Assigning liability

In good times no-one wants to hinder a deal with an overly worrisome focus on the so-called ‘legals’. Until recently booming asset markets and plentiful liquidity have meant that the primary focus of both investors and managers was, not unreasonably, on getting funds raised, deals done and putting capital to work as quickly as possible. 

James Gee

In such an environment it is easy to lose sight of the basic legal risks which can arise when making private equity investments. However, private equity investments are long-term commitments and need to be able to survive the bad times as well as the good. The recent financial crisis has highlighted this more than ever. While it will probably never be possible to capture every risk an investor may face, there are a range of legal issues new investors need to consider. 

The most fundamental issue – and perhaps the most important – is ensuring that any investment affords the investor the benefit of limited liability. Investors should be able to allocate a set amount of capital to the particular fund and, with a few specific exceptions, be sure that this is the full extent of their liability. 

Establishing limited liability is usually the foremost objective in structuring any private equity fund and the market is broadly comfortable that the vehicles most commonly used in private equity – limited partnerships – afford this benefit to its investors. There are, however, some risks that an investor should be aware of and should consider when reviewing any fund documents.

Firstly, investors should generally insist upon receiving a legal opinion from the manager’s counsel, addressed to the investor, confirming that the investor benefits from limited liability. This is particularly important where a more unusual vehicle is being used, but even with a typical limited partnership structure, it is valuable as it should also confirm that the necessary formalities to correctly establish the limited partnership have been complied with.

The opinion will however contain a number of standard caveats. One particularly important issue is that investors must avoid becoming involved in the management of the partnership. Investors that expect to have a seat on the advisory committee should check whether the opinion confirms that this role will not affect their limited liability status.

One issue that can be overlooked when considering limited liability issues is that the limited liability status of the partnership only protects the limited partners from being pursued by the partnership’s creditors for the partnership’s liabilities. It does not limit the investor’s liabilities for any breaches of its contractual obligations under the subscription and partnership documentation. So investors need to consider carefully whether any of the terms of the partnership agreement might require them to contribute more than their stated commitment. The most likely situation would be a limited partnership clawback arrangement whereby amounts distributed to investors may be recalled in certain circumstances.

This is not normally a major concern as the distribution means that investors will have further cash to recycle. Technically, such amounts may be over and above the investor’s stated commitments and investors should consider whether they give rise to any operational issues (for example, a fund of funds investor may be obliged to pass on such amounts to its own investors and not have them available for recall). Investors will usually require that they be notified when distributions are subject to clawback and seek to restrict the period over which the clawback may be used.

Investors should also ensure, when using an English limited partnership, that their commitments are made by way of loan. Amounts contributed by way of capital contribution are recallable and an English limited partnership that lacked the standard loan-capital split would leave its investors exposed to claims from the partnership’s creditors over all distributions made during the life of the partnership. Investors would usually expect, in the absence of an express clawback provision, that any distributions received from a fund are free of any such liability.

Investors also need to be aware that if they breach the terms of the fund documents or make a misrepresentation in their subscription documents then it is possible that their liabilities for such breaches might exceed their level of commitments. The legal review should, however, check that there are no express provisions of the fund documents that can require an investor to contribute more than their commitments. It is worth noting that a standard exception would be the equalisation amounts payable by late closing investors – such investors should check exactly what additional amounts they will be required to contribute. What is not standard, but we have seen occasionally in poorly drafted documents, is a requirement that the manager or general partner’s indemnity is given by the limited partners themselves. This should never occur as it completely undermines the principle of limited liability. The general partner and manager should only ever be indemnified out of the partnership’s assets.

THE SUBSCRIPTION FORM 

Investors will also need to be clear about their status when they come to complete their subscription forms. While the terms of the partnership agreement will usually limit an investor’s liability to the amount invested, investors will usually be asked to give open-ended indemnities in respect of any losses arising as a result of inaccuracies in their subscription forms. These documents will contain a large number of representations and warranties from the investor as to their status. While many of these representations are intended to help protect the manager from claims that might otherwise be made by the investor, there are circumstances where an inaccurate representation could cause losses to the fund or manager for which the investor would be liable (for example where a manager failed to comply with ERISA requirements because an investor had (mis)represented that it was not subject to ERISA). 

Most subscription forms contain fairly standard representations that are reasonable to protect the manager. Investors should, however, check that any indemnity contained in the subscription form only applies to the investor’s own misrepresentations in the subscription form and does not seek to extend the nature of their liability in other ways.

Investors should also ensure that the mechanics by which they will be accepted into the fund are clear: it is market practice for the subscription form to be accepted by the manager and for the manager to use a power of attorney contained within the form to execute the partnership agreement on behalf of the investor. Investors should ensure that the form only remains irrevocable for a defined period of time and that the mechanics do not permit the manager to make substantive changes to the fund documentation unilaterally.

Finally, it should go without saying that the form should be completed carefully: the manager will be entitled to rely upon the contact details and bank details contained therein. Investors will have little protection if losses or defaults occur due to its errors in completing these correctly. 

James Gee is a senior associate in the London office of Weil, Gotshal & Manges where he specialises in private funds regulation and private fund formation. At the time of writing, Gee was with peer law firm Clifford Chance. The above article is an abbreviated extract from The Definitive Guide to Risk Management in Private Equity, a PEI publication. It’s available to buy now at www.peimedia.com/books