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© Cumming & Johan (2013) Fund Management
Fund Covenants
Cumming & Johan (2013, Chapter 5)
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© Cumming & Johan (2013) Fund Management
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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© Cumming & Johan (2013) Fund Management
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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© Cumming & Johan (2013) Fund Management
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
LP CovenantsCovenants – Frequency of use
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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Investment Decisions
LP CovenantsCovenants – Frequency of use
DataEmpirics
Investment DecisionsInvestment PowersTypes of InvestmentFund OperationLimitations on Liability
• 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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Investment Decisions
LP CovenantsCovenants – Frequency of use
DataEmpirics
Investment DecisionsInvestment PowersTypes of InvestmentFund OperationLimitations on Liability
• 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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Investment Decisions
LP CovenantsCovenants – Frequency of use
DataEmpirics
Investment DecisionsInvestment PowersTypes of InvestmentFund OperationLimitations on Liability
• 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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© Cumming & Johan (2013) Fund Management
Investment Decisions
LP CovenantsCovenants – Frequency of use
DataEmpirics
Investment DecisionsInvestment PowersTypes of InvestmentFund OperationLimitations on Liability
• 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
LP CovenantsCovenants – Frequency of use
DataEmpirics
Investment DecisionsInvestment PowersTypes of InvestmentFund OperationLimitations on Liability
• 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
LP CovenantsCovenants – Frequency of use
DataEmpirics
Investment DecisionsInvestment PowersTypes of InvestmentFund OperationLimitations on Liability
• 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
LP CovenantsCovenants – Frequency of use
DataEmpirics
Investment DecisionsInvestment PowersTypes of InvestmentFund OperationLimitations on Liability
• 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
LP CovenantsCovenants – Frequency of use
DataEmpirics
Investment DecisionsInvestment PowersTypes of InvestmentFund OperationLimitations on Liability
• 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
LP CovenantsCovenants – Frequency of use
DataEmpirics
Investment DecisionsInvestment PowersTypes of InvestmentFund OperationLimitations on Liability
• 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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© Cumming & Johan (2013) Fund Management
Types of Investment
LP CovenantsCovenants – Frequency of use
DataEmpirics
Investment DecisionsInvestment PowersTypes of InvestmentFund OperationLimitations on Liability
• 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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© Cumming & Johan (2013) Fund Management
Types of Investment
LP CovenantsCovenants – Frequency of use
DataEmpirics
Investment DecisionsInvestment PowersTypes of InvestmentFund OperationLimitations on Liability
• 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
LP CovenantsCovenants – Frequency of use
DataEmpirics
Investment DecisionsInvestment PowersTypes of InvestmentFund OperationLimitations on Liability
• 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
LP CovenantsCovenants – Frequency of use
DataEmpirics
Investment DecisionsInvestment PowersTypes of InvestmentFund OperationLimitations on Liability
• 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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© Cumming & Johan (2013) Fund Management
Fund Operation
LP CovenantsCovenants – Frequency of use
DataEmpirics
Investment DecisionsInvestment PowersTypes of InvestmentFund OperationLimitations on Liability
• 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
LP CovenantsCovenants – Frequency of use
DataEmpirics
Investment DecisionsInvestment PowersTypes of InvestmentFund OperationLimitations on Liability
• 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
LP CovenantsCovenants – Frequency of use
DataEmpirics
Investment DecisionsInvestment PowersTypes of InvestmentFund OperationLimitations on Liability
• 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
LP CovenantsCovenants – Frequency of use
DataEmpirics
Investment DecisionsInvestment PowersTypes of InvestmentFund OperationLimitations on 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
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Limitation of Liability
LP CovenantsCovenants – Frequency of use
DataEmpirics
Investment DecisionsInvestment PowersTypes of InvestmentFund OperationLimitations on 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
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Limitation of Liability
LP CovenantsCovenants – Frequency of use
DataEmpirics
Investment DecisionsInvestment PowersTypes of InvestmentFund OperationLimitations on 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
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LP CovenantsCovenants – Frequency of use
DataEmpirics
What affects the frequency of use of covenants?
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Human Capital factors
LP CovenantsCovenants – Frequency of use
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
LP CovenantsCovenants – Frequency of use
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
LP CovenantsCovenants – Frequency of use
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
LP CovenantsCovenants – Frequency of use
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
LP CovenantsCovenants – Frequency of use
DataEmpirics
• Predictions
• Demand and supply conditions• Fewer covenants in hot markets due to dearth of fund
managers
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© Cumming & Johan (2013) Fund Management
Summary of Factors Affecting Covenants
LP CovenantsCovenants – Frequency of use
DataEmpirics
• 4 main categories:
– Fund manager characteristics
– Fund characteristics
– Legal conditions
– Market conditions
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LP CovenantsCovenants – Frequency of use
DataEmpirics
Data
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Hand Collected Sample
LP CovenantsCovenants – Frequency of use
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
LP CovenantsCovenants – Frequency of use
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
LP CovenantsCovenants – Frequency of use
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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© Cumming & Johan (2013) Fund Management
Covenants and frequency
LP CovenantsCovenants – Frequency of use
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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LP CovenantsCovenants – Frequency of use
DataEmpirics
Empirics
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Table 5.4: OLS, Ordered Logit
LP CovenantsCovenants – Frequency of use
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
© Cumming & Johan (2013) Fund Management
Summary
LP CovenantsCovenants – Frequency of use
DataEmpirics
Main Results from Table 5.4 on Frequency of Use of Covenants
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Impact of quality of law
LP CovenantsCovenants – Frequency of use
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
LP CovenantsCovenants – Frequency of use
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
LP CovenantsCovenants – Frequency of use
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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© Cumming & Johan (2013) Fund Management
Human Capital
LP CovenantsCovenants – Frequency of use
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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© Cumming & Johan (2013) Fund Management
Additional Material
LP CovenantsCovenants – Frequency of use
DataEmpirics
• Summary of key concepts and discussion questions at end of Chapter 5
• Sample LP agreement at – &&& Insert hyperlink
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