Secret passwords, traceable communications and documents labeled “For Your Eyes Only” used to be the domain of international spies. However, they've lately become part of the arsenal of many fund managers who are trying to keep sensitive information confidential while communicating with their limited partners.
In the current environment of uncertainty, many GPs are communicating more frequently with worried LPs who wish to know more about fund strategy, performance and portfolio company activity. Matt Porzio, vice president of product management for virtual data room provider IntraLinks, says his company has seen a 60 percent increase in 2008 from a year before in the number of files and documents that private equity clients – which include The Blackstone Group, Apax Partners and Novacap – have sent out.
The problem is that as the amount of information being disseminated rises so does the risk of sensitive details about a portfolio company or trade secrets ending up in newspaper article, or a letter to investors geting posted on some blogger's website. Recently hedge fund SRM Global filed suit against The Wall Street Journal in the UK for publishing allegedly confidential information about its performance.
Such leaks can tarnish a management team's reputation, as well as tip off competitors about opportunities and lead to rivals betting against their investments.
For instance, Kevin Scanlan, a managing partner at New Yorkbased international law firm Dechert, says that his firm had a client a few years ago that was rolling out a single-purpose fund dedicated to buying up 60 to 75 percent of the bonds of a bankrupt company, with the intent of controlling the bankruptcy process and becoming a majority shareholder, appointing a board of directors and eventually controlling the company. But although the fund's investors had signed confidentiality agreements, word got out to the competition and the investment strategy was killed when the bond prices went up from 30 cents to 80 cents on the dollar.
Some of the legal precautions funds can take to prevent these kinds of headaches include subscription or partnership agreements that require an LP to notify the fund in events such as a regulatory body demanding information through a subpoena. That way a fund has the opportunity to file a protest and make an injunction to prevent the information from being released. Such agreements can also call for penalties to investors who have shared confidential information with anyone other than their legal advisors or employees.
“If the company thinks they are suffering a competitive disadvantage and they can quantify those damages then technically you are on the hook for those,” Scanlan said. In its action against the Journal, SRM Global sought a court injunction restraining the paper's European edition from publishing its article, and reportedly warned investors it could take action against them if performance information was passed on.
Managers looking for other ways to control who sees their information also have an increasing number of high-tech defenses, with the focus on reducing the amount of hard copy documents given out. One thing many funds are employing is password protected websites that prohibit viewers from printing, downloading or putting files into computers.
Porzio says over the three-month period ending in November his company saw a 50 percent increase from the year before in funds signing up for security services, including secure e-mail alerts. The firm also has software that locks down protected files to a specific computer, so even if a user shares their password with someone else or tries to access the files from another computer the information can't be viewed.
But short of transporting sensitive materials in a briefcase handcuffed to an armed courier, and showing the information to LPs in a windowless room with guards watching over, there is only so much a GP can do once information is made available to keep a limited partner who wants to preserve a copy from doing so. “There's no such thing as a read-only website,” says Jonathan Axelrad, a partner in Goodwin Procter's private investment funds practice. “If someone came up with the most brilliant, unhackable software that would prevent me from pushing the print button when I was looking at a website, even that couldn't prevent me from picking up my digital camera and taking a photograph of my monitor.”
Such limitations in being able to prevent leaks has led to a greater focus on tracking down and taking action against a leaker after a breach has occurred. Many offering documents or marketing materials may have a sort of digital fingerprint with the name of the investor and date it was provided and terms like CONFIDENTIAL watermarked on every page, so even if it is put on a website it is clear who it came from.
Online reporting software can also allow a manager to perform a version of CSI: Private Equity by determining whether someone spoke to a reporter based on digital records. “People understand that you can't lock down everything; you can't protect everything,” Porzio says. “When that information is maybe used out of context you want to follow that trail: who actually accessed that information, what dates the leak happened and who was looking at that information on or before that date.”
Demonstrating that a careless investor can be tracked down will likely convince others to pay more heed in the future. But while security is a top priority for any fund manager, they also don't want LPs who are investing for the next 10 to 12 years to think they are under 24-hour surveillance.
Fortunately for managers, the regulatory framework has changed in the last five years, with many US states changing their Freedom of Information Act laws to make it easier to protect fund-level information from public disclosure. Such actions were taken in response to the battles in the early part of the decade, following the bursting of the tech bubble, over information flows between funds and limited partners.
At the time there were a number of public cases where LPs or beneficiaries of pension funds or public institutions who had lost money were using FOIA laws to extract information about the content and performance of their holdings, which led in some instances to such investors getting disinvited to top-tier funds because they were viewed as either untrustworthy or too at risk of being legally forced to publicly disclose sensitive asset data.
For instance, in 2003 Sequoia Capital Partners asked both the University of Michigan and University of California endowment systems to pull their money from its fund due to media requests for performance data. Since then several states have carved out legislative exemptions shielding public pension and university endowment funds from disclosure requests pursuant to FoIA laws.
In addition, while a number of investors and media organizations were going far beyond normal transparency in seeking the disclosure of valuations of portfolio companies that would have caused a competitive disadvantage, Axelrad says standard information requests have been polished in the last few years during negotiations with general partners and become more reasonable.
“You go back to 2002 and it was a fairly common thing to get a side-letter request that included information requests that I considered inappropriate,” he said. “That's now a relatively rare occurrence.”
David York, managing partner of Paul Capital Investments, agrees that investor reporting has benefitted from the lack of opaqueness seen before the tech bubble, as managers have figured out how to accommodate maintaining confidentiality around portfolio companies with satisfying the demand for transparency by investors. He says going forward GPs may have to focus more on transparency around how the portfolios are acting, including future funding needs and reserve requirements.
“As liquidity remains in a drought as it has for the last year going into next year you're going to run into more and more issues with investors wanting to know more about how they are doing as far as reserves are concerned,” he said.
Matter of trust
However, fund managers will likely not have to deal with the same kinds of problems faced a few years ago, as the industry is not being scapegoated by investors and reporters for the current downturn as it was for the tech crash. “Venture capital and private equity funds are not the villains in the current situation,” Axelrad says. “I've had a whole bunch of calls with LPs in the last few months during this crisis and literally none of them have focused on enhanced informational demands.”
In the end though a manager can take every precaution in the world, but the best way to maintain peace of mind is to do business with those you trust the most.
“I've had general partners come to me absolutely hopping mad because they believed a particular limited partner had leaked information,” Axelrad said. “Sometimes the answer is if you believe a limited partner is untrustworthy then you don't let them into the next fund.”