Niche Private Markets: Key Person Risk

Investing in private market exposures is somewhat akin to entering a multi-dimensional contract. There are the governing documents (e.g., LPA) that provide a set of legal parameters (type of investments, partnership duration, etc.), and then there’s the more qualitative piece—the social layer of sorts—that is, “I [the investment partner] will go out and do what I said I was going to.’ Investors can, and should, underwrite both layers when vetting a prospective investment partner. Legal and qualitative. One risk that overlaps both layers is key person risk. A risk that is often under-appreciated in private markets.

It is generally taken as given that the managing partner(s) of a firm are expected to remain at the helm for the duration of the investment vehicle, which may be upwards of 7-10 years, or longer. However, life happens. Key personnel may leave or be impacted by exogenous events. Such events may be caused by death or disability, personal or professional legal matters, or a voluntary departure for any number of reasons (interpersonal disputes, retirement, other professional opportunities, etc.).

As with most “known” risks, investors should use qualitative heuristics during the due diligence process in addition to codifying protections to prepare for the possibility of a key person exiting the fund.

Data shows that ~88% of GPs automatically suspend investment activity when a key person event occurs.1 Why? A key person departure typically triggers a cessation event, automatically suspending new investment activity, with LPAC (and/or LP) majority (or supermajority) approval often required to resume normal course operations.?

For private equity firms that have suspended activity during a key person event, ~70% suspended new investments for 6 months or more2, illustrating a meaningful disruption to the fund’s activities.

The length of the suspension is impacted by a variety of reasons, including the circumstances of the key person(s) departure, their level of involvement in the fund’s activities, the length of the anticipated search and selection process for replacing the key person(s), and the development of new strategies (if necessary) for managing fund assets in the aftermath of the key person event.

Here’s a few considerations for investors related to key person risk when reviewing a prospective investment:

Does the management team have material skin-in-the-game? GPs/key persons who invest meaningful personal capital into their own strategies are more likely to stay committed to the fund (i.e., their “switching costs” are high, reputationally, and socially). The average GP commitment typically hovers around 1-2%—investors should filter for outsized GP alignment. In our view, 1-2% is typically de minimis.

What are the typical terms of the key person (and related) provisions in an LPA? These provisions generally outline any steps to be taken to seek a replacement key person, changes to the investment period/impact on investment activity and timelines/process regarding the same, and the terms of key person insurance (if any), among other factors. In addition to key person provisions related to departures, some fund documents will include cause event triggers that provide LPs the optionality to end the investment period and/or remove the GP entirely in the event of certain “bad acts” such as legal or regulatory transgressions on the part of the GP/key persons. These clauses typically entail a majority (or supermajority) vote by the LPs to exercise. Funds may even have a no-fault termination where a specific ownership or LP percentage can remove the GP for any issue, or none at all.

What are the working dynamics of the partnership? LPs should paint a mosaic via qualitative questioning to understand the relative departure risk and operational risk, of an investment partner’s firm. These risks are easy to overlook, and often perceived as unsound reasons to pass on a deal—but this instinct should be curbed if long-term, durable outperformance is the ultimate objective.

• What is the relationship duration of the key partners?How are decisions made?
• How is the committee structured (if there is one)?
• What is their employee retention rate?How is the firm governed?
• How is employee compensation structured?
• Are the members of the LPAC a “group of friends” or individuals from reputable institutions (i.e., what are their incentives)?

Does the management team have a strong personal and professional reputation? Reference checks are a critical component of due diligence. In the context of key person risk, investors are assessing the investment partner’s character. Prospective LPs should examine any previous legal matters the GP has been a party to, actions taken against them by regulatory bodies, and negative press stories, among other checks. Reference checks are useful in determining the strength of the relationship between managing partners of the fund and their track record related to conflict resolution. In addition, investors should seek out specific key person risks and understand the investment partner’s responding contingency plans.

• Are key persons replaceable in the event of departure/is there a defined succession plan in place?
• Is the success of this fund materially important to the personal and professional success of the key persons?
• Are key persons sufficiently incented to remain in the fund for its duration?
• Are any key persons nearing retirement age?

In the aftermath of a key person event, LPs should remain active in working with the GP to reach a prompt resolution. This may entail thorough vetting of replacement candidates nominated by the GP, or even leveraging one’s own network to source potential key persons for the fund. LPs should also prepare for the (albeit unlikely) possibility of an early liquidation of the fund.

Key person risk should not be underestimated—and over time—patterns will emerge that serve to protect against future headaches. If a “red flag” surfaces, just pass; there’s ample opportunity in the vast ocean of private markets.

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1 Karen Chao et al., "How Long Do Funds Suspend the Investment Period Due to 'Key Person Events'?", Goodwin, April 19, 2024. https://www.goodwinlaw.com/en/insights/publications/2024/04/insights-privateequity-pif-how-long-do-funds-suspend-investment-period-due. 2 See footnote #1 above