Although hedge funds vary widely in terms of size, profile and investment strategy, it is not uncommon for a single individual at a fund to wield vast authority and oversee most or all trading and investments. Often, that same person – who may be the founder, managing partner or head portfolio manager, for example – conducts outreach, brings new investors on board, builds relationships and commands the trust and respect of investors, who may not want to grant oversight of their money to anyone else. If someone wielding so much responsibility were to die suddenly, fall chronically ill, quit, retire or otherwise cease to be part of the fund’s operations, the consequences could be dramatic. Some investors may seek to redeem their shares as fast as possible and exit the fund, while others may wish to stay on under new leadership, necessitating careful succession planning. The SEC’s enforcement action against E. Magnus Oppenheim & Co. Inc. (EMOC) for failing to draft and implement policies and procedures reasonably designed to anticipate the loss of a key person, among other violations, underscores the need for robust compliance in this area.
For all these reasons, it is imperative for hedge funds to have the right key person provisions in their governing documents. Though a standard feature of such documents, their drafting does not always take into account all the ramifications of losing a key person. In fact, a hedge fund with what might sound like fairly standard key person terms in place could end up in a chaotic situation if they are not drafted with care.
This article, the first in a two-part series, explains what key person provisions are and in which documents they typically appear; the terms of such provisions, including which personnel they cover, what scenarios could trigger them and investor rights if they are triggered; why they are vitally important in the SEC’s eyes; and how they relate to succession planning. The second article will delve into the operational logistics of what happens when a key person event occurs.
See our two-part series on succession planning: “A Blueprint for Hedge Fund Founders Seeking to Pass Along the Firm to the Next Generation of Leaders” (Nov. 21, 2013); and “Selling a Hedge Fund Founder’s Interest to an Outside Investor” (Jan. 16, 2014).
What Are Key Person Provisions?
Key person provisions outline the steps that fund managers will follow when a designated “key person” ceases to be sufficiently involved in the fund’s operations and what rights investors will have if a “key person event” occurs. Such provisions are usually found in limited partnership agreements (LPAs), although there can also be notification rights of key person events in side letters.
LPAs
As the contractual documents setting forth the terms of investor and fund manager relations, LPAs are an obvious place for language concerning key person events. Besides LPAs, hedge fund private placement memoranda (PPMs) may, in some cases, give a description of the provisions and say which individual or individuals they cover, but PPMs are not contracts, noted Laura Hirst, partner at Ropes & Gray. Hence, it is LPAs that give these provisions force.
Including such provisions in the LPA is not only common but an expectation. “Key person provisions are basically universal, and I would recommend including them and not waiting for investors to ask for them,” said Heather Wyckoff, partner at Alston & Bird. “If you were to go out without them in your documents, I would expect them to be requested.”
See “Investment Fund Survey Finds Growing Investor Bargaining Power” (Aug. 17, 2023).
Side Letters
Apart from the terms set forth in LPAs and PPMs, notifications of certain types of key person events may be guaranteed in side letters between specific investors and fund managers, Hirst acknowledged. In particular, institutional investors often ask for side letter terms regarding notifications of any enforcement actions that might interfere with a fund principal’s daily involvement in operations, she said. However, key person events are of concern to all investors in a fund and should not be addressed in a side letter, advised Wyckoff.
See “Key Person Provisions in Hedge Fund Documents: Structure, Consequences and Demand From Institutional Investors” (Sep. 17, 2009).
What Terms Do Key Person Provisions Include?
Key person provisions typically cover the individuals designated as key persons; what events will trigger the key person provision; the fund manager’s notification duties if such an event occurs; and the fund investors’ rights if that should happen.
Designation of a “Key Person”
The key person provision should identify which individual or individuals at the fund are considered a “key person.” Although the identity of a key person will vary depending on the fund’s size and profile, it is often the founder or the lead portfolio manager. In some instances, the provisions may apply to a few lead portfolio managers. Whatever the case, the individual or individuals covered should be those who are central to the fund’s day-to-day activities, said Chris Lokken, partner at K&L Gates. For example, with startups, “usually, but not in all cases, they’re founded by somebody who is primarily responsible for the firm and its trading strategy,” he explained. “But you have startup risk, so if that person is no longer available, investors need notice that they have the ability to redeem.”
Investors will seek assurances regardless of the size of the fund, noted Scott Moss, co-chair of the investment management practice at Lowenstein Sandler. “Generally speaking, investors don’t want the ship to be rudderless. In general, what investors are investing in are the people they think can guide them properly in making investment decisions,” he said. “Sometimes that’s a person; sometimes it’s a group of people.”
Whatever the scenario, the key person should be limited to someone whose loss will have a material adverse effect on the operations of the fund and/or the fund manager, said Lokken. It is rare for a key person provision to extend beyond the lead portfolio manager or the principal of the firm, he noted. But, in some instances, a COO or risk manager might be named as a key person, he acknowledged. The latter situation might arise in a startup launched by people who have never run a hedge fund before, and whose investors are more comfortable knowing that a given COO or CFO is covered under the provision, he observed.
There are personnel in addition to the founder who would be candidates for key person coverage, concurred Wyckoff. If an institutional manager offers multiple product types and uses different people to oversee particular strategies, it would not be uncommon to have a key person clause triggered by the departure of multiple team members - such as two of three, she said. “Ultimately, if a fund is being marketed on the basis of a given team, the investors are signing up to have their money managed by that team,” she stressed.
At the same time, selectivity with regard to the naming of key people is essential, continued Wyckoff. “It has to be someone who’s critical to the future success of the fund. Whenever you include extra people beyond what’s typical, you’re giving each of those people outsized power internally,” she explained.
Trigger Events
Typically, key person provisions will be triggered when a designated key person ceases to be involved with a fund’s operations for a specified period of time. Designated trigger events usually include a key person’s:
- death;
- long-term illness or disability;
- departure;
- retirement; or
- relocation.
Of course, there are circumstances other than the above that could limit or end someone’s involvement in a fund’s daily operations, pointed out Hirst. For example, a fund principal who is subject to an enforcement action might have to shift a bulk of his or her time to mounting a defense against the regulators and may have to stand trial, she noted. Someone sitting in a courtroom for several days a week obviously has limited time to devote to managing a fund. Moreover, someone who ends up in jail has severely limited or no ability to manage a fund.
If a key person provision is not drafted with proper care, then one can envision a scenario in which extended leave, vacation or some other normal, wholly appropriate action or decision on the part of a key person could inadvertently trigger the provision, continued Hirst. “It’s bad drafting if it doesn’t contemplate the fact that somebody is going to take vacation or might not be well for a certain number of days,” she said.
The amount of time required to trigger the provision is likely to vary from one fund manager to another. The specified period might be 45, 60 or 90 days, according to Lauri Goodwyn, counsel at Seward & Kissel, who noted that she had never seen a key person provision that allowed for longer than 90 days of noninvolvement before it was triggered. “Some investors may want it to be shorter, but you don’t want it to be triggered because somebody took a vacation, fell off a bike or something. That’s not going to be a long-term problem or issue,” concurred Lokken.
See “How Fund Managers Can Withstand the Coronavirus Pandemic: Marketing Disruptions, Key Person Clauses and Cybersecurity Concerns (Part Two of Three)” (Apr. 9, 2020).
Risks of Premature Triggering
It is imperative to craft key person provisions in a way that recognizes the seriousness of potential regulatory complications, while avoiding premature notification of investors because of what might turn out to be a relatively minor issue, advised Lowenstein Sandler partner Michael Saarinen. This could cause unnecessary problems, he cautioned. “There are often situations in which, if I’m advising on an LPA, I would say, ‘I don’t think investors should have a key person notification right just because someone is under investigation and it’s relatively routine,’” he shared.
Accommodation of Personnel Changes
The drafting of key person provisions must take into consideration the sheer variety of fund strategies – some far more complex and demanding than others – and the reality that investing is not equally time-intensive across the whole gamut of funds and vehicles, noted Saarinen. A one-size-fits-all clause in an LPA, branding any kind of retreat from past patterns of involvement on the part of designated individuals as a key person event, obviously will not work, he emphasized.
“There are lots of nuances in terms of how much time key persons need to devote and how much their stepping away is truly a concern. Is the trigger if a key person never does anything at the fund again or devotes only some time to the fund?” Saarinen asked. “Hedge fund managers often provide investors with notice of planned personnel adjustments well in advance, giving them ample opportunity to redeem in their customary manner before any changes take effect.”
Expiration Dates
Some fund managers have even gone so far as to include expiration dates when drafting key person language, observed Lokken. Although it is often true that investors come to a fund looking to have a specific person manage their money and would not want the task delegated to anyone else, this is not invariably the case. He recalled advising on a fund formation 15 years ago in which the LPA included a fairly standard key person provision, in line with investor requests, except that it expired after two years.
“The thinking was that this made sense based on what the fund traded and the fact the key person was relying on three or four team members. At some point, if he became unavailable, it wasn’t going to have an immediate and disastrous effect on the fund,” Lokken recalled. “If people didn’t like the fact that he wasn’t involved anymore, they could just redeem in the ordinary course of things.”
Notification Requirements
Typically, when a key person event occurs, the provisions will give the fund manager 20 to 30 days to notify investors of what has happened. Usually, the manager will notify them by letter that they have 30 days (or, in some cases, longer) from the date of the letter to submit redemption requests. But windup of the fund is not automatic in all cases, and investors may opt to stay invested pending the appointment of a replacement for the key person.
Investor Rights
A critical element of a key person provision is investors’ right to be notified when a key person event has occurred. Even if not all investors enjoy the same rights concerning notifications, a fund manager’s fiduciary duty to investors will – in many, if not all – cases require notifying all investors at the same time, Hirst said. “You wouldn’t want to give one investor notice of a departure and then allow that one investor to redeem based on that information,” concurred Wyckoff.
Besides notifications, some key person provisions may provide preferential terms with regard to liquidity and redemptions if a key person event occurs, but legal experts generally agree that this is not the best approach. The use of key person provisions to grant different liquidity or disclosure rights to some investors is ill advised, stressed Lokken. “It does not mollify the other investors nor do regulators tend to approve. I would never advise someone to give one investor a key person provision and not apply it to all fund investors,” he said. “The SEC, to put it lightly, takes a dim view of giving certain investors preferential liquidity over others.”
See “SEC Penalizes Adviser for Preferential Redemptions and Undisclosed Conflicts” (Sep. 26, 2024).
The SEC is concerned about this issue, confirmed Saarinen. With proper disclosures, it might be possible to work out technically permissible arrangements that place investors in different liquidity classes in the wake of a key person event. But whether the issue is liquidity rights or notifications, Saarinen does not view it as prudent to prioritize the access of some investors over that of others. “As an investor, I would be very reluctant to ever invest in a fund when I knew some people had access to information about key person departures, incapacitation or long-term noninvolvement and/or the ability to act on it – and I did not,” he said.
“And, as a manager, I would be mindful that my fiduciary duties to all fund investors may – especially during a liquidity crisis – come into direct opposition with any superior information and redemption rights that I have granted to a smaller subset of fund investors,” continued Saarinen. “You never want to be caught in that double bind.”
See “Study Tracks Evolving Seed Deal Terms” (Aug. 18, 2022).
Why Are Key Person Provisions Critical to the SEC?
Although SEC investigations and enforcement actions specifically related to violations of key person provisions may not be common, the issue is very much on the regulator’s radar. For example, in March 2023, the SEC announced settled charges against EMOC, a New York-based adviser and broker-dealer with $56 million in AUM at the time, for, among other violations, failing to have reasonably designed policies and procedures in place to anticipate and make plans for the loss of a key person when its founder and CCO died in 2019. Notably, the SEC alleged that EMOC had failed to adopt proper succession measures even after a 2019 SEC examination cited it for “failing to establish procedures in the event of the loss or incapacitation of key individuals, including Mr. Oppenheim, then [EMOC’s] sole principal.”
See “SEC Cites Adviser, Whose Founder and CCO Had Died, for Multiple Compliance Failures” (Oct. 26, 2023).
Moreover, an SEC risk alert on examinations of private fund advisers issued in January 2022 named “failure to follow fund disclosures regarding adviser personnel” as an area of concern. More specifically, the alert stated that staff from the Division of Examinations had “observed advisers that did not adhere to the LPA ‘key person’ process after the departure of several adviser principals or did not provide accurate information to investors reflecting the status of key previously-employed portfolio managers.”
See “SEC Risk Alert Reflects Growing Concerns About and Focus on Private Funds” (Feb. 24, 2022).
How Do Key Person Provisions Relate to Succession Planning?
In addition to providing a measure of comfort and security to investors around what can or should happen in the event of the loss of a key person, the drafting of key person provisions should, ideally, drive a discussion at the top levels of a fund manager around how to handle the succession issues that such a change entails, observed Moss. Having such a conversation, and drafting the provisions thoughtfully, is especially urgent at a small shop where one person essentially makes investment decisions from day to day and is the sole point of contact for outside vendors and custodians, he cautioned. “What happens to the investors’ money in the fund if something happens to you? Even in a hedge fund context, there’s nobody left to buy or sell or even administer the fund,” he commented.
LPAs should identify who will have legal authority to act on the fund’s behalf. “I’ve seen cases in which a key person at a fund dies suddenly and the investors said, ‘We’re really sad this person died, but now there’s no one running this fund anymore! There’s nobody even with the authority to contact the broker and say what happens with the custody account,’” Moss shared. The resulting situation was chaotic, he recalled, with outside counsel trying to contact the estate of the deceased, while the absence of a liquidator made further actions with respect to fund assets impossible to execute.
In fact, third-party service providers simply did not recognize the executive authority of remaining personnel at the fund. “If anybody called up the custodians who held the fund account, they said, ‘Who are you? You don’t have authority over these accounts. Why are you telling us to liquidate them?’” Moss recalled. The relevant clause in the fund documents may have had the title “key man provision,” but, in his view, the LPA was worthless because it failed to anticipate what would actually happen if the developments named as key person events came to pass.
Like many other types of businesses, hedge fund managers may opt to purchase key person insurance as part of their succession planning. In return for paying a premium, the manager will be the beneficiary of insurance to help cover business losses if a key person event occurs. However, if a fund is going to wind down when a key person ceases to be involved, then paying heavy premiums for key person insurance may be of questionable utility. “I see key person insurance more at a management company level than at a fund level,” said Moss.