Term Extensions: Negotiating the Value of Optionality in a Distribution Drought
>> After a decade of easy exits and buoyant valuations, private equity appears to be in a distribution drought. Higher interest rates, slower economic growth, and a muted IPO market have made it harder to sell portfolio companies or unlock value through dividend recapitalizations. According to MSCI data covering more than 15,000 closed-end funds, distribution rates are at record lows. When performance is strong and fundraising prospects are bright, the agency relationship at the heart of private equity works as intended—GPs and LPs are aligned in their desire to realize value efficiently. But when market conditions deteriorate, that alignment frays. GPs are forced to choose between holding onto assets acquired at rich valuations or writing them down to provide LPs with liquidity. Researchers frame this dilemma as the exercise of an “option to wait.” That option preserves upside and income for the GP, but it erodes liquidity for LPs who are effectively short the “option to do something else.” For investors, the question is no longer how much they earn, but how soon they receive their cash. Unfortunately, the rational move for the GP is often to wait: defer exits, extend fund life, and preserve control. The result? The capital that should be flowing back to LPs is staying put.
Negotiating extension management fee: fund term just got interesting
You might expect fund term and extension to be a sleepy provision, but in the current market it’s highly relevant. Just take a recent high-profile example where the GP of a prominent megafund approached investors with a two-year extension permitted by the LPA:
Term … the expiration of the term of the Partnership on the tenth anniversary of the Final Closing Date; provided that the term of the Partnership may be extended by the General Partner for up to two years after such date with the consent of the Advisory Board (in advance of which consent, the General Partner shall call a meeting of the Advisory Board) and for additional periods thereafter with the affirmative consent of Fund Investors representing a majority in Interest of the Fund Investors.1
ILPA recommends that “no fees should be charged after the original term.” If a fee is necessary to incentivize the GP to liquidate remaining assets, it should reflect the GP’s “lower expense burden,” particularly where a successor fund has already been raised. In this case, the GP expected to keep charging the same management fee used during the post-commitment period. But because the LPA required the GP to convene the LPAC and obtain its consent for the extension, LPs had an opportunity to push back. Citing current market conditions, the LPs successfully negotiated an LPA amendment clarifying that no management fee would be charged during the extension in exchange for LPAC approval. In this article, we use the language from this megafund (and comparisons from other LPAs) to highlight the key drafting points LPs should scrutinize in the fund term and extension provision.
Notice, consent & meetings: the terms that shift leverage
The outcome of any fund extension negotiation depends heavily on what the LPA says—and, more importantly, what it doesn’t.
In our full writeup, we look at the core terms that determine whether LPs have real leverage or whether the GP holds all the cards, including:
1. Approval mechanics: GP discretion vs. LP consent
2. Meeting requirement: create a forum for pushback
3. LPAC independence: not all consent is created equal
4. Hardwired economics vs. negotiated outcomes
and the conclusion of how extensions can be a key governance test
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1 Sourced from an LPA drawn from the large-cap segment.
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