Change of control provisions in investment fund structures

Change of control provisions are a common feature in a wide range of transactional agreements, including those involving investment funds. However, their application within the typical structures of investment funds can present unique challenges that require careful consideration during negotiations. Fund managers must navigate the challenging balance between implementing these provisions and maintaining the flexibility needed to adapt to the evolving structures and operations of investment funds.

 

Importance of change of control provisions

Change of control provisions which typically trigger specific rights or obligations when there is a significant shift in the ownership or management of a company – whether through ownership transfer, voting power shift, or management changes – serve a critical function for various stakeholders.

• Lenders want to ensure that their borrower and the entities or persons behind it continue to be effectively the same, in terms of financial strength and creditworthiness. A change of control may qualify as an event of default, leading to accelerated loan maturity.
• Minority, or non-controlling, investors want assurance that the company in which they have invested continues to be managed by the same individuals or group, and not taken over by a competitor. If there is a change of control, these investors may have the right to trigger a put option for their own investment, or a call option for acquiring the rest of the company.
• Joint venture partners and other counterparties want to ensure that their coshareholders continue to be effectively the ones they initially struck the deal with – particularly avoiding the involvement of a competitor. Similarly in this context, a change of control may trigger unintended consequences.

 

Complexity of investment fund structures

Investment funds, too, along with the companies they control are often required to agree to change of control provisions. Care is needed when negotiating those provisions, taking into account all levels of the investment fund structure, since those structures tend to be quite complex.

Different levels of those structures may involve different legal advisers, who might not have a complete view of the entire framework. However, it is crucial that the change of control provisions are consistent across all levels of the structure to ensure coherence and  effectiveness.

Investment funds typically operate through a multi-layered structure designed to manage investments and risks efficiently while optimizing overall performance. This structure is generally comprised of the investment fund itself, one or more layers of intermediate HoldCos, and SPVs. Each entity within this structure has a distinct role:

• The investment fund itself pools capital from investors and sets the investment strategy and
• HoldCos form one or more intermediate layers, enabling structural subordination of borrowing, enhancing tax efficiency and managing risk by holding interests in SPVs.
• SPVs, in turn, are responsible for directly holding and managing the fund’s underlying assets.

Entities at each level in this structure may incur borrowing and give security. Additionally, SPVs and Holdcos may enter into shareholder agreements with other investors in the same company, and the partnership agreement governing the fund itself operates as an agreement between the general partner and the investors. Change of control provisions are likely to be included in all of these agreements, making it essential to understand their implications across the entire fund structure.

 

Change of control in a fund context

Defining Control. When negotiating change of control provisions in a fund context, it Is essential to clearly define what constitutes “control”.

Control can take various forms. For instance, HoldCos and SPVs are often managed, in the sense of corporate law, by their boards of directors or managers. Typically, the fund itself is  organised as a partnership (such as SCSp, SCS, SCA) and is managed by its general partner, which in turn has a board of managers. Alternatively, if the fund is structured as a corporation (such as SA, Sàrl) it will have its own board of directors or managers.

But the fund may also be  "managed” in a different sense under the AIFM Directive by its external alternative investment fund manager (AIFM). In this scenario the AIFM may double up as the “manager” (gérant) in the sense of corporate law too. Additionally, there may be a portfolio manager, subordinate to the AIFM and exercising “management” in the sense of the AIFM Directive with regard to the fund’s investments.

“Control” might be defined as the direct exercise of management in any of these capacities; or it could refer to the ability to appoint or remove those who exercise that  management (such as board members or the external AIFM), or to direct how these managers operate.

Identifying which entities exercise that control. The identification of the entity exercising control depend on how “control” is defined. It may be the general partner of the fund, if it extends its “control” down to the level where the change of control provisions are being agreed. Alternatively, it may be the ultimate parent of that general partner or the individuals holding shares in that ultimate parent.

Control could reside with the board of directors of the entity agreeing to the change of control provisions, such as the SPV investing directly into the target company, or the board of directors of the fund itself, if it is a corporation (an SA or another form of limited company). Or “control” might be exercised by an intermediate-level HoldCo, if the chain of “control” is interrupted as one moves up the structure.

Identifying entities subject to the same control. The scope of entities subject to control provisions may encompass all entities within the same fund structure. It may include other funds managed by affiliates of the same general partner (subsidiaries of the same ultimate parent), or by the same AIFM, or it may be restricted to the subsidiaries of a specific  intermediate Holdco, or the particular entity agreeing to the change of control provisions.

 

Importance in a fund context

Fund structures are inherently complex and subject to frequent changes.

Multiple funds  managed by the same entity (or its affiliate) may invest into the same target or increase their investment over time. Internal reorganisation within the funds or their structures are common, and new HoldCos may be created, or existing ones removed as needed for structuring purposes.

Changes can also occur in AIFMs and portfolio managers, with service providers or board members potentially being replaced by an internal management company, once the necessary authorisation has been achieved.

During a structured exit mechanism, the fund’s investment in a portfolio company, SPV or HoldCo, can change from a majority to a minority stake. Additionally, key individuals involved in management may depart, new members may join, or existing members may be promoted, resulting in changes to the team that exercises “control”. As the management team grows, its members may be based in multiple jurisdictions and operate through (or be employed by) different legal entities.

Fund managers need to ensure that their structures remain adaptable to accommodate necessary reorganizations. Consequently, when agreeing change of control provisions across all levels of a fund structure, it is essential to design these provisions with sufficient flexibility in mind. The individuals involved in designing these provisions must be aware of how all of those levels are structured and operate, and what kinds of reorganisations and adjustments may become necessary in the normal course of operating the fund.

Without this foresight, a fund may end up with a structure that no longer aligns with its objectives, merely to avoid triggering unintended consequences from an agreement that was never intended to prevent reasonable restructuring.

*This article was previously published in the AGEFI Luxembourg