Fund Covenants

© Cumming & Johan (2013) Fund Management

Fund Covenants

Cumming & Johan (2013, Chapter 5)

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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.

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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

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Issues

• What are the covenants?

• What affects their frequency of use?– Law quality?– Human capital?– Style focus of fund?

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LP CovenantsCovenants – Frequency of use

DataEmpirics

Five types of LP covenants:1. Investment decisions2. Investment powers3. Types of investments4. Fund operations5. Limitations on liability

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Investment Decisions


DataEmpirics

Investment DecisionsInvestment PowersTypes of InvestmentFund OperationLimitations on Liability

• 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)

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DataEmpirics


• 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

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DataEmpirics


• 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

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DataEmpirics


• Restrictions on reinvestment of capital gains

• Why?

• Moral hazard… fund managers pursuing fame (building CV with lots of IPOs) as opposed to fortune

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DataEmpirics


• Restrictions on the fund manager making investment decisions independently, without fund input.

• Why?

• New inexperienced fund, desire to mitigate adverse selection costs

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Investment Powers


DataEmpirics


• 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

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Investment Powers


DataEmpirics


• 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

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Investment Powers


DataEmpirics


• Restrictions on investment principal additions to the fund manager

• Why?

• LPs did not agree to invest with new unknown managers

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Investment Powers


DataEmpirics


• 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

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Types of Investment


DataEmpirics


• 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!

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Types of Investment


DataEmpirics


• 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

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Types of Investment


DataEmpirics


• 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!)

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Types of Investment


DataEmpirics


• 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

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Fund Operation


DataEmpirics


• Restrictions on sale of fund interest by any investor

• Why?

• Influences structure of LP, possibly to detriment of other LPs or even the GP

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Fund Operation


DataEmpirics


• 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

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Fund Operation


DataEmpirics


• 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

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Fund Operation


DataEmpirics


• 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

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Limitation of Liability


DataEmpirics


• 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

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DataEmpirics


• 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

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DataEmpirics


• 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

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DataEmpirics

What affects the frequency of use of covenants?

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Human Capital factors


DataEmpirics

• 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

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Impact of quality of law


DataEmpirics

• 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

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Civil/Common law


DataEmpirics

• Predictions

• Civil law countries have fund managers more inclined to be rule-based and write more covenants in fund contracts

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Offshore


DataEmpirics

• Predictions

• Offshore funds involve institutional investors from a greater number of disparate countries, have greater negotiation and contracting costs, and therefore fewer covenants.

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Market Conditions


DataEmpirics

• Predictions

• Demand and supply conditions• Fewer covenants in hot markets due to dearth of fund

managers

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Summary of Factors Affecting Covenants


DataEmpirics

• 4 main categories:

– Fund manager characteristics

– Fund characteristics

– Legal conditions

– Market conditions

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DataEmpirics

Data

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Hand Collected Sample


DataEmpirics

• 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.

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Figures 5.1 & 5.2 and Table 5.2


DataEmpirics

• 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

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Covenants and frequency


DataEmpirics

Type 1 (Investment Decisions)

Type 2 (Investment Powers)

Type 3 (Types of Investment)

Type 4 (Fund Operation)

Type 5 (Limitation of Liability)

0

5

10

15

20

25

30

01

23

45

67

Numberof

Funds

Number of Covenants

Figure 5.1. Histogram of Different Types of Covenants

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Covenants and frequency


DataEmpirics

0 5 10 15 20 25 30 35 40 45 50

Size of Investment

Use of Debt

Co-Investment (Another Fund)

Co-Investment (Fund Investors)

Reinvestment Capital Gains

Fund Board Oversight

Co-Investment (Fund Managers)

Sale of Fund Interests by FM

Other Actions

Key Person Provisions

Fund Manager Additions

Investment in Other Funds

Re-Investment (Prior Fund)

Public Securities

LBOs

Foreign Securities Banned

Minimum Domestic Investment

Bridge Financing

Sale of Fund Interests by Inv

Fundraising Restrictions

Public Disclosure Restrictions

Removal of Fund Manager

FM Liability Limited (Low Returns)

FM Liability Limited (Low Investment)

FM Liability Limited (Other)

Typ

e 1

: In

vestm

en

t D

ecis

ion

s;

Typ

e 2

: In

vestm

en

t P

ow

ers

; T

yp

e 3

: T

yp

es o

f In

vestm

en

t; T

yp

e 4

: F

un

d O

pera

tio

n;

Typ

e 5

: L

imit

ati

on

of

Lia

bil

ity

Figure 5.2. Frequency of Use of Each Covenant

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DataEmpirics

Empirics

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Table 5.4: OLS, Ordered Logit


DataEmpirics

• 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

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Table 5.2(Condensed)

LHS Variable: Sum of Covenants for Investment Decisions

Model 1 Model 2 Model 3

Coefficient t-Statistic Coefficient t-Statistic Coefficient t-Statistic

Constant 4.752 1.568 6.762 1.971** 110.821 1.116

Legal and Market Conditions

Log (Country Legality Index) -0.880 -0.934 -1.427 -1.338 -1.652 -1.379

Common Law Country 0.202 0.585 -0.016 -0.043

Log (1+MSCI) 1.273 1.870* 0.712 0.990

Vintage Year of Fund -0.053 -1.064

Outbound Offshore Fund -1.099 -2.095**

Inbound Offshore Fund -0.576 -1.089

Fund Manager Characteristics

Percentage of Legally Trained Fund Managers 0.037 2.455*** 0.041 2.549** 0.027 1.466

Percentage of MBA/CFA Trained Fund Managers -0.009 -0.960

Percentage of PhD (Science) Trained Fund Managers

-0.004 -0.363

Log (Average # Years of Relevant Work Experience of Principal Fund Managers)

0.815 1.758*

Fund Characteristics

Log (Funds Raised) -0.035 -0.368 -0.033 -0.322 0.200 1.285

Bank Institutional Investors -0.398 -0.588 -1.232 -1.547

Government Investors 0.449 0.561 0.638 0.796

Limited Partnership Funds 0.005 0.011

Log (Industry Market / Book) -0.057 -0.112 0.056 0.107 0.036 0.057

Early Stage Investee Focus 0.258 0.550

Number of Observations 50 50 50

Pseudo R2 0.043 0.075 0.139 40


Summary


DataEmpirics

Main Results from Table 5.4 on Frequency of Use of Covenants

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Impact of quality of law


DataEmpirics

• 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%.

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Civil/Common law


DataEmpirics

• 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.

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Offshore


DataEmpirics

• 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

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Human Capital


DataEmpirics

• 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.

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Additional Material


DataEmpirics

• Summary of key concepts and discussion questions at end of Chapter 5

• Sample LP agreement at – &&& Insert hyperlink

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Fund Covenants

Documents

Transcript of Fund Covenants