COVID-19: Issues affecting closed-end private investment funds
This alert, the first in a three-part series, focuses on issues for private investors to consider in relation to closed-end private investment funds. Future alerts will focus on issues in relation to open-ended private funds as well as considerations related specifically to the secondaries market.
The spread of the coronavirus disease 2019 (COVID-19) pandemic has created widespread economic volatility and has led many economists and world leaders to consider the possible effects of an economic downturn caused (in whole or in part) by the COVID-19 pandemic. Unlike the 2008-09 financial crisis, which was caused by a breakdown in the banking and credit system, this unprecedented crisis is instead a result of significant disruption in commercial activity across the globe. Set forth below are certain issues that private investors in closed-end private investment funds may want to consider as we move forward into this uncharted territory.
Market disruptions leading to fundraising delays, potential partner defaults and shifts in the availability of viable investment opportunities and liquidity may increase the risk of certain concentration issues for funds and private investors therein.
Given the current market volatility, investors looking to close on primary commitments to closed-end funds still within their fundraising periods may become increasingly uncertain about their commitments. Some private fund investors may find themselves overexposed to alternative assets due to a reduction in the value of their public market investments, while others may pause their investments and adopt a wait-and-see approach. As a result, managers may seek to delay upcoming closings (particularly where there are first closing commitment thresholds or management fee start dates that are tied to a certain threshold of aggregate commitments), or try to extend the fund’s final closing date past what is set forth in the fund’s governing documents. The reduction in aggregate commitments experienced by an undersubscribed fund may skew an early closing investor’s equity percentage in a fund to a level that creates additional regulatory headaches.
Investors in ongoing negotiations for mid- or end-of-fundraising-cycle closings may consider undertaking diligence as to current or expected aggregate commitments vis-à-vis the fund’s stated target, and consider the impact of fundraising shortfalls on the fund’s ability to execute its strategy. Sensitive investors may want to push for side letter protection that their commitment will not represent more than a certain percentage of aggregate commitments, or that a fund will not begin making investments (or accruing management fees) until a certain threshold of aggregate commitments has been met.
Limited partner defaults on capital call obligations may occur, whether due to reduced overall liquidity or internal disorganization as part of the transition to remote working environments (though we anticipate that managers will be flexible as investors seek to manage transitional disruption). Investors may consider reviewing their funds’ “overcall” limits to determine potential exposure for defaults by other investors, which may result in overexposure to a subset of investments and concentration risk for non-defaulting investors relative to the fund’s overall investment strategy. This is particularly notable for funds already pursuing a concentrated portfolio strategy with a smaller number of portfolio investments. Investors are encouraged to consider taking a proactive approach to discussions with their managers to understand what is happening not just at the portfolio company level, but at the fund level, as well.
Investors may also consider whether funds still in their investment periods will be able to continue executing their investment objectives in the event of significant market changes. Managers of funds focused in depressed industries may be tempted to stretch the letter of their investment limitations in order to expand their strategies and access different opportunities. This may eventually lead to an overall style drift and potentially create liquidity challenges within the fund or excess risk in its ability to achieve expected returns. Across an investor’s portfolio, this could potentially lead to overexposure to certain markets or sectors if managers are collectively drawn towards similar opportunities.
Additionally, during the fundraising period, investment restrictions measured as a percentage of a fund’s aggregate commitments are often based not on actual aggregate commitments, but rather on a benchmark amount – typically either the fund’s target or its hard cap. In principle, this allows the manager to build the fund’s portfolio with a more long-term view towards portfolio balancing; however, if aggregate commitments ultimately fall substantially short of the fund’s stated target, a portfolio investment representing, for example, <10 percent of “targeted” commitments could potentially represent >30 percent of actual commitments to the fund. This may ultimately lead to a significantly different risk profile for the fund’s portfolio than originally contemplated. Investors in ongoing negotiations for new primary commitments are encouraged to consider pushing for capital deployment limitations (e.g., pacing limits or hard dollar limits) in order to prevent managers from calling capital in excess of certain thresholds over the course of a specified period of time.
Finally, investors with advisory board seats need to be careful stewards of their rights to approve requests to invest outside stated investment limitations. Given the potential for available investment opportunities to dwindle or shift, single investment limitations may become increasingly important as a tool for limiting these risks.
Fund managers may require additional liquidity or infusions of capital to support struggling portfolio companies, particularly if they are running low on unfunded commitments, and may engage in a number of strategies or actions geared towards accessing or retaining such liquidity. [Note that liquidity options available to managers via manager restructurings or manager-led secondaries are not addressed here, but will instead be discussed separately in a subsequent post.]
Calls and distributions
Managers may determine to keep cash on hand instead of making distributions to limited partners. Investors may consider looking at requirements set forth in fund documents for managers to return called but unused capital within stated time periods (including whether such unused amounts will accrue preferred return), or for how frequently managers are required to make distributions to investors. Private investors (particularly pension plans) may want to consider the implications on internal cash flows if distributions from private funds across their portfolios slow for an extended period of time.
Further, managers may turn to in kind distributions as another method for shifting risk and market volatility directly onto investors. Depending on the flexibility of its valuation policy, a manager may be able to make in kind distributions using stale financial information or opaque valuation markers, and collect carry on investments that might otherwise have been sold for a lesser profit or even for a loss. Investors with advisory board seats are encouraged to consider their rights to review and contest valuations, and all investors are encouraged to familiarize themselves with their rights to opt out of in kind distributions (including any processes that may be required in order to do so).
Limited partner “giveback” provisions may also become increasingly relevant if managers resort to calling distributed capital back from investors as another means for gaining access to liquidity (including for the payment of management fees). Funds’ governing documents may permit the manager to call distributions back from partners in order to meet “any obligation” of the fund, which could potentially include paying management fees or making carried interest distributions (although calling capital to pay carried interest may be viewed as improper given that carry is not a fund obligation). Even if such carried interest distributions would be redistributed to limited partners as part of the clawback later in the fund’s life, these provisions may serve as a way for managers to funnel investor liquidity into their own coffers as a means for weathering any imminent financial storms.
Increasing the fund’s leverage may also allow managers to access liquidity without an infusion from capital contributions. Utilizing credit facilities instead of calling capital may reduce the length of time that preferred return would otherwise be accruing on contributed capital, thereby allowing managers to artificially boost fund performance metrics and reach the carried interest stage of the waterfall more quickly without any changes in overall returns. Investors are encouraged to be cognizant of a fund’s ability to draw down on its credit facility, including any borrowing caps and time limitations for repayment, as well as whether preferred return will accrue on borrowed amounts.
MANAGER FIDUCIARY DUTIES
Governing documents may attempt to waive a manager’s fiduciary duties of care and loyalty, effectively allowing a manager when making decisions on behalf of the fund to consider its own interests ahead of those of the fund and its limited partners. As managers seek new avenues for liquidity or returns, investors are encouraged to be mindful of the limits placed by the fund documents on manager decisions and discretion.
Manager economics are driven primarily by carried interest, management fees and other fees received in connection with services provided to the fund or its portfolio companies by manager affiliates.
Carried interest. With portfolio company valuations in flux or declining, managers may seek to extend the fund’s investment period or term in order to protect overall returns, which they are often permitted to do for limited time periods without investor consent. Extending the fund’s investment period may allow a manager to hedge against the fund’s existing investments by making new investments. Investors are encouraged to be mindful of any hedging limitations and permitted levels of manager discretion set forth in fund documents. Managers with underperforming funds may be incentivized towards risk tolerance as they push to achieve their carried interest hurdle. Extending the fund’s term may also allow the manager to continue funding follow-on investments in order to bridge the time until valuations have started to recover, as well as to push out clawback performance while still receiving management fees and charging transaction fees to portfolio companies.
Management fees. Extending the fund’s investment period or term may also allow managers to continue receiving management fee payments at the highest permissible rate, or past such time as they may have otherwise terminated in full. Investors are encouraged to review the terms of management fees that are based upon a fund’s invested capital, where write offs or write downs resulting from significant markdowns in portfolio company value may or may not reduce the fund’s “invested capital” for purposes of calculating the management fee.
Fees and transactions with affiliates. Affiliate transactions may also provide an avenue for managers to funnel additional cash into their pockets without alerting investors. Investors are encouraged to pay special attention to managers’ policies for fees paid to, or transactions entered into with, affiliates of the fund or the manager. Engagement with managers as to any changes in how they utilize fund management tools or charge fees are encouraged to remain towards the top of diligence and monitoring lists.
If successor fund limitations are linked to capital drawn down, invested or reserved, the breadth of purposes for which a manager may reserve capital may be considered, as well. In a desperate situation, managers may rush to raise a new fund rather than continuing to deploy the capital of its existing fund in order to gain access to new management fee streams and an infusion of capital for follow-on investments in existing portfolio companies (which may be provided by a successor fund).
In light of the social distancing and quarantine measures in effect to varying degrees throughout the world, requirements for original or “wet ink” signatures raise concerns for managers and investors alike as they seek to close transactions.
In connection with closings taking place in jurisdictions that may require receipt of original signatures pursuant to applicable law (e.g., “know-your-customer” documentation in Jersey, certain documents under English or German law), managers are willing to work with investor requests to proceed to closing using only electronic signatures and to waive receipt of originals until an unspecified future date when delivering original signatures is practicable. Managers also have been willing to accommodate waivers of requirements for witness signatures or notarization, except where such signatures or notarizations are required by applicable law to be received before closing.
For investors needing assistance with electronic signing or virtual notarization, DLA Piper attorneys may be able to provide support by way of electronic signature software capabilities as well as virtual notary services. In the first instance, however, investors should inquire as to whether originals, witness signatures or notarized signatures are required in order to close, or whether such requirements may be waived (whether on a temporary or permanent basis).
In spite of increased market volatility, it is likely there will be no shortage of viable investment opportunities for private funds. This is a good time for investors to more aggressively seek alignment in terms. With sponsors seeking new investors or liquidity options in order to supplement cash flows, investors will have more opportunities to better align interests following nearly a decade in a manager-friendly fundraising environment.
The DLA Piper Global Investment Funds group is a global leader in counseling institutional investors in the alternative asset space across all major market sectors, and we will continue to monitor the market in real time in relation to COVID-19-related matters. If you have any questions concerning these developing issues, please contact a member of the DLA Piper investment funds group or your DLA Piper relationship partner.
This information does not, and is not intended to, constitute legal advice. All information, content, and materials are for general informational purposes only. No reader should act, or refrain from acting, with respect to any particular legal matter on the basis of this information without first seeking legal advice from counsel in the relevant jurisdiction.