Legal traps: Conflicts of interest

Private equity firms must consider various conflicts of interest in organizing and operating a fund. Once a sponsor or manager has identified the particular actual or potential conflicts of interest that its organization faces, it should develop compliance policies and procedures designed to manage and mitigate these conflicts. 

In general, it may be sufficient to disclose the conflicts to investors and potential investors and, for registered advisers, to disclose how the adviser addresses the conflicts. However, in certain circumstances additional steps may need to be taken. Below several common potential conflicts of interest are identified, and methods to manage or mitigate these conflicts are discussed:

PLACEMENT AGENTS

Often private equity fund sponsors will engage a placement agent to solicit new investors for a fund.

Frequently the sponsor will pay any fees charged by the placement agent. However, some sponsors allocate at least a portion of the fees to the fund. A sponsor that intends to allocate placement fees to a fund should disclose this information to investors. In addition, a US-based sponsor that uses a placement agent must ensure compliance with ‘pay-to-play’ restrictions in Section 206 of the Investment Advisers Act, and, if applicable, rules which sets the guidelines by which a registered adviser may pay compensation to a solicitor.

SIDE LETTERS

A manager of a private equity fund that enters into side letters should make appropriate disclosure to investors of the existence of such side letters. In determining the appropriate disclosure to be made, a manager should consider the impact of different side letter provisions on all other investors and on the fund. For example, the ability of an investor to opt out of certain investments will generally lead to other investors bearing a greater pro rata portion of the investment than they otherwise would

PRINCIPAL TRANSACTIONS   

A ‘principal transaction’ is a transaction between a private equity fund manager (or an affiliate) and the fund it manages, such as the sale of a fund investment to another fund managed by the same manager, or the co-investment by the manager (or a vehicle in which it has a significant interest) and a managed fund in the same investment. To mitigate conflicts related to principal transactions, it is common for funds, at their launch, to create an independent advisory committee of investors to address potential conflicts of interest and grant consents. Other means of addressing the conflict that may arise if a fund manager consents on behalf of the fund to a fund transaction in which it has an interest include engaging outside fiduciaries, relying on an independent board of directors (mainly in the non-US fund context) or putting the matter to a vote of the fund’s investors. Depending on the facts and circumstances, such a committee or other process can serve as the means for the fund, as the ‘client,’ to provide consent under Section 206(3) of the Advisers Act, under the fund’s own consent provisions or as the adviser otherwise deems advisable.

CO-INVESTMENT  

Conflicts of interest can arise if a private equity fund manager, principals of the manager or their affiliates receive co-investment rights in a fund it manages. Although co-investment by the manager can help to align the manager’s incentives with those of the fund, investors are likely to be sensitive to the possibility that the manager may cherry-pick desirable opportunities or obtain preferential terms. Typically if a manager is allowed to co-invest with the fund, the fund documents will set forth the terms on which co-investments may be made. The manager should clearly disclose the co-investment terms to investors and potential investors.

Likewise, investors may be concerned that the manager will offer preferential co-investment opportunities to particular investors. However, flexibility in allocation of co-investment opportunities can benefit the fund as a whole by allowing the manager to make investments quickly and fluidly. Consequently, the manager will often seek to maintain maximum discretion in deciding how to allocate co-investment opportunities. If the manager intends to allow investors to co-invest with the fund, the basis for the fund’s allocation of such opportunities should be disclosed to investors and potential investors.

BOARD OF DIRECTORS

Often a principal of a private equity fund manager will sit on the board of directors of a portfolio company. Such a relationship may create conflicts between the principal’s fiduciary duties to the fund and his or her fiduciary duties to the portfolio company, which include the state law fiduciary duties of loyalty and care. In certain situations, such as when

a portfolio company is in a distressed financial position, it may be difficult for a director to simultaneously fulfill these duties to both parties. A director should resign from the board of the portfolio company if the situation becomes untenable. Even if the portfolio company is in good financial health, a director may find that the short-term goals of the fund and the long-term interests of the portfolio company conflict.

A director must also remember his or her role when it comes to business opportunities and communications with third parties. A director may be tempted to pursue a corporate opportunity that belongs to the portfolio company for the benefit of the fund. A director must also make sure when communicating to third parties that it is clear in what capacity the person is acting. A private equity fund manager that fails to properly manage the conflicts of interest between the portfolio company and the fund runs the theoretical risk that a person may seek to pierce the portfolio company’s corporate veil, which could result in liability for the fund.

RECEIPT OF FEES FROM PORTFOLIO COMPANIES  

If a manager (or its affiliate) receives fees from portfolio companies, including monitoring fees, break-up fees, transaction fees or director’s fees, this needs to be disclosed to investors. Many fund investors will insist that any such fees be offset fully or partially against management fees payable to the manager. While this offset partially mitigates the conflict, disclosure and/or consent of an advisory board of the fund with respect to any such fees remains market practice.

ALLOCATION OF TIME OR NEW FUNDS  

A private equity fund manager should disclose the amount of time that its principals will devote to the management of the fund, and whether and on what terms they are permitted to enter into competing businesses. Usually a private equity fund manager will be restricted in its ability to raise funds with similar investment strategies until a certain percentage of the capital commitments of an existing fund have been invested. However, if a manager does manage funds with similar investment strategies and overlapping investment periods, a conflict may arise with respect to the manager’s allocation of investment opportunities between the funds. The manager should disclose its investment allocation methodology to all of its investors.

VALUATION

Private equity fund managers are generally responsible for valuing the unrealized investments in a fund. This can create conflicts of interest between the manager and its investors and potential investors. For example, a manager typically uses its prior track record in soliciting investors for a new fund. The manager will want to present an attractive track record and may be incentivized to ambitiously value unrealized investments in an existing fund to show a higher track record to potential investors.

Laura Friedrich

Valuation is also relevant to the calculation of management fees. In many cases, management fees are calculated based on a percentage of invested capital after the investment period, subject to write-downs of underperforming investments. This creates an incentive for the manager to retain underperforming investments and discourages a manager from assigning a valuation lower than cost. To mitigate such conflicts, a manager should use consistent valuation methods and consider using an independent valuation process, such as requiring advisory board approval of valuations. The manager should also clearly disclose these methods and processes to investors.

CARRIED INTEREST AND OTHER PERFORMANCE CONSIDERATIONS 

The use of carried interest as incentive compensation may create conflicts between private equity fund managers and investors in terms of risk assessment. A manager should disclose to investors and prospective investors that the payment of carried interest creates an incentive for the manager to take greater risks than it otherwise might take in the absence of this compensation structure. This incentive may be even greater in situations where the fund has had poor performance. A manager of a poorly performing fund may be tempted to invest aggressively in an attempt to salvage its carried interest.

Poor performance could create other conflicts of interest between a manager and the fund. For example, a manager may have an incentive to invest additional funds into a poorly performing investment in an attempt to save the investment. Alternatively, a manager of a very poorly performing fund must avoid becoming apathetic, deciding that there is no chance of salvaging the performance of the fund. A manager must remember that in all cases it owes a fiduciary duty to the fund and must act in its best interest.

CONFLICTS AMONG LIMITED PARTNERS 

Different investors in a private equity fund may have conflicting interests. A private equity fund manager must make decisions based on the interests of the fund as a whole, rather than the interests of a particular investor or group of investors. This may result in disadvantages to particular investors, particularly in terms of tax treatment.

A private equity fund manager may also find itself in a difficult situation if an investor defaults. Private equity funds typically impose severe penalties in the event of a default to disincentivize investors from defaulting. Among other things, a default by an investor may cause the fund to lose an attractive investment opportunity, breach a contract or suffer embarrassment. However, a manager may be reluctant to exercise default remedies in order to preserve a long-term or lucrative relationship with an investor. In the event of a default by an investor, the manager should act in the best interest of the non-defaulting investors and the fund. A manager that is consistent in its handling of defaulting investors will generally find its conflicts mitigated. 

This was an excerpt from a chapter in PEI's US Private Equity Fund Compliance Guide. Available now by clicking HERE.