1. © Cumming & Johan (2013)Fund Management Fund Covenants Cumming & Johan (2013, Chapter 5) 1

2. © 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. 2

3. © 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 3

4. © Cumming & Johan (2013)Fund Management Issues What are the covenants? What affects their frequency of use? – Law quality? – Human capital? – Style focus of fund? 4

5. © Cumming & Johan (2013)Fund Management LP Covenants Covenants – Frequency of use Data Empirics Five types of LP covenants: 1. Investment decisions 2. Investment powers 3. Types of investments 4. Fund operations 5. Limitations on liability 5

6. © Cumming & Johan (2013)Fund Management Investment Decisions LP Covenants Covenants – Frequency of use Data Empirics Investment Decisions Investment Powers Types of Investment Fund Operation Limitations 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) 6

7. © Cumming & Johan (2013)Fund Management Investment Decisions LP Covenants Covenants – Frequency of use Data Empirics Investment Decisions Investment Powers Types of Investment Fund Operation Limitations 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 7

8. © Cumming & Johan (2013)Fund Management Investment Decisions LP Covenants Covenants – Frequency of use Data Empirics Investment Decisions Investment Powers Types of Investment Fund Operation Limitations 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 8

9. © Cumming & Johan (2013)Fund Management Investment Decisions LP Covenants Covenants – Frequency of use Data Empirics Investment Decisions Investment Powers Types of Investment Fund Operation Limitations 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 9

10. © Cumming & Johan (2013)Fund Management Investment Decisions LP Covenants Covenants – Frequency of use Data Empirics Investment Decisions Investment Powers Types of Investment Fund Operation Limitations on Liability Restrictions on the fund manager making investment decisions independently, without fund input. Why? New inexperienced fund, desire to mitigate adverse selection costs 10

11. © Cumming & Johan (2013)Fund Management Investment Powers LP Covenants Covenants – Frequency of use Data Empirics Investment Decisions Investment Powers Types of Investment Fund Operation Limitations 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 11

12. © Cumming & Johan (2013)Fund Management Investment Powers LP Covenants Covenants – Frequency of use Data Empirics Investment Decisions Investment Powers Types of Investment Fund Operation Limitations 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 12

13. © Cumming & Johan (2013)Fund Management Investment Powers LP Covenants Covenants – Frequency of use Data Empirics Investment Decisions Investment Powers Types of Investment Fund Operation Limitations on Liability Restrictions on investment principal additions to the fund manager Why? LPs did not agree to invest with new unknown managers 13

14. © Cumming & Johan (2013)Fund Management Investment Powers LP Covenants Covenants – Frequency of use Data Empirics Investment Decisions Investment Powers Types of Investment Fund Operation Limitations 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 14

15. © Cumming & Johan (2013)Fund Management Types of Investment LP Covenants Covenants – Frequency of use Data Empirics Investment Decisions Investment Powers Types of Investment Fund Operation Limitations 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! 15

16. © Cumming & Johan (2013)Fund Management Types of Investment LP Covenants Covenants – Frequency of use Data Empirics Investment Decisions Investment Powers Types of Investment Fund Operation Limitations 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 16

17. © Cumming & Johan (2013)Fund Management Types of Investment LP Covenants Covenants – Frequency of use Data Empirics Investment Decisions Investment Powers Types of Investment Fund Operation Limitations 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!) 17

18. © Cumming & Johan (2013)Fund Management Types of Investment LP Covenants Covenants – Frequency of use Data Empirics Investment Decisions Investment Powers Types of Investment Fund Operation Limitations 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 18

19. © Cumming & Johan (2013)Fund Management Fund Operation LP Covenants Covenants – Frequency of use Data Empirics Investment Decisions Investment Powers Types of Investment Fund Operation Limitations 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 19

20. © Cumming & Johan (2013)Fund Management Fund Operation LP Covenants Covenants – Frequency of use Data Empirics Investment Decisions Investment Powers Types of Investment Fund Operation Limitations 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 20

21. © Cumming & Johan (2013)Fund Management Fund Operation LP Covenants Covenants – Frequency of use Data Empirics Investment Decisions Investment Powers Types of Investment Fund Operation Limitations 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 21

22. © Cumming & Johan (2013)Fund Management Fund Operation LP Covenants Covenants – Frequency of use Data Empirics Investment Decisions Investment Powers Types of Investment Fund Operation Limitations 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 22

23. © Cumming & Johan (2013)Fund Management Limitation of Liability LP Covenants Covenants – Frequency of use Data Empirics Investment Decisions Investment Powers Types of Investment Fund Operation Limitations 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 23

24. © Cumming & Johan (2013)Fund Management Limitation of Liability LP Covenants Covenants – Frequency of use Data Empirics Investment Decisions Investment Powers Types of Investment Fund Operation Limitations 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 24

25. © Cumming & Johan (2013)Fund Management Limitation of Liability LP Covenants Covenants – Frequency of use Data Empirics Investment Decisions Investment Powers Types of Investment Fund Operation Limitations 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 25

26. © Cumming & Johan (2013)Fund Management LP Covenants Covenants – Frequency of use Data Empirics What affects the frequency of use of covenants? 26

27. © Cumming & Johan (2013)Fund Management Human Capital factors LP Covenants Covenants – Frequency of use Data Empirics 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 27

28. © Cumming & Johan (2013)Fund Management Impact of quality of law LP Covenants Covenants – Frequency of use Data Empirics 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 28

29. © Cumming & Johan (2013)Fund Management Civil/Common law LP Covenants Covenants – Frequency of use Data Empirics Predictions Civil law countries have fund managers more inclined to be rule-based and write more covenants in fund contracts 29

30. © Cumming & Johan (2013)Fund Management Offshore LP Covenants Covenants – Frequency of use Data Empirics Predictions Offshore funds involve institutional investors from a greater number of disparate countries, have greater negotiation and contracting costs, and therefore fewer covenants. 30

31. © Cumming & Johan (2013)Fund Management Market Conditions LP Covenants Covenants – Frequency of use Data Empirics Predictions Demand and supply conditions Fewer covenants in hot markets due to dearth of fund managers 31

32. © Cumming & Johan (2013)Fund Management Summary of Factors Affecting Covenants LP Covenants Covenants – Frequency of use Data Empirics 4 main categories: – Fund manager characteristics – Fund characteristics – Legal conditions – Market conditions 32

33. © Cumming & Johan (2013)Fund Management LP Covenants Covenants – Frequency of use Data Empirics Data 33

34. © Cumming & Johan (2013)Fund Management Hand Collected Sample LP Covenants Covenants – Frequency of use Data Empirics 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. 34

35. © Cumming & Johan (2013)Fund Management Figures 5.1 & 5.2 and Table 5.2 LP Covenants Covenants – Frequency of use Data Empirics 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 35

36. © Cumming & Johan (2013)Fund Management Covenants and frequency LP Covenants Covenants – Frequency of use Data Empirics 36

37. © Cumming & Johan (2013)Fund Management Covenants and frequency LP Covenants Covenants – Frequency of use Data Empirics 37

38. © Cumming & Johan (2013)Fund Management LP Covenants Covenants – Frequency of use Data Empirics 38

39. © Cumming & Johan (2013)Fund Management Table 5.4: OLS, Ordered Logit LP Covenants Covenants – Frequency of use Data Empirics 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 39

40. © Cumming & Johan (2013)Fund Management Table 5.2 (Condensed) LHS Variable: Sum of Covenants for Investment Decisions Model 1Model 2Model 3 Coefficientt-StatisticCoefficientt-StatisticCoefficientt-Statistic Constant4.7521.5686.7621.971**110.8211.116 Legal and Market Conditions Log (Country Legality Index)-0.880-0.934-1.427-1.338-1.652-1.379 Common Law Country 0.2020.585-0.016-0.043 Log (1+MSCI) 1.2731.870*0.7120.990 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 Managers0.0372.455***0.0412.549**0.0271.466 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) 0.8151.758* Fund Characteristics Log (Funds Raised)-0.035-0.368-0.033-0.3220.2001.285 Bank Institutional Investors -0.398-0.588-1.232-1.547 Government Investors 0.4490.5610.6380.796 Limited Partnership Funds 0.0050.011 Log (Industry Market / Book)-0.057-0.1120.0560.1070.0360.057 Early Stage Investee Focus 0.2580.550 Number of Observations50 Pseudo R 2 0.0430.0750.139 40

41. © Cumming & Johan (2013)Fund Management Summary LP Covenants Covenants – Frequency of use Data Empirics Main Results from Table 5.4 on Frequency of Use of Covenants 41

42. © Cumming & Johan (2013)Fund Management Impact of quality of law LP Covenants Covenants – Frequency of use Data Empirics 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%. 42

43. © Cumming & Johan (2013)Fund Management Civil/Common law LP Covenants Covenants – Frequency of use Data Empirics 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. 43

44. © Cumming & Johan (2013)Fund Management Offshore LP Covenants Covenants – Frequency of use Data Empirics 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 44

45. © Cumming & Johan (2013)Fund Management Human Capital LP Covenants Covenants – Frequency of use Data Empirics 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. 45

46. © Cumming & Johan (2013)Fund Management Additional Material LP Covenants Covenants – Frequency of use Data Empirics Summary of key concepts and discussion questions at end of Chapter 5 Sample LP agreement at – &&& Insert hyperlink 46