Closing down dialogue

New proposals by the EU that would enforce strict disclosure requirements on managers could hinder GP-LP communications and lead to reduced use of side letters.

Rather than increasing transparency as intended, new EU regulatory proposals may actually have the unintended consequence of making some private equity managers more opaque, as well as putting up impediments to a proper dialogue between GPs and LPs.

If passed by the European Parliament later this year, the “Directive on Alternative Investment Fund Managers” would subject many EU fund managers to significant disclosure requirements. To investors, the managers would have to provide information on the investment strategy, limitations and risk management of the fund; the process by which the fund can change that strategy; the identity of all the service providers to the fund; the fund’s valuation procedures and pricing models; a description of the fund’s fees, charges and expenses; and any favourable arrangements with specific clients.

Fund managers would have to provide a similar type of disclosure to regulators, with more extensive detail of their use of leverage: managers would have to identify their major lenders and describe the breakdown of leverage arising from borrowing versus leverage from entering into derivatives. Foreigners trying to market their funds in Europe will also have to demonstrate to the relevant authorities that they are subject to equivalent regulation in their home jurisdiction. It is unclear that many such managers – especially those based in the US – would be able to do so.

Such proposals could have a serious impact on investor relations and communications, according to Adam Levin, partner at law firm Dechert. “The concern is that there will be a tendency because of the new disclosure rules to be much more cautious about the information that is disclosed to investors, because they would have to disclose it to a range of stakeholders, including the employees,” he said. “Perhaps to stop themselves from being punished for what they say they will be inclined to say, ‘well actually this is all we’re prepared to say’.”

This may make meetings between investors and managers far less productive than before. “It is possible that people will fear the liabilities that they will have, for example, if they communicate their plans to investors but they haven’t communicated the same plans to their employees,” Levin said. “They could find themselves in hot water, so the tendency will be to say one thing at the start when required to do so to the employees, and then say nothing else because they fear the potential liability. The idea of the Directive was to make the managers more transparent and make them more accountable, but they actually may become more opaque and less accountable as a consequence of the fear of liability.”

The need to disclose the identity of holders of preferential terms could also impact the ability to negotiate side letter terms.

“We are already starting to see funds where this is occurring actually, where they say ‘no side letters’,” Levin said. “And the market to some extent may be moving that way, where the manager will effectively have to say to everyone, ‘these are the true terms at which you have to invest’ and it may be different to what you may normally expect on a 2-and-20 type basis. It may be that everyone will be entitled to 50 percent rebates on fees if they invest more than X million or something like that.”