Over the past few weeks, our private fund manager (GP) clients have been focusing on their portfolios, supporting investments with liquidity concerns as cashflows dry up, and exploring new opportunities in dislocated markets. At the fund level, the immediate preoccupation of GPs has been valuations – particularly for their Q1 reporting to investors (LPs).
In this note, we look at some of the medium- and longer-term issues that GPs may face at fund level and some key considerations GPs should bear in mind.
Capital calls, defaults and recycling
Understandably, there has been speculation in some quarters about whether GPs should brace themselves for a slew of LPs defaulting on capital calls. However, from what we actually see and hear in the market, including from both GPs and LPs as well as bodies such as the BVCA and the Fund Finance Association, defaults have not been an issue; market participants expect LPs to continue to meet their drawdown obligations as normal.
Of course, some LPs do find themselves in difficult situations. For instance, Australian superannuation schemes (significant investors in private funds across multiple asset classes) are being required by the Australian government to provide financial support to Australian households, by giving scheme members early access to their scheme benefits. Reportedly, over 620,000 Australians have already applied for early access, and there is some concern that this may cause liquidity issues for these schemes – at least in the short term. It is easy to imagine a situation where public pension funds in other countries come under similar pressures.
There will also undoubtedly be cases where a GP has concerns about the liquidity position of a specific LP and may be thinking about delaying an impending call to avoid “forcing” that LP to default. It may be that, in a given situation, avoiding an LP default is in the best interests of the fund as a whole, but a GP in this position must tread carefully and consider all its duties in the round, and seek legal advice where necessary.
Transparent communications between GPs and LPs can alleviate some of these problems. For example, GPs should consider giving LPs (to the extent they do not already) an indicative schedule of upcoming capital calls, as well as asking LPs to confirm that their operations teams are all functioning as normal, even if working from home – are notices, including capital calls, still being received (through secure email addresses) and acted upon? GPs should also double check the notice requirements in LPAs, and any bespoke provisions agreed in LP side letters, especially regarding capital calls: are there specific timings that must be complied with or particular methods of delivery that must be used? For example, some LPs still require their GPs to deliver notices by fax or with wet ink originals; bespoke requirements may be impractical in a number of cases at the moment, and so alternative arrangements should be agreed.
GPs should also ensure there is clear communication around recycling (i.e. the GP’s ability to retain and re-use certain investment proceeds, instead of distributing them to LPs). LPs may have planned on, or have become accustomed to, receiving distributions from particular funds on a regular or predictable basis; so, a GP increasing its use of recycling may have a dramatic impact on an LP’s liquidity position. Typically, private equity GPs have the ability to recycle the cost of investments realised within two years of acquisition; GPs pursuing credit strategies tend to have more flexibility and usually can recycle all proceeds (except net income) received during the investment period. Given liquidity requirements in portfolios, we may see GPs stretch their recycling powers fully over the next few months.
Raising additional capital into closed funds
Some GPs are looking at re-opening funds that have already held a final closing, to raise additional capital to support existing portfolio investments. This can be done, but is not straightforward: closed-ended funds are not designed to be “re-opened” after the final closing. In particular, these issues would need addressing.
- The need to get LP consent (and whether a higher than normal level of consent might be needed).
- The speed with which LPs can give their consent (e.g. will their investment committees (ICs) need to sign off on an increased fund size and/or increased commitment, and when can their ICs meet and give their decisions)?
- Whether all existing LPs participate pro rata in the additional capital raising; if not, how are dilution issues to be addressed?
- What valuations will form the basis on which the additional capital is raised – can those valuations be defended in the current market environment?
GPs looking to do this should engage early with their LP advisory committee (LPAC) to build support as well as to identify and mitigate any conflicts of interest between LPs who participate in the additional capital raising and those who do not. GPs may also want to consider whether alternative solutions might work – such as raising the additional capital into a separate top-up fund, or structuring the additional capital as a loan from participating LPs into the main fund. Each solution will bring its own complexities as well as conflicts needing management and mitigation.
Extending the closing period
Since March, our experience has been that closings are still taking place and GPs are continuing to fundraise. That said, it is clearly easier for established GPs who have strong relationships with their LPs. For newer GPs, or those looking to broaden out their LP base to include new LPs, the current situation is difficult: it is much harder to conduct a due diligence session over Houseparty or WhatsApp.
GPs who are in the market now should nevertheless think about whether they will need to extend their closing period to give LPs the time they need to complete their primary investment processes. For example:
- Are LPs happy to run virtual due diligence meetings, or do they need to do these in person after lockdown restrictions are eased? (And bear in mind this will occur at different stages across different countries, and the ramifications for international travel are not yet clear.)
- Do LPs have the capacity right now to consider new primary investment opportunities, or are they fully engaged in assessing their existing portfolios?
- Are IC meetings still running as normal, or have IC meetings to approve new primary investments been delayed/deferred for now?
Extending the investment period
Some GPs, such as those operating in the stressed/distressed and special opportunities sectors, see the current conditions as playing to their strengths. They are looking to deploy capital as soon as opportunities present themselves. For other GPs, the immediate focus is on their current portfolios rather than new investments, at least until market volatility eases and truer valuations can be struck. For a GP in the second camp, one option might be to extend the investment period of its current fund, to ensure alignment between the GP’s investment decision-making and the fund’s investment capacity.
Extending the investment period is, in itself, relatively straightforward. Typically, as an amendment to the LPA, it will mean obtaining a simple LP consent (some LPAs even give the GP the power to extend, without LP consent, but in consultation with the LPAC). However, a number of factors will also need to be considered.
- The impact of the extension on the management fee – will the normal “investment period level” of management fee continue to be charged during the extension?
- The impact on investor protections, such as key person or change of control provisions – as drafted, do these hinge on the investment period definition and, if so, how will they be affected by the extension?
- The interaction between the investment period and the restriction on raising successor funds – will the GP be able to raise and invest a successor fund during the investment period extension?
- Will the divestment (or “harvesting”) period also be extended as a result (meaning an extension to the fund’s overall term)?
GPs should think through these and any other relevant issues before seeking LP approval to the extension, to ensure LPs are presented with a comprehensive and considered proposal.
Extending the fund’s term
For GPs with funds approaching the end of their term, the question may be whether to extend that term to allow disposal of the final remaining investments. Most LPAs cater for term extensions, by allowing the GP to extend for up to two years – sometimes this is conditioned on obtaining LP or LPAC approval. Further extensions, beyond those already provided for in the LPA, will normally be classified as amendments to the LPA requiring LP consent. As with an extension of the investment period, GPs should consider:
- the management fee to be charged during the extension;
- the availability of undrawn commitments to fund any follow-on investments that may be needed to prepare investments for disposal; and
- the need for audited accounts, quarterly reports as well as other reporting (e.g. tax reporting) during the extension.
A GP who does want to extend the term should also be prepared to answer LP questions as to whether an extension is necessary at all, and whether the GP could simply make use of the winding up phase that follows the end of the fund’s term to dispose of the final remaining investments. Typically, following the end of a fund’s term, a GP will still have power to continue managing the fund for the purpose of winding up its affairs – i.e. disposing of any final assets, settling any final liabilities and distributing the remaining proceeds to LPs. For some GPs, this may be sufficient and they may decide that a term extension is an unnecessary distraction for its LPs at this time.
However, there can be some uncertainty about the winding up phase. For instance, there is normally no defined timeframe within which the GP must complete the winding up, and there may also be grey areas around the GP’s ability to call capital during the winding up phase. A GP wanting a certain mandate may therefore prefer to opt for a formal term extension.
The most immediate consequences of Covid-19 for the fund finance market have included a widening in credit spreads (in common with the credit markets generally) and an increased appetite for NAV-based financings, particularly in funds with underlying portfolio company liquidity requirements. As noted above, whilst there have been numerous rumours to the contrary, there has not been an increase in LP defaults that could result in a reduction in availability of capital call facilities or, in the worst case, defaults under those facilities. Nonetheless, GPs should think about the following:
- for new funds (or funds that have not previously used capital call facilities), consider engaging with banks earlier in the fundraising process about putting in place a capital call facility. Some lenders have indicated a desire, in limited cases, to pull back from the capital call facility market entirely and, in other cases, to concentrate on more established managers and/or users of capital call facilities;
- NAV facilities might well prove a useful liquidity source to fund follow-on investments, particularly if GPs need to support their portfolio companies during covenant waiver discussions between a portfolio company and its lenders. We have seen a number of GPs considering this type of facility in that context;
- whether a preferred equity investment, structured either into a subsidiary vehicle or into a specific portfolio company, would be a viable alternative or attractive complement to a NAV facility;
- whether the GP itself might benefit from additional liquidity for working capital or other purposes. If so, thought should be given to a “manco” facility. A number of lenders are experienced in providing these facilities (although they are the most dependent on the relationship between GP and lender of all fund financing products);
- related to the previous point, GPs should review the terms of any existing NAV facilities from a general compliance perspective including the potential for any investments to have become ineligible (which might affect diversity requirements and/or trigger prepayment) and any notification requirements affecting those investments or the fund; and
- lastly, in the context of the points mentioned above relating to changes to LPAs and/or other fund documents GPs should check whether they are obliged to seek consent from their capital call lenders to those changes or at least provide copies of the amended documents and related correspondence with LPs to the lenders. Most capital call facilities have extensive provisions regulating changes to fund documents and information provided to LPs that also needs to be delivered to lenders.
Engagement with regulators
GPs should expect financial regulators to start conducting information-gathering exercises, with a view to identifying areas of systemic risk; GPs may find that they have to respond to regulatory requests of this sort on short notice. For instance, the Luxembourg authorities recently announced that all Luxembourg GPs, as well as non-Luxembourg GPs managing Luxembourg-based funds, must submit weekly reports on their funds’ net assets, subscriptions and withdrawals, with the first report due by 22 April.
The coming weeks and months will be difficult, even with the easing of lockdown restrictions in some countries. To navigate through this period, GPs should have clear plans for both their portfolios and their funds, and – importantly – communicate those plans to their LPs and lenders. Clear, effective and regular communication will be key in building LP and lender support, and will demonstrate that GPs are also sympathetic to the pressures under which both LPs and lenders are currently operating.
This article is provided as a general informational service and it should not be construed as imparting legal advice on any specific matter.
Alex Amos advises a wide range of asset managers and investors on the structuring and establishment of, and investment in, alternative funds. His particular focus is on credit and real estate funds. Alex’s focus is on the raising of alternative funds, as well as funds-of-one / managed accounts, joint ventures, pledge funds, co-investment vehicles and alternatives to the traditional widely held blind pool fund model. Alex also advises asset managers on team incentive arrangements, conflicts, allocation policies and all the wider elements relating to operating an alternatives business. He has advised on funds domiciled in Luxembourg, Cayman Islands, the Channel Islands, Ireland and the UK.
Christopher Good advises on private fund formation, looking after fund sponsors who are establishing and operating private investment funds. He advises across a range of asset classes, including private equity, credit, real estate, venture capital and growth and secondary capital. As well as advising on fundraisings, Christopher also advises upon and helps structure and implement carried interest, co-invest and other executive incentive schemes. Christopher also regularly advises secondary purchasers and GP clients on secondary transactions, including portfolio transactions, liquidity solutions and fund recapitalisations and restructurings. He is also regularly asked to advise institutional clients on their primary investment programmes, co-investment operations and bespoke management arrangements with managers.
For more information, please visit www.macfarlanes.com