Key Person, GP Commitment and Source of Funds in a Two-Partner Firm

In a firm with two partners, the key person provision, the GP commitment and the source of the money behind that commitment work as one alignment mechanism. ILPA Principles 3.0 and the ILPA Model LPA give each a market form. For a two-partner manager, three drafting choices decide whether the mechanism holds: which departure trips the suspension, how a cure is voted, and whether the commitment is funded in cash.

01The Key Person Event

The ILPA Model LPA term sheets, last updated in July 2020, define a Key Person Event in two limbs. The first applies when, during the Commitment Period, named individuals cease to devote substantially all their business time and attention to the partnership, its manager, the general partner, any prior fund and any parallel vehicles. The second applies on a Change of Control: the Key Persons cease to control the general partner and the manager, or together hold less than a bracketed 75 percent of the carried interest (ILPA Model LPA term sheet, whole-of-fund version). The deal-by-deal version repeats both limbs (ILPA Model LPA term sheet, deal-by-deal version).

The term sheet leaves the trigger itself in brackets: "[NAMES OF KEY PEOPLE OR HOW MANY OF THEM]". On a large platform that bracket supports a count, such as two of five named partners. With two partners it collapses to a binary choice: either the departure of one partner is an event, or only the departure of both is.

ILPA Principles 3.0 resolve that choice for most two-partner firms. Key persons "should be the individuals that will determine the investment outcomes of the fund," and the provision "should not be so broadly drafted such that departures of individuals reasonably believed to be key people would not trigger the provision" (ILPA Principles 3.0, Key Person). When two people make every investment decision, a trigger that requires both to leave fails that test, because the firm can lose half its judgment with no consequence under the agreement.

The second limb matters more in a small firm than it first appears. As a two-partner manager hires senior professionals and grants them carried interest, the combined share held by the two named Key Persons falls, and below the bracketed threshold the Change of Control limb trips although no one has left. The cleaner course is to add new professionals as Key Persons once they determine outcomes, a change the Principles say a majority in interest of limited partners should approve.

Limited partners treat the term as central. ILPA's 2021 report on fund terms found that a strong key person provision was the highest-ranked negotiating priority among the limited partners it surveyed. In Colmore data cited there, the most common trigger in a sample of 150 partnership agreements, at 60 percent, was a failure to devote substantially enough time to fund activities, and 96 percent of funds required suspension of the investment period on a key person event (ILPA, What's Market in Fund Terms?). The report adds that key person provisions "are no substitute for strong fiduciary duties."

02The Key Person Event Tree

The table sets the sequence in order, from trigger to removal. Bracketed figures are the term sheet's own placeholders and defaults; they are market reference points, and none is a recommendation.

03The GP Commitment

The glossary to ILPA Principles 3.0 calls the general partner commitment "a critical aspect of alignment of interest with the LPs" and states the market convention directly: "Standard practice is that the GP commit 2-5 percent of the capital of the fund as a whole" (ILPA Principles 3.0, glossary). The Model LPA leaves the figure in brackets, requiring the general partner and its affiliates to make and maintain a commitment of at least a stated percentage of the limited partners' aggregate commitments.

The Principles attach four structural conditions. The commitment should be "a substantial equity interest." It should be contributed in cash, "as opposed to contributed through the waiver of management fees or via specialized financing facilities." It should be held through a pooled vehicle, with no cherry-picking of individual deals and a sharing percentage that may not decrease. And the general partner should be restricted from transferring its real or economic interest, which the Model LPA enforces by requiring the prior written consent of 85 percent in interest to any such transfer.

In a two-partner firm the commitment is, in practice, the personal capital of two people. The Principles frame alignment as the general partner's wealth creation being "primarily derived from a percentage of the profits generated from the GP's substantial equity commitment to the partnership, after LP return requirements have been met." The useful measure is the commitment's weight on each partner's own balance sheet. A headline percentage cannot show that; the source of the money can. New York's program for emerging managers lists reduced key person risk among the marks of a maturing firm.

04Source of Funds

ILPA's Due Diligence Questionnaire 2.0 turns the source question into a checklist. Section 10 asks how the general partner's contribution "will be financed, including any commitments financed through means other than cash," and then asks whether any commitment will be leveraged or loaned, financed through long-term indebtedness, deferred management fees, assets from another investment the firm manages or a credit facility, or financed by affiliates or outside persons (ILPA DDQ 2.0, section 10). Each answer has a governance consequence and, for individual partners, a tax consequence.

The tax line between cash and a fee waiver starts with Section 707(a)(2)(A). Where a partner performs services and receives a related allocation and distribution that, "when viewed together," are properly characterized as a transaction with someone acting other than as a partner, the statute treats them that way (26 U.S.C. § 707).

Proposed regulations published in July 2015 would apply that rule through a test of entrepreneurial risk: "an arrangement that lacks significant entrepreneurial risk constitutes a disguised payment for services." The preamble states that Treasury and the IRS have determined that Rev. Proc. 93-27 does not apply where a management company waives a fee while a related party receives a profits interest whose value approximates the waived fee (80 Fed. Reg. 43652, REG-115452-14).

Section 1061 lengthens to three years the holding period for long-term capital gain on an applicable partnership interest, and excludes a capital interest that shares in partnership capital "commensurate with" the capital contributed (26 U.S.C. § 1061(c)(4)(B)). The final regulations deny capital interest treatment to allocations on capital funded by a loan "made or guaranteed, directly or indirectly, by the partnership, a partner in the partnership, or any Related Person." The exception is a loan from another partner, other than the partnership, that is fully recourse to the individual, with no right to reimbursement and no guarantee by any other person. Repayments count as capital contributed when made (T.D. 9945, Treas. Reg. § 1.1061-3(c)(3)(v)).

05Continuity After the Commitment Period

The Model LPA's time-and-attention limb runs only during the Commitment Period, which the term sheet sets at a bracketed five years within a bracketed ten-year term. The Principles ask limited partners to consider how the provision would operate afterward, "as the harvest period may present the most critical time for continuity of key persons." In life sciences and healthcare that is the ordinary case. BIO, Informa Pharma Intelligence and QLS Advisors report that a Phase I asset takes 10.5 years on average to reach regulatory approval (BIO, Clinical Development Success Rates 2011-2020). A growth equity investment enters later, but its value still turns on clinical, regulatory and reimbursement milestones that can arrive after new investment has stopped.

For a two-partner firm the gap is sharper: one departure in year seven removes half the judgment applied to every remaining exit, and no Model LPA limb responds. A post-investment-period standard can close the gap without restarting the suspension machinery. It can provide notice to all limited partners and discussion with the LPAC on any partner's departure, a defined time standard for the existing portfolio, and an explanation of how the departing partner's economics will be reallocated, mirroring the disclosure the Principles call for on any transfer of GP interests.

06Drafting Positions for a Two-Partner Manager

1. Name both partners and make the departure of either a Key Person Event. The Principles' test of who determines investment outcomes requires it when two people decide every investment.
2. Define time and attention across predecessors, successors and parallel vehicles. Pair it with the Principles' bar on a key person acting as general partner of a substantially equivalent vehicle until the investment period ends or the capital is invested, committed or reserved.
3. Draft the Change of Control limb with the hiring plan in view. Carry granted to new professionals should be matched by adding them as Key Persons, with limited partner approval.
4. Choose the cure vote deliberately. When the remaining partner proposes the remediation plan, excluding general partner and affiliate interests, as the Principles recommend, is what makes the vote independent of the person it judges.
5. Fund the commitment in cash and answer DDQ section 10 completely. Where any part is borrowed, the personal-liability standard in T.D. 9945 marks the line for capital interest treatment.
6. Keep a written succession plan. DDQ 2.0 asks whether one exists and whether the firm will discuss known health, financial, litigation or personal conditions of senior professionals that might affect their ability to perform.

07Frequently asked questions

How should a key person provision work in a firm with two partners?

ILPA Principles 3.0 say key persons should be the individuals who determine investment outcomes, and that the provision should not be drafted so that the departure of someone reasonably believed to be key fails to trigger it. When two partners make every decision, that points to naming both and treating the departure of either as a Key Person Event that suspends new investment.

Why does ILPA prefer a GP commitment funded in cash?

ILPA Principles 3.0 state that the commitment should be contributed in cash, as opposed to through the waiver of management fees or specialized financing facilities. Cash puts the partners' own capital at risk alongside limited partners. Fee waivers also carry tax risk under Section 707(a)(2)(A) and the 2015 proposed regulations on disguised payments for services.

Does a key person provision apply after the investment period ends?

Under the ILPA Model LPA term sheet, the time-and-attention trigger applies during the Commitment Period. ILPA Principles 3.0 ask limited partners to consider how the provision operates afterward, because the harvest period may be the most critical time for continuity. That is common in life sciences, where value often turns on milestones that arrive late in a holding period.

Nothing in this piece is investment, legal, tax or accounting advice, and nothing in it is an offer to sell or a solicitation of an offer to buy any security.