There’s no doubt private fund managers are becoming increasingly exposed to legal action, with portfolio company-related litigation being the most common. So far this year, big names like Benchmark Capital, Sycamore Partners and Apollo Asset Management have all become involved in lawsuits related in some way to the assets they own.
Marco Pierettori, general counsel at InvestIndustrial, a Europe-focused private equity firm, and Timothy Mungovan, a partner at Proskauer, an international law firm, share their thoughts on this trend, and the other legal headwinds fund managers should be aware of.
Concern: Fund liability for portfolio company problems
RISK LEVEL: HIGH
In the US and EU, liability laws have far-reaching consequences for operators and owners of individual companies. Following the EU’s enforcement actions against large corporates like Apple, firms should be keenly aware of the expensive litigation risk stemming from a portfolio company being charged with legal wrongdoing.
“Investment committees need to be cautious when reviewing deals. Compliance executives need to be engaged at pre-deal due diligence time, at the investment committee level and maintain communication with external counsel who are doing the due diligence,” says Pierettori.
Litigation risk has increased substantially in recent years, says Mungovan.
“More private equity firms are involved in more transactions. As a result, PE firms are involved in more disputes. Ten years ago, private equity firms were rarely involved in litigation. Today, litigation risk is part of the business,” Mungovan comments.
Example: In 2015, CVC Capital Partners and Bencis Capital Partners funds were fined a total of €1 million, after they were found liable for the cartel activity of their joint portfolio company Meneba. The company, in which the two firms held a combined 92 percent shareholding, was found to be involved in a Dutch flour cartel.
Concern: Conflicts in co-investments
RISK LEVEL: MEDIUM
The rise in co-investment deals requires a keen eye on potential conflicts of interest, says Pierettori, who says the trend is “relatively new territory” for private equity from a legal perspective.
“The largest LPs are going more direct and have a large co-investment appetite. There can be a tendency in those scenarios to underestimate the legal challenge this poses,” Pierettori says. “To manage risk of conflicts, there needs to be proper disclosure for co-investors and LPs alike. Identify the LPs’ interests and where they sit in the corporate governance structure.
“The same needs to be done for the other fund investors and third parties indirectly brought into the fund commitments. Properly disclose and embed fund document clauses, for instance on broken deal costs, fees and other sensitive matters.”
Example: In August 2016, WL Ross & Co was fined $2.3 million by the Securities and Exchange Commission, for failing to disclose that it excluded transaction fees received by co-investors from management fee offset provisions in its Limited Partnership Agreements. The SEC said while individual fund LPAs included these details, the documentation was “ambiguous” over how transaction fees would be allocated in the case multiple WL Ross funds and other co-investors invested in the same portfolio company, as had occurred here.
Concern: Unicorn valuation mis-steps
RISK LEVEL: HIGH
The SEC ramped up its focus on unicorn valuations in 2016, and since then they have continued to make headlines, as numerous companies have floated at well over $1 billion but failed to perform as expected. Choppy valuations in the public market can spell trouble for private equity funds looking to exit, says Mungovan.
“Top of mind for private equity and venture capital is the valuation of unicorns and the path to liquidity. The performance of many unicorns is under pressure, which creates challenges for valuation and exits,” he says. “When tech valuations for comparable companies drop in the public markets, and mutual funds reduce values on private holdings, it puts pressure on private equity to reprice. Reduced valuations create risk around performance marketing based on unrealized returns.”
Example: So far no firm has been taken to task over the valuation of unicorns, but that’s not an excuse for complacency. Given the SEC’s focus on the matter, firms must ensure their valuation policies and procedures are robust and stand up to scrutiny.
Of all the ongoing risks to private funds, cybersecurity is getting the most attention, especially in the wake of the WannaCry and NotPetya ransomware attacks earlier this year. Regulators, too, remain focused on the area. In August, the SEC published the results of a cybersecurity sweep, which were mixed. Nearly all examined firms were conducting regular risk assessments of critical systems, penetration tests and vulnerability scans, and had a process in place to ensure regular system maintenance. But many fell short in tailoring their policies to specific risks to their business, and some provided contradictory or confusing guidance to staff on cybersecurity.
The G7 is expected to release its standardized cybersecurity strategy in October, which will be non-binding. It will include guidance on monitoring industry-specific cyber threats and how national financial regulators can improve intelligence sharing on risks.
Example: No firms have been involved in legal action over cybersecurity issues so far this year, but businesses have been victims of attacks. Fund administrator TMF Group and law firm DLA Piper were among those affected by the Not Petya cyber-attack in June. Client data was not believed to have been compromised in either case, but systems including telephones and computers were offline for a number of days.
Building a defence
As private equity firms expand and take on more employees in multiple jurisdictions, it can be difficult to maintain a culture of strong due diligence and regulatory adherence.
“With all this growth and lateral hiring, private equity firms need to have clear compliance standards and procedures to guide the employees into a coherent culture of best practice,” Pierettori says. “Committee structures and information flows need to reflect a strong compliance culture. That means compliance executives providing the tools and discipline to vet the investment process.”
Private equity is changing, in some ways similar to how investment banks did after the 2008 crisis. Firms are moving from being boutique, exclusive sophisticated outfits to big, global operators – especially in the US – with the largest having many product lines and thousands of employees, Pierettori adds.
With legal threats requiring sharper compliance procedures, firms should ensure their internal professionals have the resources they need to take on the challenge. However, there are murmurs in the market of some brighter news, said Mungovan.
“Anecdotally, the SEC seems to have turned down the focus on private equity, as the volume of new enforcement cases and investigations seems lower than in prior years. It’s hard to know whether this is a temporary lull or a shift in focus.”
Whether this is the case or not, firms are advised to ensure they stay on the right side of the law to avoid any negative repercussions should the worst happen.