A Key Man clause or Key Person clause provides protections to LPs against adverse events related to the fund’s most critical leaders.

A limited partner (LP) will allocate capital to a certain fund because it believes that the fund’s investment team will be able to successfully execute and drive returns. Given the size of most investment teams, LPs are realistically putting their trust in a small handful of individuals.

What happens if one of these team members leaves the firm over the life of the fund? What happens if the founder of the fund gets hit by a bus or signs into one too many Zoom calls with no pants on? Key Man clauses provide some assurance should things go south, with a few scenarios outlined below.

When is a Key Man Clause Triggered?

A Key Man or Key Person clause is typically triggered when one or more key persons experience what is known as a “Key Person Event.” If one of these events occurs, a fund will halt new investment activities until a go-forward plan is agreed upon between the firm and its LPs. This may involve appointing a new Key Person or some other work around. However, if the firm and the LPs can’t agree, then the new investment halt becomes permanent. If this happens, the fund will then enter a harvesting period to realize the already completed investments. 

Most Important Pieces of a Key Man Clause

• Who are the key persons?
• What are the “key person events”?
• What happens after a key person event occurs?

Who Are the Key Persons?

Determining who the “key persons” are for the Key Man Clause is critical.  Sometimes it’s simple (e.g. only one senior partner at a lower middle market fund). Other times it is heavily negotiated. In general, the determination of Key Persons will be different for each fund.

In some cases, there are two levels of Key Persons: a senior level and a junior level.  For example, a firm has eight investment professionals at the partner level. Three of the partners are senior and the remaining five are junior. A Key Person Clause might stipulate that a minimum of two of the three senior partners and three of the five junior partners must be continuously active at the firm for the duration of the fund.

What Are the Key Man Events?

Standard terminology in a Key Man Clause is usually that the key persons must devote substantially all of their business time and efforts to the activities of the fund. There will typically be certain agreed upon carve-outs such as ability to serve on public boards, charitable activities, etc.  Practically speaking, certain events will prevent a key person from devoting “substantially all of their business time to the activities of the fund” such as death, permanent disability or termination of employment (a key person quits or is fired). The limited partnership agreement (“LPA”) may also stipulate that other specific events relating to a key person may be deemed to prevent the person from devoting substantially all of their business time and effort to the fund, such as fraud, material breach of the LPA, securities laws violations, etc.

What Happens After a Key Man Event Occurs?

Once a Key Man Clause has been triggered, generally the fund’s investment period is automatically suspended for a period of time (usually 180 days), which leads to permanent suspension of the investment period unless a majority of the LPs vote to reinstate the investment period.  The suspension period is meant to allow the general partnership time to present a plan to the LPs. Often the plan includes next steps to replace the departed Key Persons with new investment professionals. 

If the LPs approve the plan, then the investment period is reinstated. However, if they don’t, then the suspension of the investment period becomes permanent. If this happens, the the fund effectively enters into realization mode. 

One nuance is that the suspension of the investment period only restricts new platform investments. The fund is still able to make add-on acquisitions for existing portfolio companies.

Another issue is the impact to management fee over the suspension period. Typically the fee is actually unaffected by the triggering of a Key Man event and LPs will continue to pay.

Example of a Triggering Event

Here’s a quick example of a situation that could be covered by a Key Man clause, triggering a Key Man or Person event.

The Key Man Problem

Homie Capital is your standard middle market private equity shop. The firm is managed by five general partners and five managing partners. The fund’s Limited Partnership Agreement dictates that a majority of each of the general partner and managing partner groups must be fully involved (devote a majority of their time to the firm) for the duration of the fund’s lifecycle.

Everything is going perfectly until the firm’s annual ski trip. The group of partners decides to play beer pong late into the night in Vail. Sounds like great firm bonding, but things go downhill after one of the partners fails to sink a single cup.

A group of five other partners pressures the ‘trash at pong’ partner to do a naked lap (standard house rules). However, the ‘trash at pong’ partner subsequently files a sexual harassment claim alleging behavior that probably isn’t chill for a work environment. Long story short, more than half the partners end up departing Homie Capital.

This unfortunate event triggers Homie Capital’s Key Man Clause (Key Person Clause) in the Limited Partnership Agreement. The clause dictates that the investment period is automatically suspended for a period of 180 days.

If, after the 180 days, a majority-in-interest of LPs vote to reinstate the investment period, operations may continue as before. However, if the required LP vote is not obtained during the 180-day period, then the suspension of the investment period becomes permanent.

The Key Man Resolution

Things are looking pretty dire at Homie Capital. However, the remaining partners find a group of new senior investment professionals at a competing firm. This group of IPs is particularly strong in both their investment acumen and beer pong skills. So, Homie Capital’s remaining partners make a proposal to their LPs to poach the potential new team members. The new hires placate the LPs, who then vote to reinstate the investment period.

After a close call, Homie Capital is now free to continue operations as usual and can continue saddling underperforming Midwest industrial companies with far too much debt.