A key person clause is a probability, not a list of names. How many people it names and how many must leave decide how often it fires.
The probability of a key person event is one minus the probability that enough of the named people stay. If each of three named partners has an illustrative 4 per cent annual chance of leaving or ceasing to devote the required time, an any-one-of-three clause triggers 45.8 per cent of the time over a five-year investment period, while an any-two-of-three clause triggers 9.0 per cent of the time. The clause design moves the answer more than the names do.
Worked in full in Operational Due Diligence in Private Equity by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
Key person risk sits in every operational due diligence report, usually as a list of names and a sentence on succession. The clause in the LPA turns that risk into a mechanism: if the named people leave, the investment period is suspended. Whether the mechanism is a real protection or a near certainty that will be waived depends on arithmetic nobody writes down.
| Input | Value |
|---|---|
| Named key persons | 3 |
| Annual probability each one leaves, dies, is incapacitated or stops devoting the required time | 4% |
| Investment period, years | 5 |
| Fund life, years | 10 |
| Departures assumed independent | Yes |
The 4 per cent is an assumption to replace with your own view of the team: age, tenure, economics, and whether a successor fund or a spin-out is plausible. Independence is generous; departures in a troubled firm tend to come together.
One person gone by year T: q = 1 − (1 − p)T = 1 − 0.965 = 18.5%
Clause fires if at least k of n are gone: P = Σj=k..n C(n, j) qj (1 − q)n−j
In Excel, with q in B2: =1-BINOM.DIST(k-1,n,B2,TRUE). For any one of three that is =1-(1-B2)^3.
Each person stays the full five years with probability 81.5 per cent. All three stay with probability 81.5 per cent cubed, so at least one leaves 45.8 per cent of the time. At least two leave 9.0 per cent of the time and all three 0.6 per cent. Over the full ten-year life the figures are 70.6, 26.2 and 3.8 per cent.
| Clause | Probability |
|---|---|
| Named founder only | 18.5% |
| Any 1 of 3 | 45.8% |
| Any 2 of 3 | 9.0% |
| Any 1 of 5 | 64.0% |
| Any 2 of 5 | 23.2% |
| Any 3 of 5 | 4.7% |
Adding names with a trigger of one makes the clause fire more often, not less: 64.0 per cent for any one of five. A clause that is more likely than not to fire will be renegotiated or waived when it does, which is protection in name only. Raising the trigger count goes the other way: any three of five fires 4.7 per cent of the time, which may be too rare to catch a team that is genuinely coming apart.
The question for the analyst is not which number is right but whether the clause fires in the situations that matter. If one founder makes every investment decision, a founder-only clause at 18.5 per cent is the honest one. If the firm runs on three senior partners with overlapping deal flow, two of three at 9.0 per cent matches the risk.
| Annual rate per person | Any 1 of 3 | Any 2 of 3 | Any 2 of 5 |
|---|---|---|---|
| 2% | 26.1% | 2.6% | 7.6% |
| 4% | 45.8% | 9.0% | 23.2% |
| 6% | 60.5% | 17.5% | 40.1% |
| 8% | 71.4% | 26.9% | 55.4% |
The two-person triggers are far more sensitive to the rate than the one-person trigger: doubling it from 4 to 8 per cent takes any two of three from 9.0 to 26.9 per cent, a factor of three. That is why the departure rate is the input worth diligence time. Partner turnover in previous funds, unvested carry, and the economics of the firm all inform it. A firm with falling fee income, of the kind worked in how long a GP can survive without a new fund, has a higher rate than its history suggests.
Timing matters as well as probability. A departure in year 1 suspends a fund with most of its commitments uncalled; one in year 5 suspends very little. Under any one of three, with deployment spread evenly, a first departure inside the investment period suspends on average about 54.9 of every 100 committed. Weighted by the 45.8 per cent chance that it happens at all, the expected commitment exposed to a suspension is 25.1 per 100.
The common mistake is negotiating for more names on the clause and treating the longer list as stronger protection. With a trigger of one, every name added raises the chance of a suspension that LPs will then be asked to waive, and a waiver granted once makes the next one easier. The second mistake is reviewing the clause and not the people: the clause only fires on a departure the manager reports, so the ODD question is how time commitment is defined and monitored.
Compute the trigger probability for the clause as drafted: 1 − the chance enough named people stay. At 4 per cent a year, any one of three fires 45.8 per cent of the time over five years and any two of three 9.0 per cent. Match the trigger to how decisions are actually made at the firm. The free workbook for this case applies the same principle to the rating model: whether a single issue is allowed to be disqualifying is a design decision, and it decides the outcome.
Likelier than most LPs assume when the clause names several people and needs only one to leave. At an illustrative 4 per cent a year per person, each of three people has an 18.5 per cent chance of going within five years, so an any-one-of-three clause fires 45.8 per cent of the time. Over a ten-year fund life it is 70.6 per cent.
Only if the trigger count rises with it. Naming five people and triggering on any one gives a 64.0 per cent chance of suspension in five years at 4 per cent a year each, which makes the clause noisy. Any two of five is 23.2 per cent, against 9.0 per cent for any two of three.
Typically the investment period is suspended and new investments stop until LPs vote, so the exposure is the uncalled commitment. Under an any-one-of-three clause at 4 per cent a year, with deployment spread evenly over five years, a first departure inside the investment period finds on average about 54.9 of every 100 still uncalled; weighted by the chance it happens, 25.1 per 100.
This article is one calculation from Operational Due Diligence in Private Equity. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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