments • Why? • Inappropriate for the desired risk/return profile for the institutional investors 18

  19. LP Covenants Covenants – Frequency of use Data Empirics Investment Decisions Investment Powers Types of Investment Fund Operation Limitations on Liability Fund Operation • Restrictions on sale of fund interest by any investor • Why? • Influences structure of LP, possibly to detriment of other LPs or even the GP 19

  20. LP Covenants Covenants – Frequency of use Data Empirics Investment Decisions Investment Powers Types of Investment Fund Operation Limitations on Liability Fund Operation • Restrictions on the fund manager raising new funds • Why? • Moral hazard • Want the fund manager to spend time investing capital and adding value (Chapters 14-18) to investees • Don’t want the fund manager to spend time raising capital for next fund • Note: usually effective for only first 5 years of a 10 year fund 20

  21. LP Covenants Covenants – Frequency of use Data Empirics Investment Decisions Investment Powers Types of Investment Fund Operation Limitations on Liability Fund Operation • Restrictions on public disclosure of fund matters • Why? • Possibly detrimental to interests of investees (e.g., confidential matter that could affect the success of the entrepreneurs), as well as the GP and LP 21

  22. LP Covenants Covenants – Frequency of use Data Empirics Investment Decisions Investment Powers Types of Investment Fund Operation Limitations on Liability Fund Operation • The presence of a no-fault divorce provision that allows fund investors to remove the fund manager without cause • Why? • Mitigates risk associated with delegated fund management, particularly for a 10-13 year fund 22

  23. LP Covenants Covenants – Frequency of use Data Empirics Investment Decisions Investment Powers Types of Investment Fund Operation Limitations on Liability Limitation of Liability • Limitation of liability includes in the event of disappointing returns from investments made • Why? • Depends on relative bargaining power at the time of contract between LPs and GPs as to whether this clause gets put in place 23

  24. LP Covenants Covenants – Frequency of use Data Empirics Investment Decisions Investment Powers Types of Investment Fund Operation Limitations on Liability Limitation of Liability • Failure to invest committed funds within the agreed investment period • Why? • Mitigates risk associated with adverse changes in market conditions and investment opportunities, which are not perfectly foreseeable at the time of setting up the limited partnership 24

  25. LP Covenants Covenants – Frequency of use Data Empirics Investment Decisions Investment Powers Types of Investment Fund Operation Limitations on Liability Limitation of Liability • Mismanagement of funds • Why? • Depends on relative bargaining power at the time of contract between LPs and GPs as to whether this clause gets put in place 25

  26. LP Covenants Covenants – Frequency of use Data Empirics What affects the frequency of use of covenants? 26

  27. LP Covenants Covenants – Frequency of use Data Empirics Human Capital factors • Predictions • Legally trained fund managers write more covenants governing the activities of the fund • Funds with more experienced managers will have fewer restrictive covenants, and more covenants granting limited liability protections for the fund managers 27

  28. LP Covenants Covenants – Frequency of use Data Empirics Impact of quality of law • Predictions • Higher rule of law indices, and related legality factors, give rise to improved legal certainty and therefore a greater benefit/cost of negotiating and implementing covenants governing funds • Higher rule of law indices, and related legality factors, give rise to fewer covenants as the need to substitute for poor country-wide legal protections diminishes 28

  29. LP Covenants Covenants – Frequency of use Data Empirics Civil/Common law • Predictions • Civil law countries have fund managers more inclined to be rule-based and write more covenants in fund contracts 29

  30. LP Covenants Covenants – Frequency of use Data Empirics Offshore • Predictions • Offshore funds involve institutional investors from a greater number of disparate countries, have greater negotiation and contracting costs, and therefore fewer covenants. 30

  31. LP Covenants Covenants – Frequency of use Data Empirics Market Conditions • Predictions • Demand and supply conditions • Fewer covenants in hot markets due to dearth of fund managers 31

  32. LP Covenants Covenants – Frequency of use Data Empirics Summary of Factors Affecting Covenants • 4 main categories: • Fund manager characteristics • Fund characteristics • Legal conditions • Market conditions 32

  33. LP Covenants Covenants – Frequency of use Data Empirics Data 33

  34. LP Covenants Covenants – Frequency of use Data Empirics Hand Collected Sample • 50 funds from 17 countries (8: NL,US; 6, UK, Malaysia; 4, NL Antilles; 3,Germany, Belgium; 2,Cayman Islands, South Africa; 1,Philippines, Canada, Finland, NZ, Luxembourg, Brazil, Switzerland, and Italy) • Response bias mitigated as much as possible. 34

  35. LP Covenants Covenants – Frequency of use Data Empirics Figures 5.1 & 5.2 and Table 5.2 • The data presented in the figures are presented according to the sub-categories of the covenants • The data are presented in the table is by country in which the fund was formed 35

  36. LP Covenants Covenants – Frequency of use Data Empirics Covenants and frequency 36

  37. LP Covenants Covenants – Frequency of use Data Empirics Covenants and frequency 37

  38. LP Covenants Covenants – Frequency of use Data Empirics Empirics 38

  39. LP Covenants Covenants – Frequency of use Data Empirics Table 5.4: OLS, Ordered Logit • Dependent Variables (Left Hand Side Variables) • Sum of covenants for investment decisions, investment powers,types of investment, fund operations, limited liability, all types (excluding limited liability) • Explanatory Variables (Right Hand Side Variables) • Legality (legality indices, common/civil law, offshore/onshore, vintage) • Fund manager characteristics (human capital) • Fund characteristics (type of investor, legal structure) • Market conditions 39

  40. 40

  41. LP Covenants Covenants – Frequency of use Data Empirics Summary Main Results from Table 5.4 on Frequency of Use of Covenants 41

  42. LP Covenants Covenants – Frequency of use Data Empirics Impact of quality of law • Higher legal indices tend to give rise to more covenants used by institutional investors • An increase in the Legality index from 20 to 21 (a typical improvement among developed nations) increases the probability of an extra covenant pertaining to fund operation by approximately 1%, • An increase from 10 to 11 (a typical improvement among emerging markets) increases the probability of an extra covenant pertaining to fund operation by approximately 2%. 42

  43. LP Covenants Covenants – Frequency of use Data Empirics Civil/Common law • Civil law countries have fund managers more inclined to be rule-based and write more covenants in fund contracts • Civil law countries are approximately 6% more likely to have covenants pertaining to the types of investment; however, the common/civil law differences were not notable for any other type of covenant. 43

  44. LP Covenants Covenants – Frequency of use Data Empirics Offshore • Offshore funds have greater negotiation and contracting costs, and therefore fewer covenants. • Offshore funds are about 10% less likely to have each covenant for the authority of the fund manager and the types of investment 44

  45. LP Covenants Covenants – Frequency of use Data Empirics Human Capital • Legally trained fund managers write more covenants governing the activities of the fund • An increase in one fund manager of five with legal training increases the probability of additional covenants pertaining both to investment decisions (such as the size of any single investment and co-investment) and types of investment (in different asset classes) by approximately 10%. • Funds with more experienced managers will have fewer restrictive covenants, and more covenants granting limited liability protections for the fund managers • A fund with managers with an average of 30 years relevant work experience are 20% more likely to have an extra covenant pertaining to limited liability than a fund with managers with an average of 5 years relevant experience. 45

  46. LP Covenants Covenants – Frequency of use Data Empirics Additional Material • Summary of key concepts and discussion questions at end of Chapter 5 • Sample LP agreement at • &&& Insert hyperlink 46

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