The Kentucky Retirement System looks like it may set a second important precedent in alternative investments, after being targeted for path-breaking litigation over its investment in Blackstone, KKR-Prisma, and PAAMCO hedge funds.
Former Kentucky Retirement Systems trustee Chris Tobe called our attention to a new suit against the pension system by San Francisco fund of fund manager Bay Hill Capital. The outrageous part of this suit is that Bay Hill is suing Kentucky Retirement Systems for invoking what it conceded is a contractual right, that of the so-called key man provision which allows the limited partners to dissolve a fund if a key man departs the fund or reduces the time he spends on it below a threshold level.
The founder of Bay Capital, Lance Mansbridge, previously ran a boutique private equity consulting firm called Strategic Investment Solution. Industry sources say that Mansbridge would regularly tell private equity fund manager that he had considerable sway over Kentucky Retirement Systems. That appears to be confirmed by the fact that Mansbridge was able to make the unusual jump from being a fund consultant to a fund manager by having Kentucky Retirement Systems serve as the sole investor in a series of fund of funds.
The critical part to keep in mind is that once a fund of fund manager has selected the funds in which the fund of fund limited partners invest, his value added is pretty much over.
The lawsuit alleges that Kentucky Retirement Systems schemed for years to oust Bay Hills after it set up some fund of funds that performed particularly well (note that the suit describes the supposedly standout results of two of four funds of funds at issue). Kentucky Retirement Systems’ former chief investment officer allegedly told Bay Hills in 2016 that the pension system wanted to move the Bay Hills funds in house and then contrived a series of false pretexts to try to do that.
Some efforts at a “Cause for Removal” of Bay Hills looks trumped up, that of the replacement of the fund auditor and a change in expense structure, when Kentucky Retirement Systems apparently approved of the changes. However, another row looks more debatable but apparently wasn’t material enough to force a change. Bay Hills says a “spreadsheet error” led the fund manager to get carry fees earlier than it was due. Even though it claims this ” would have self-corrected over time,” money has time value, so this looks an awful lot like the sort of grifting that the SEC was pursuing until Team Trump came to town. The filing says that Bay Hills said it would repay the funds…which is not exactly the same as repaying the funds. It’s not hard to infer that the repayment was accelerated by Kentucky Retirement Systems’ use of that, erm, error as a basis for a Cause for Removal.
But here is where things get interesting. This is the claim Bay Hills makes early on:
KRS has launched a campaign to oust Bay Hills and the Fund GPs and to seize control of the Funds, all in derogation of the Funds’ limited partnership agreements (“LPAs”) and basic principles of equity and fairness
But Bay Hills admits that Something Happened that gives Kentucky Retirement the right to assume management of the funds:
In October 2016, Fund III experienced a so-called “Key Person Event” when an important employee departed Bay Hills, and this gave KRS the contractual right to dissolve the partnership.
Needless to say, no general partner would ever cut a limited partner a break when he had the terms of the deal on his side. But Kentucky Retirement Systems is supposed to be nice and act like a chump like everyone else:
Given that Fund III’s performance had been and was expected to remain strong, a typical limited partner would have reached out to the general partner and the investment advisor about how best to address the issue, with a view to continuing the partnership. But KRS, without so much as trying to consult with the Fund III GP or Bay Hills to resolve the issue, elected to dissolve the partnership and began attempting to transfer Fund III’s assets to KRS, and later, to an entity controlled by KRS.
Aside from the fact that contractual rights are contractual rights, there is a big practical difference between what the supposed “typical limited partner” would do, because the key man issue has usually come up with funds, as opposed to funds of funds. With a private equity funds, even after the investment period, the general partner still plays a critical role because they have a finely tuned sense of when is the right time to sell a company in order to get the best return. And on top of that, running a private equity fund does entail ongoing work in terms of keeping their boot on the neck of the executives in the various portfolio companies, and upon occasion, making complementary acquisitions.
So a big reason limited partners don’t want to exercise their power to take over a fund when they have the right to is it would be a huge hassle to find new fund managers to step in. And they would of course also worry that taking that sort of move would lead other general partners not to take their money (a fondly cultivated myth that somehow succeeds in keeping limited partners suitably cowed). Even if there were a few limited partners who were inclined to be bloody minded (a scenario I doubt ever happens), they’d be certain to be in a minority.
But as we indicate above, in a fund of funds, there is little work to be done once the funds are chosen and the monies committed. Indeed, I suspect that fund of funds generally don’t have key man provisions precisely because they recognize they are much more vulnerable to an ouster, and that Bay Hills had to agree to this provision because Kentucky Retirement Systems had negotiating leverage as the sole investor to extract this concession.
However, a factor working against Kentucky Retirement Systems is that the underlying funds must consent to the transfer, and so far, all but two are digging in their heels. The filing claims it’s because the pension fund is such a mess. But a single limited partner isn’t going to pose any threat to how a fund is operated. So it seems more likely the driver is that they don’t want to see the precedent of the removal of a general partner to go forward, even in an outlier situation like this. And a secondary consideration in the mutual back-scratching world of private equity, may be that no one sees any reason to cross even a small fund of funds, since fund of funds are a meaningful source of funds for private equity firms.
I do need to eat a wee bit of crow, since I argued in comments not all that long ago that key man language was an example of a term that limited partners loved arguing over to maintain the fiction that the limited partnership agreements were negotiated, when in practice, their unwillingness to invoke them for structural reasons meant they weren’t all that important in practice. Kentucky Retirement Systems so far looks like an exception that proves the rule. But if a court were to buy Bay Hills’ argument that clear contractual language should be ignored because no one heretofore has exercised those rights, it should serve as a massive wake up call to limited partners. Even with the general partners already enjoying extremely one-sided agreement, the implication would be that the few rights the limited partners thought they had don’t amount to a hill of beans.BayHills