Corporate Governance. Key Man Risk in Private Equity Firms and Hedge Funds is a Potential Credit Risk for Bondholders. Special Comment.

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1 Special Comment Moody s Corporate Governance December 2007 Table of Contents: Summary Defining the Nature of Key Man Risk 1 2 Mechanisms Adopted to Address Key Man Risk 3 Executing an Effective Leadership Transition 3 About Moody s Alternative Investment Research 4 Moody s Related Research 4 Analyst Contacts: New York Janet Holmes Vice President-Corporate Governance Matthew Noll Vice President - Senior Credit Officer Joel Levine Senior Vice President Gary Witt Team Managing Director Key Man Risk in Private Equity Firms and Hedge Funds is a Potential Credit Risk for Bondholders Summary Recent CEO departures at Merrill Lynch Co. Inc. and Citigroup Inc. have brought to the fore the need for effective succession planning and management development, even in the largest companies. Departures in the wake of major concerns about corporate under-performance can add to existing uncertainty and, in some instances, lay bare deficiencies in succession planning and management bench-strength. But both cases also highlight that large firms can cope with such departures, however unsettling. Hedge funds and private equity firms, however, can face considerably more acute CEO (or founder) leadership transition risk. Leaders in those firms typically have played a central role in building their firms and are closely associated with their firm s success. This special comment focuses on the distinctive features of key man risk found in these firms and outlines steps taken by some firms to mitigate this risk.

2 Defining the Nature of Key Man Risk An important consideration in Moody s corporate governance analysis is the presence, or not, of key man risk. This refers to situations in which the loss of a single individual or small group could have a material adverse effect on the firm s creditworthiness. It is generally a risk in small institutions but can also be present larger firms dominated by a single person or a few individuals. In such a context, boards can be challenged to cope with the loss of the key executives, even when management succession planning processes have been robust. Key man risk in hedge funds and private equity firms typically is more acute than in many other types of firms due a number of their distinctive factors: Successful, founder executives usually have played a central role in the building of the franchise. These individuals are always difficult to replace, because they are strongly associated with the business, its brand and its success. They can play an active role in creating a competitive edge vs. peers, for example, by participating in senior client relationships and by taking a lead role in investor relations. Coupled with the importance of their investing acumen and track record, their ongoing presence in the firm can be (or be seen to be) a material factor in firm s success and viability, and thus its creditworthiness. One or a handful of founders tend to hold most, if not all, of the voting stock. Thus, the firm could face, concurrently, leadership and, for non-public companies, ownership transition risk. Rarely do closely held firms have a formally constituted and active board with outside, independent directors, whose role in a typical public company would include planning for and managing through CEO succession. This presents concerns that founder/ceo succession in a closely held firm will not be wellplanned or executed. In some instances, key man risk can change from a risk associated with the key individual s departure to one associated with his or her decision to remain with the firm. That is, at some point, founder executives can stall a firm s development or otherwise create real problems for the firm s sustainability. Recognizing the importance of key individuals, certain constituents may expect or demand that key man risk clauses are written into key corporate documents: In investment or partnership agreements. Limited partners (investors) often are provided with rights such as waiver of redemption restrictions or early termination of an investment period, early liquidation of a fund, or even an ability to replace the general partner. If such rights are linked to the departure of any of the firm s key individuals, the resulting impact may be a faster liquidation of the fund, a loss of investor confidence, or, in the absence of withdrawal gates (which put limitations on the investors ability to withdraw their investments), a run on the funds/firms. In financing arrangements. If such arrangements contain covenants linked to a departure of a named individual(s), this could clearly be detrimental to the firm s liquidity. The extent to which these concerns are warranted varies significantly, depending on the firm s: Maturity. The older the firm, the more likely equity has been distributed away from the founder(s), to some degree, and institutional (e.g., risk management and operational) capabilities have been established. Origins. In particular, whether the firm was founded with one or more equity owners. In this sense, private equity firms may be better placed, from a key man perspective, than hedge funds; the latter are more likely to have a single owner. 2 December 2007 Special Comment

3 Mechanisms Adopted to Address Key Man Risk Given the potentially acute risk associated with the departure, unexpected or not, of founder CEOs, leading firms have addressed (some of) these concerns proactively, in an effort to minimize the potential credit risk: Formalizing key operations. A critical success factor in managing through leadership and ownership transitions is the degree to which the firm has formalized its decision-making processes, for example, around risk management or the investment process. While the existence of committees or processes is not a panacea for mitigating key man risk, it can provide a framework for key individuals, other than founder(s), to have an influence on key facets of the business. Addressing ownership event risk. Some firms have planned for orderly ownership transitions by documenting the steps that would be taken if the founder or one of the founders were to depart (expectedly or otherwise). Typically, the plan centers on the transfer of the departing founder s ownership interest to other key executives. Some firms, notably, The Blackstone Group and Fortress Investment Group, have used initial public offerings as a means to provide liquidity to partners, which lessens the ownership (though not necessarily leadership) transition risk because founders often sell down some, or a major portion of, their equity. Handling key man clauses in contracts. While they do create some potential concerns, the insertion of such clauses probably also provides some momentum for addressing the overall succession issue. Nonetheless, mechanisms are available to counter the problems associated with these clauses: For investors. In practice, whenever a key individual leaves a firm, there is potential for withdrawals. By incorporating that risk into the fund/firm s investor agreements, investors gain some comfort that they have rights, if they wish to use them, in the event of such a departure. In some cases, investor agreements include withdrawal gates or deferred payment dates to give the firm some time to present plans to investors for their review and approval. In financings. Where such clauses exist, firms try to ensure they have multiple banking/broker relations and longer-term agreements with fixed terms and strong liquidity; in practice, therefore, the clause simply impels a firm to renegotiate its financing to have alternative sources. Managing succession risk. Larger funds have started management succession programs to replicate the practices typical of a large, public company; this is particularly true for large firms where founders are nearing retirement. Executing an Effective Leadership Transition Many founder owner/ceos find it tremendously difficult to let go of the reins and are reluctant to delegate real authority. In this context, it becomes important to develop and communicate a staged leadership (and ownership) transition. For hedge funds and private equity firms, this necessitates informing the firms key constituents non-equity principals, employees, limited partners, investors, key creditors (and portfolio companies, in the case of private equity firms) the broad outline of how the succession will occur. This includes establishing milestones for the transition of power, with room (and protocols) for extensions, if needed. As part of the transition, compensation may have to be restructured to ensure key principals remain with the firm after the succession has taken place (this could be challenging in private firms, because a significant portion of compensation is paid annually in cash, in light of that year s investment returns or firm profits). To the extent the plan is communicated, but then not executed, this can prove damaging, particularly if it proves difficult to retain the senior talent that is supposed to be ascending to the key leadership roles. 3 December 2007 Special Comment

4 About Moody s Alternative Investment Research Since 2006, Moody s has intensified its commitment to the alternative investment sector broadly, and to hedge fund research, in particular. In July 2006, Moody s launched Operations Quality (OQ) ratings for hedge funds. The OQ rating is the result of an in-depth assessment of a range of key categories, including the valuation process, accounting controls, regulatory compliance, risk reporting and control, legal and financial structure, human resources (including key man risk) and systems infrastructure. An operations assessment of the fund by Moody s is an integral input to the overall debt rating process. Moody s analytic framework for rating hedge fund debt obligations rests on three pillars: (i) risk management and governance; (ii) the fund s business profile; and (ii) the fund s financial profile. Other qualitative considerations complement the framework in order to create a structure flexible enough to handle the diverse universe of hedge funds. Moody s publishes research on individual funds, as well as broader research on key issues in the hedge fund industry. Contacts: For Operations Quality ratings, contact Gary Witt: gary.witt@moodys.com For debt ratings, contact Joel Levine: joel.levine@moodys.com Moody s Related Research Special Comments Assigning Unsecured Credit Ratings to Hedge Funds, April 2007 (102552) Moody's Investors Service Hedge Fund Operations Quality (OQ) Rating Frequently Asked Questions, March 2007 (SF93078) Moody's Approach to Evaluating and Assigning Operations Quality Ratings to Hedge Funds, June 2006, (SF77845) To access any of these reports, click on the entry above. Note that these references are current as of the date of publication of this report and that more recent reports may be available. All research may not be available to all clients. 4 December 2007 Special Comment

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