Not fit for the PPM

Private placement memoranda should never contain or omit language that, in retrospect and with perfect hindsight, can provide fodder for disgruntled LPs looking for a basis to make a legal claim. By Michael Lawson and Matthew Judd

It is widely acknowledged that over the last few years private equity fundraising has become increasingly institutionalized and process driven.

One consequence of this is that investors have increased expectations in respect of the content and quality of PPMs. A well prepared PPM that addresses the expectations of investors is a very success, fmeans of building the momentum vital to any successful fundraising.

We all know that the PPM is one of the primary marketing documents in a fundraising. But what must not be for-gotten is that the PPM is also a legal document that forms part of the investment contract between the general partner and its investors. This tension presents a challenge for the general partner when preparing the PPM. On one hand the PPM is a key instrument used in building the momentum of a fund raising and whetting the appetite of investors for more information, more dialogue and more due diligence. On the other hand – as a legal document – the PPM needs to be complete, balanced and accurate.

So the PPM is a legal document. What does this mean? It means that if the PPM is found to be deficient it could have potential adverse consequences for the general partner. In addition to reputational and commercial damage, a deficient PPM (i.e., one that is incomplete, inaccurate and/or misleading) could give rise to litigation for a claim for breach of fiduciary duty, breach of contract or negligence. There are two important points to note here. Firstly, a PPM can fail on what information it does not contain just as much as what it does contain. Secondly, the examination of whether a PPM is deficient will be made retrospectively with full benefit of hindsight and usually in the presence of disgruntled investors who have lost money or have unmet expectations and who are looking for a basis for the making of a legal claim.

In relatively recent times there has been a noticeable change in the attitude of the community of private equity investors with respect to litigation. This is a consequence as much as anything else of the increased sophistication of private equity investors and the increasing reliance of private equity funds on financial institutions and fund of funds for their investor base. If a fund performs below expectations, investors may well seek to use the PPM as a basis for litigation against the general partner.

Much attention has been given to the Unilever v Mercury Asset Management and State of Connecticut v Forstmann Little litigation and these cases provide a vivid illustration of the increasing propensity for disgruntled investors to litigate in respect of investment mandates.

In no particular order, the following are examples of things that should not appear in your PPM in today’s more litigious environment:

The aim of any marketing campaign is to present the relevant product in the best light and a PPM in this respect is no different. The overriding test is that the PPM should present a complete, true and balanced view in respect of the relevant fund and the investment team. The temptation to omit unsuccessful investments on the grounds that they are not relevant to the current strategy, to start track-record calculations from a more favorable date or to acknowledge write-offs, needs to be resisted. The full list of risk factors and potential conflicts of interest that may impact on the performance of the fund need to carefully considered and disclosed so that investors are forewarned.

It is relatively common for a PPM to include a statement as to the fund’s targeted returns. For example, a statement similar to ?the general partner will seek to achieve a targeted annual return for each transaction of between 18 percent and 22 percent can be found in any number of PPMs. The inclusion of statements relating to targeted returns, particularly in light of the recent litigation, needs to be carefully considered. The Unilever and the State of Connecticut litigation show that great care needs to be taken before such statements are included in the PPM, as a court may determine that such targets form part of the investment contract and that a failure to meet such a target could provide a basis for legal recourse by a disgruntled investor against the General Partner. Before such statements are included in a PPM the ability to achieve the targeted returns needs to be stress tested and it needs to be established that at the time of the issue of the PPM there were reasonable grounds to believe that the targeted returns could be achieved. Appropriate risk warnings in respect of the targeted returns need to be included.

A large part of the PPM is dedicated to the investment strategy of the proposed fund. Increasingly it is market practice to use historical case studies to illustrate the investment strategy and to use these case studies as a means to differentiate the investment strategy of the promoted fund from other competing funds. The inclusion of case studies in a PPM gives rise to a number of considerations which require special attention. The starting point is that to tell the full story, a summary that places emphasis on the deals that went well to the exclusion of the deals that were less successful does not present a balanced impression of the historical position of the general partner and the investment team. Another consideration is to make sure that the case studies are in fact relevant to the cur-rent fund. Case studies that relate to a former or irrelevant investment strategy need to be carefully presented or excluded.

The inclusion of track record information in a PPM has obvious marketing advantages and assists greatly in the process of catching the attention of investors in a competitive fund raising market. The presentation of this track record information takes many forms. For example, many PPMs in the marketplace include gross IRRs by company in respect of realized and unrealized investments. If a PPM is to include track record information it is important that the PPM itself fully discloses and explains the basis of the calculation of the numbers and what the numbers actually mean. This means the disclosure of the valuation methodology. The general partner, especially in respect of additions to its investment team, needs to make sure that it is legally entitled to present the track record information.

Depending on the targeted investors, the PPM will need to address a host of regulatory issues across the relevant jurisdictions. For example, the marketing of a fund to US taxable and ERISA investors will require special content to be included in the PPM. Because the fund will not be publicly offered or listed the formal content requirements are not usually extensive. The general partner needs to make sure that all of the required rubric is included and current. Rubric that was current for the last fund may be out of date for the successor fund.

?Case studies that relate to a former or irrelevant investment strategy need to be carefully presented or excluded.?

If the PPM makes reference to data from external sources, refers to deals or names individuals the general partner needs to make sure that it is fully entitled to include such material in the PPM. The fund raising will come to a sudden halt if the PPM has to be withdrawn because it infringes a data agency’s copyright or breaches a confidentiality obligation entered into in respect of a prior deal.

The PPM is typically issued at the commencement of the active fund raising period and it is essential that the PPM is updated to reflect altered circumstances that may occur during the fund raising. Any changes in the investment team, fund terms, investment strategy or investment performance should be updated and presented to investors so that the PPM, at the time of admission of the investors to the fund is current and accurate.

Prior to the issue of the PPM the general partner needs to implement a process in order to ensure that the PPM is complete, accurate and not misleading. The process usually manifests itself as a verification exercise which involves dissecting the PPM into its constituent statements and then asking the appropriate people to confirm the accuracy of the statements and to provide any supporting independent documentary evidence. Whilst arguably one of the less enjoyable aspects of a fund raising, this process is important as it helps to minimize the risk of civil or criminal liability of those persons responsible for the PPM by providing them with evidence in order to establish a potential defense to a claim that the document contained material misstatements or omissions.

Michael Lawson and Matthew Judd are lawyer and partner, respectively, in the Private Funds Group of Clifford Chance LLP in London.