Marketing a private fund in Europe has never been a straightforward exercise in compliance terms. But now the Alternative Investment Fund Managers Directive (AIFMD) has come into effect, the EU regulatory landscape is far murkier.
Despite this new challenge, non-EU private fund professionals speaking to pfm about the directive – a legislative effort that was five years in the making – aren’t ready to write Europe off anytime soon. In 2013 alone the industry amassed roughly €54 billion in fundraising (a figure more than twice the volume of 2012), according to figures from the European Private Equity & Venture Capital Association. And there’s one particular marketing strategy that is giving GPs hope to do it: the concept of reverse solicitation.
Reverse solicitation, which permits non-AIFMD-authorized GPs to accept capital from European investors, occurs when a LP is actually the one to initiate contact about a fund opportunity. Only after this is done can a GP start putting marketing materials and subscription documents in front of the investor under the concept.
Reverse solicitation is a promising way for GPs to skip all the hassle that comes with being AIFMD-authorized and still access EU investors – especially those LPs who they’ve already built a relationship with. But industry legal advisors note a major problem with the strategy: nearly all EU member states have neglected to produce any clear guidance on what constitutes reverse solicitation, and just as importantly, what does not.
For example UK regulator the Financial Conduct Authority (FCA) says it will acknowledge reverse solicitation when there is written confirmation from an investor that it approached the GP in a document separate from the subscription agreement – as long as the GP is not asking for this to circumvent the AIFMD, of course. But lawyers interpreting this provision say asking an investor to sign a document confirming it was in fact they who initiated contact is probably not enough to prove reverse solicitation, which has led to some market confusion on the matter.
“When trying to document reverse solicitation, nothing is going to be less credible in the eyes of a regulator, or heaven forbid a court, than the same template email or same template note on every file, that just looks like a marketing campaign,” says Gregg Beechey, regulatory attorney at King & Wood Mallesons SJ Berwin.
Take for instance an LP who asks about a fund during a dinner conversation; creating a formal document stating so doesn’t look particularly believable, says Beechey. “On these occasions GPs could create an internal memo that describes what happened; what you spoke about; that the LP expressed an interest in the fund – and on that basis you are treating it as reverse solicitation and are going to provide fund documentation accordingly.”
Of course complicating matters further still is that determining whether reverse solicitation actually happened will depend on the EU jurisdiction it takes place. In the UK and Germany, marketing under the AIFMD essentially means making a fund available for investment, meaning a prospective LP was presented with a limited partnership agreement, private placement memorandum or subscription document. Accordingly, in these countries “talking to [existing institutional investors] about the possibility of raising a successor fund or branching out to a different strategy is not considered to constitute ‘marketing’ – therefore you don’t have to run the reverse solicitation argument at that point,” says Phil Bartram, regulatory lawyer at law firm Travers Smith.
But in other jurisdictions marketing is viewed to begin much earlier, at the soft circling stage, so you get into reverse solicitation territory sooner. And once a GP moves beyond soft circling and is talking to LPs about a fund that is available for subscription, then the fact they were in the GP’s last fund doesn’t automatically constitute the basis for reverse solicitation, adds Bartram.
Reverse solicitation can be even trickier when it comes to finding new LPs, say legal sources, who add it is still nonetheless feasible.
A common scenario GPs often ask about is talking to LPs at conferences. “Best practice here is to avoid talking about a specific fund you want to market. Instead, talk about the team, the track record and potential future investment opportunities and the sorts of things you might be targeting,” says Beechey.
If a GP keeps the conversation generic and an investor says “that sounds great, terrific story, I’m really interested in your new fund”, a GP can legitimately label it as reverse solicitation, according to legal sources.
“And if there is no record of the conversation, a GP can ask the investor to send a letter asking for the information saying the LP has met the GP specifically asking for X, Y & Z,” Beechey elaborates.
But not all lawyers are so confident about the strategy. Travers’ Bartram thinks GPs need a paper trail before talking about any funds ready to solicit capital, regardless of the setting. “If you say ‘I would love to tell you about that fund, however I’ve got to exchange a bit of paper with you first; what I’ll do now is get on the BlackBerry to my team and they’ll send you an email. If you could reply to that email we can have the conversation in the next coffee break.’”
GPs also say they wonder if reverse solicitation takes place if they receive a letter from an LP requesting information about any future funds they work on. The answer? It’s a start, agree legal sources. What they advise is that a GP should respond with a very high level summary of what it is doing. And as long as the LP follows up and asks for fund-specific information, a GP should be on safe ground.
Happily for firms intending to rely on reverse solicitation, it appears that many of Europe’s largest LPs are aware of the concept and intend to be proactive about making use of it, says Alex Amos, a funds partner at law firm Macfarlanes. But with LPs aware that access to many fund managers will come from them initiating contact, some legal sources worry that certain GPs might rely on reverse solicitation too heavily.
Aside from the challenge around defining reverse solicitation, legal advisors are highlighting a couple other major risks in the strategy. One is investor risk. If a fund turns sour a LP may say they were not the ones to initiate contact, meaning reverse solicitation never actually took place, and they therefore should no longer have certain legal obligations to the fund like honoring capital call commitments, or could even look to recover their investments. The chances of this happening may seem slim, says one UK-based funds lawyer, but similar stories have played out in regions where marketing rules are unclear. The Carlyle Group for instance experienced this when Kuwait-based investor National Industries Group’s (NIG) sought to reclaim $25 million it lost in a 2006 Carlyle real estate fund that collapsed in 2008, claiming that Carlyle did not have the correct license to market in Kuwait.
A related risk is that EU regulators will clamp down on GPs who they feel reached too far on the new marketing rules as a way of indirectly issuing guidance. Fund managers approved under the new AIFMD regime will also be put on a list showing who has an EU-wide marketing passport, which some speculate will be used by EU regulators as a way of targeting non-AIFMD authorized managers for further scrutiny.
As of today GPs are attempting to mitigate these risks by writing representations into their fund documents, according to legal sources. A typical sentence included says something along the lines of “this fund has not been marketed to me [the investor]”, according to the UK lawyer. Another representation GPs have been looking at would be one that says: “By signing up to fund X we automatically solicit you to tell us about every single future fund you might ever raise,” the lawyer said.
Particularly bold GPs are also considering inserting clauses that say LPs cannot claim against a GP for incorrect marketing practices, note legal sources. These types of provisions are being used to eliminate the risk of an investor bringing a claim against a GP for not performing reverse solicitation correctly, though advisors stress that a GP would still be at risk from regulators for breach of securities laws. Amos warns that GPs often make reps and warranties to LPs that they will be in compliance with securities regulations, and so given the uncertainty surrounding what constitutes reverse solicitation, they could potentially breach these reps and warranties.
And the consequences of getting it wrong are pretty severe, adds Cathy Pitt, fund formation partner at law firm CMS. “In some cases it could be a criminal offence. There are also fines, certainly regulatory investigations and maybe an impact on your approved status if you are a regulated entity somewhere.”
All told, with the absence of clear guidance there will always be an element of risk involved in reverse solicitation. But private fund managers that can provide a certain degree of proof that an LP expressed interest in a specific fund (of their own volition) appear to have at least one way of continuing to access the EU’s deep capital markets in a post-AIFMD era.