31st March 2013
Welcome to our Spring 2013 newsletter
Some signs of “spring” do seem to be in the air right now. We sense that 2013 may be a relatively good year for private equity in the region. I hope you are feeling the same way.
In this article (permanent link here) I will focus on the practical steps in managing the responsibilities of a private equity fund. We’ll take the broad meaning of complying with the varied obligations of a general partner, but I won’t write specifically about regulation. With AIFMD on the horizon regulation is a huge topic right now, but much is being written about it elsewhere and in any case, not all funds are equally affected. Even with regulation put aside, governance and compliance is a very large topic and this article will only be able to touch on a few areas. I’ve focused attention around first closing and I hope the article may be of interest.
Managing the responsibilities of a private equity fund
The critical first step is assembling the fund’s governing documents and understanding their implications. All private equity funds are different - even so-called “standard terms” can be calculated on a different basis. It also is highly likely that substantial investors will have negotiated some quite specific terms in the fund documents and side letters.
One way to get to grips with a brand new Limited Partnership Agreement (“LPA”) is to plan the first capital call in detail. Start by understanding the pro-rata basis on which funds should be called from the LP’s. This could be based on commitments or remaining commitments, or a combination of both. Look for any special terms, such as an LP whose commitment may be capped at a certain percentage of fund size, or an option for the GP to offset its own capital contributions against management fee waivers. Check how the GP’s own capital commitment is determined (it could be a fixed amount or a percentage of fund size or a combination). Also check the cap on organizational expenses. A capital call soon after first close is likely taking place with the fund size still at a fraction of its target amount. What are the key investment restrictions? Do investment concentration restrictions therefore constrain any potential pipeline deals? Are any exceptions available? Finally, for any capital calls before final close, be aware that these calls will be subject to equalization and so it’s important to make sure that the management team and the LP’s are all aware of how the equalization process works. On this latter point, some capital call scenario tests with the fund administrator may be helpful.
Of course it will be necessary to go much more deeply into the LPA than just planning a single capital call. My personal advice is to resist the temptation to make a “summary” of the key LPA terms. Such a document is likely to be self-defeating if it means that the LPA itself is no longer being consulted as the primary source to govern all of the events in the fund’s life. All of the terms are in there for a reason! It may be better to use a highlighter on the original document to provide signposts, but in the end your copy of the LPA should become very well thumbed!
Alongside the LPA are the subscription documents and it is essential to properly leverage the information provided by each LP. First of all the KYC status of each investor needs to be confirmed. Ideally KYC procedures will have been completed on each investor before they were admitted to the fund, but in some cases follow-up may be required after closing. It will also be necessary to make sure that the right investor contacts are logged for different purposes (capital calls, tax, legal, etc.). If in doubt as to whether all of the relevant contacts have been provided, revert to the investor for the full set. Going forward in the FATCA era, it is also going to be necessary to make sure that LP’s have provided sufficient FATCA status information for the fund to become FATCA compliant if it chooses to do so. (FATCA is likely to have a significant impact on almost all Asian funds for a variety of reasons, but there is not space to discuss these here). Lastly, assuming the fund has been marketed exclusively to institutional and professional investors, it is important to document that all HNW investors meet the relevant requirements for professional investor status.
The LPA does not stand alone and the set of LP side letters will likely add quite a bit of complexity to the operational management of the fund. Often similar terms can be written in quite different ways in different letters if LP’s have insisted on their own wordings, while other requirements can imply conflicting requirements because different LP’s have different needs (often in the area of tax).
In reviewing the side letters keep in mind the three broad areas of Economics (management fees, waterfall, etc.), Governance (e.g. advisory committee) and Tax (especially relevant for US investors). At the very least it would be necessary to pull together an operating file including the side letters with their key terms highlighted or colour coded. Even better if a fund operations manual/matrix is developed to capture the requirements for events such as capital calls, reporting, further closings, etc. Tax terms in the side letters are likely to impact structuring decisions that the transaction teams should be aware of. We do not offer tax advice, but as an example some investors may be sensitive to UBTI and ECI while others are sensitive to PFIC’s. This can have directionally opposite implications for whether to seek check-the-box elections for fund SPV’s. It’s essential to take proper tax advice, and also to make sure that transaction tax advisors are aware of the fund level investor requirements. ESG (Environmental, Social, and Corporate Governance) policies are becoming more important to European and U.S. investors and we expect these will feature more predominantly in side letters going forward.
Complying with the varied requirements of the fund should be made more systematic by establishing the right internal infrastructure. For example, in IT the right systems will be needed to ensure the security and retention of information, data backup, and resilience of e-mail servers. Valuation is another important topic. Typically a private equity fund may adopt the IPEV guidelines as its valuation policy, but implementation is where attention needs to be focused. For example, are the transaction team aware of the input to the process that they will be required to give? Has the timeline for valuations been determined? What is the review process for valuations internally, for example the investment committee or a separate monitoring committee? Are a standardized set of models going to be used, or will each team construct their own bottom up? LP’s in different jurisdictions, such as PRC, may have different valuation preferences based on their local GAAP. Last but not least are the procedures for keeping the accounting records of the fund and related entities. Our advice is to make sure as a starting point that there is a suitable person in the finance function who can keep a clear track of bank statements, invoices, payments, etc. and make sure this information is shared with the fund administrator on a timely basis.
The next level of responsibility concerns responding with the right governance when unexpected events occur during the life of the fund. These may be issues with transactions, often arising from the uncertainty of making and realizing investments, or issues with investors, perhaps if their circumstances change. There is no simple advice here but knowing both the fund’s own documents in depth and having a broad view of market practices are vital.
This article only paints a quick sketch of the management of a private equity fund. Perhaps the advice in summary is on the one had to assemble the highest calibre group of professional advisors from fund counsel, through placement agent, tax advisor, auditor and fund administrator, and on the other hand build close working relationships with them to leverage the knowledge and experience that is available.
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