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. 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.
Before considering the key issues that an investor faces, it is worth pausing for a moment to consider how an investor will go about resolving these issues. The simple answer is that before subscribing to any particular investment an investor needs to carefully review the terms of the legal documentation governing the fund. It is at this point that investors will have the opportunity to ensure that the legal risks arising from a fund investment have been properly addressed. The complexities of private equity investing are such that most managers raising funds will expect their fund documentation to be subject to detailed review and comment from, at the very least, its larger investors. In practice given the range of specific issues that institutional investors may face, even smaller investors will often have detailed requests that a manager may need to consider.
All investors should, as a minimum, consult with professional advisers to prepare a legal review checklist or set of guidelines specific to that particular investor to work through before making an investment. The checklist will likely cover many of the topics raised in this chapter, but can only be prepared properly after a detailed review of the investor’s particular requirements. Having established such guidelines it may well be possible for professionals within the investor’s organisation to apply them to individual investments.
However many investors, and certainly the larger ones, will appoint professional advisers to review fund documentation for each investment on a broader basis. A good adviser should be able to pick up on potential drafting defects that a mechanical checklist process might not identify. Additionally, a good adviser may also be able to provide useful further insight upon, and improvements to, the appropriate commercial terms of the fund.
Whatever approach is taken, investment professionals responsible for an investing entity need to remember that they will often be acting as fiduciaries for their underlying investors/organisations and so at the outset of a private equity investment programme careful consideration needs to be given to what the most appropriate approach to legal review should be and whether the investing entity has any particularly key issues that it needs to consider (and which it cannot assume other investors will pick up).
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.
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.This partial chapter is one of 19 in The Definitive Guide to Risk Management in Private Equity: A comprehensive intelligence source for investors, fund managers and professionals who need to manage risk, a new book from PEI Media. Edited by risk management experts Capital Dynamics, this guide provides investors and fund managers with valuable tools and practical guides to risk management scenarios, as well as case studies and best practices. Sample contents and more information on the book are available at www.peimedia.com/risk.