Partner withdrawal

Partner withdrawal is one of the most critical issues that hedge fund management companies must address in their partnership agreements Partnership agreement A partnership agreement is the primary governing document for a hedge fund structured as a limited partnership. It establishes the relationship between general partners and limited partners. The agreement details rights, obligations, economic terms, and operational provisions for all parties involved. . The process allows partners to leave the firm in an organized way at a predictable cost to all parties involved. However, what a departing partner receives when they leave is often misunderstood and has major consequences for both the person leaving and the business that remains.

When someone becomes a partner in a hedge fund management firm, they typically contribute money and expertise in exchange for ownership rights and profit sharing. When that person decides to leave or gets terminated, the partnership must have clear rules about what happens next. Without these rules, the departure process can become chaotic and expensive.

Hedge fund managers generally follow a simple principle when partners leave voluntarily or face termination. The departing partner should receive their capital account balance—essentially the money they originally invested plus any accumulated profits—but nothing more. They should not continue sharing in future business profits or expect the firm to buy out their ownership stake at full market value.

This approach reflects how hedge fund managers view their business. They believe the firm only creates value through the active work of current partners. This philosophy comes from traditional investment banking partnerships, where departing partners historically received only their account balances rather than ongoing business interests. The reasoning is straightforward: if you are not actively contributing to the firm's success, you should not continue benefiting from it.

Buyout arrangements create serious problems for hedge fund management firms. When a key partner leaves, the firm often loses revenue-generating capacity and may see clients withdraw their money. At the same time, the firm must calculate what the departing partner's ownership stake is worth, often resulting in valuations that are several times the firm's annual profits.

These high valuations create financial strain because hedge fund profits are inherently unpredictable and volatile. A firm might have a great year followed by several poor ones, making it risky to commit to large fixed payments. Additionally, under current tax law, these buyout payments typically cannot be deducted as business expenses, making them even more expensive for the remaining partners.

The timing also creates problems. Valuations are usually calculated when the partner announces their departure, but market conditions and business performance can change dramatically by the time payments are actually due. This disconnect between valuation dates and payment dates adds another layer of financial uncertainty.

Instead of buyout mechanisms, hedge fund managers typically use "sunset payments" to handle partner departures. These arrangements give departing partners a gradually decreasing share of future profits and sale proceeds over a period of three to five years. Founding partners may receive longer sunset periods because of their unique contributions to building the business.

Sunset arrangements work better for several reasons. First, payments only occur when the firm actually generates profits, so there is no risk of forced payments during difficult periods. Second, the declining payment structure acknowledges the departing partner's past contributions while recognizing that their value to the business decreases over time. Third, these payments provide tax benefits to remaining partners because they reduce the firm's taxable income.

For example, a departing partner might receive 50% of their normal profit share in year one, 30% in year two, 20% in year three, and nothing thereafter. This structure provides the departing partner with ongoing income while avoiding the financial strain of large upfront payments.

When partnership agreements do not address partner withdrawal properly, state law steps in to fill the gaps. This creates significant problems because different states have different rules, and it may be unclear which state's law applies. If partners live in different states or the firm operates across state lines, multiple jurisdictions might be involved.

Under Delaware law and similar state partnership statutes, departing partners may retain their ownership interests indefinitely and can demand that the firm buy them out at fair market value Fair value Fair value is the price that buyers and sellers would agree upon in a normal, competitive market transaction. This market-based approach serves as the primary method for valuing hedge fund portfolios under generally accepted accounting principles (GAAP). . This fair value calculation typically includes the firm's goodwill—its reputation, client relationships, and future earning potential—which can result in valuations four to eight times the firm's annual earnings.

These buyout obligations can be financially devastating. Hedge fund businesses have uncertain cash flows and limited access to financing, making it difficult to raise the money needed for large buyout payments. In extreme cases, these obligations can force successful firms to close or merge with larger competitors simply because they cannot afford to pay departing partners.

Comprehensive partnership agreements address withdrawal through multiple interconnected provisions. These agreements typically establish governance structures that determine how major decisions are made, including decisions about partner departures. They specify how profits and losses are allocated among partners and what happens to these allocations when someone leaves.

The withdrawal provisions themselves cover various departure scenarios. Partners might leave due to death or disability, voluntary resignation, termination for cause (such as misconduct), or termination without cause (such as poor performance or strategic disagreements). Each scenario may trigger different consequences and payment structures.

Modern agreements also include restrictive covenantsContractual provisions that limit what departing partners can do after they leave the firm, such as restrictions on competing with the former employer or soliciting clients. that limit what departing partners can do after they leave. However, the regulatory landscape for these restrictions has changed significantly. The Federal Trade Commission's 2024 Non-Compete Rule broadly prohibits most worker non-competition agreements, though some exceptions may apply to senior executives at banks and certain other financial institutions.

Garden leave arrangements remain permissible under current federal rules. In these arrangements, departing partners continue receiving their full compensation for a specified period while being restricted from working elsewhere. This approach protects the firm's interests while providing financial security for the departing partner during their transition period.

The right to receive sunset payments is usually conditional on the departed partner's compliance with all contractual obligations, including any permissible restrictive covenants. However, enforcement mechanisms must now account for evolving federal and state restrictions on post-employment obligations in the financial services industry. Firms must carefully balance their need to protect confidential information and client relationships with the increasingly limited ability to restrict former partners' future employment opportunities.