All industries globally have been affected by the economic consequences of the Covid-19 pandemic, and private equity ("PE") is no exception given its exposure to the full spectrum of international asset classes.
Much has been written about the issues which PE funds may face from a performance perspective and the considerations that fund managers and directors need to factor into decision-making processes and efforts to weather the storm. This article represents the first in a series we are producing to address from a legal perspective, in high level terms, some of the questions and considerations which will be relevant to limited partners (or equivalent investor positions) ("LPs") in closed-ended unlisted private equity funds, both prior to investing in a fund and during the life of the fund.
This first article addresses some of the key areas of current focus for LPs in existing funds, and our second article will set out practical tips on how to improve your position as a prospective LP in light of Covid-19 as well as our thoughts on key asks for a side letter, with insights brought to you from experts in our Abu Dhabi, Bahrain, Dubai and Kuala Lumpur offices.
If it would be helpful to discuss the content of this article or explore in more detail any of the areas covered, please get in touch with your usual contacts at Trowers & Hamlins or one of the authors listed below.
As mentioned above, the main subject we address in this article is where you are an existing investor in a PE fund – what sorts of issues / fund terms may arise for you as an LP because of the Covid-19 pandemic and how could you address them?
Capital and other financing (calls, recycling and alternative options) – a key area of concern at the moment for LPs, understandably, will be how capital is being called and deployed. Some GPs may be looking to call on committed capital earlier than anticipated, or may be looking to recycle capital, but LPs should press for transparency on the reasons for the capital call or triggering of recycling provisions and whether they meet the requirements under the limited partnership agreement ("LPA") or equivalent. If it is intended to fund new investments in line with investment objectives then that is likely to be subject to less scrutiny, especially for funds that will likely be particularly active at the moment, such as opportunistic and distressed asset funds. Where the call is to support existing portfolio entities that have encountered trading difficulties, whether by way of follow-on investment or otherwise, then LPs would do well to seek to ensure that steps have been taken to consider alternative options, which may be more beneficial to the fund overall. For example, is government support available in the relevant portfolio company's jurisdiction, through schemes that have been established to support businesses through the Covid-19 crisis?
On the subject of capital calls, if certain LPs find themselves in financial difficulties, or other issues arise, such that they are unable to meet capital calls and so trigger default investor provisions in the LPA, non-defaulting LPs will need to consider their position, in particular if there is a requirement on them to 'top up' their capital contributions to make up for the shortfall created by the defaulting LP(s). Consider first if such an extended capital call can be met. If so, would it be considered an overexposure to certain investments, and ultimately to the viability of the fund depending on the point in the drawdown period at which the provisions are triggered? If such 'top up' requirements result from the general partner having waived the defaulting LP's default or cure requirement, the non-defaulting LPs may wish to challenge that decision to understand its basis, especially if there is a requirement for the general partner to take into account the non-defaulting LPs' interests.
Rescue financing – on the subject of financing, many LPs will not necessarily have seen rescue financing requests over the last few years, but more will no doubt be anticipated in the current environment and LPs will need to consider how comfortable they are with such requests and the associated risk and reward balance. If an LP is considering the provision of rescue financing to a fund in which it has invested, or one of its portfolio companies, various conflict considerations should be kept in mind and adequately addressed, in particular where the financing LP sits on the limited partner advisory committee ("LPAC") or its stake in the fund is such that it would typically have a material impact on any LP decision-making. Fund documentation may not expressly provide for LP rescue financing, and so there may be a need for clearly drafted and negotiated legal documentation to address this specifically.
Bank financing – given the current strains on business cash flow and, in some cases, almost a complete halt, funds may be drawing under existing bank facilities or looking to increase financing arrangements to support portfolio companies. LPs should monitor whether this is justified, any limitations on such financing in the LPA, the impact on valuation and expected returns over the longer term, and whether an alternative form of financing may be in the best interests of the fund and its investors.
Fund valuations and fund duration – clearly, for many the current crisis is going to have a significant impact on valuations, some of which may be easily ascertainable and some of which may take some time to establish, depending on the asset class. LPs should seek transparency and frequent updates on valuation impact from their managers.
As some funds approach the end of their term, LPs may find GPs seeking an extension to the term with a view to the fund being able to exit existing investments on more optimal terms than the current climate allows. LPs should consider the corresponding requirements of the fund documentation in this regard, require GPs to provide detailed rationale as to the anticipated benefits of the extension of the term, depending on the duration of the extension requested, and take legal and financial advice as needed in order to form a view as to whether an extension to the term is likely to be a remedy to current valuation concerns. If the term is extended, LPs should consider what the LPA position is on management fees beyond the original term and any requests from managers in this regard.
Investment strategy – some funds with undrawn capital may approach LPs for approval to amend the investment strategy of the fund to allow the fund to benefit from perceived market opportunities that have arisen in the last quarter and based on the anticipated business and economic environment in the coming 12 months and beyond. LPs should consider what levels of consent are required to approve changes to the investment strategy, whether any limitations should be implemented to cap the level of investment into alternative asset classes, and, for investors which do not wish to, or are unable to, participate in proposed alternative asset classes, they should consider whether excused investor provisions can be triggered or obtained. LPs, particularly those who do not wish to, or are unable to, participate in new investments, should also consider the impact a change of strategy will have on existing investments and the management team's efforts to preserve and generate cash in relation to those.
GP reporting – general market sentiment seems to be that GPs are engaging with investors to update them as to performance and plans to try to get through, and come out of, the current crisis in as best shape as possible. There is a balance to be struck between the frequency of reporting by GPs and the need for them to focus on the performance of the fund's assets themselves in a climate that is changing by the day. For those LPs that are receiving limited information from managers, they may wish to consider pressing for information, including calling LPAC / LP meetings where permitted by the LPA.
LP liquidity and the denominator effect – LPs which are bound by allocation limits on public / liquid and private / less liquid investments may well be impacted by the so-called "denominator effect", in circumstances where a fall in the value of their more liquid public equities causes the relative value of less liquid assets, such as PE investments, to grow, and potentially see LPs exposed more greatly to less liquid assets in breach of, or approaching, their allocation limits. Various corrective steps may need to be taken in such circumstances. For example, LPs will need to consider whether future PE investments are possible in the near term and whether the terms of existing PE investments allow them to sell-down their interests. If a sell-down is possible, and needed, then some LPs may face difficult decisions around valuations in the current climate, but any discounts may be preferable to winding-down more liquid positions that may be trading at bigger discounts to previous market values. For some there may be a need to press the pause button, if possible, while awaiting PE reporting to catch up with public equity reporting to understand where any denominator risk may lie.
Distributions – depending on the performance of the fund, LPs may not see the levels of distribution they had anticipated, which may impact on their own position. LPs should check that relevant provisions with respect to distribution are being complied with by managers and, to the extent that a lack of liquidity, even if temporary, from the funds in which they have invested would have an impact on their own cash flow, they should provide for that.
On the subject of distributions, LPs should familiarise themselves with the mechanisms around distributions in kind (also known as distributions in specie), i.e. a distribution of the fund's assets to LPs in place of a distribution of cash. While this mechanism tends to be a less frequently utilised mechanism by managers in large scale funds, and is often reserved for distributions at the end of the life of the fund, in the current climate we may see a rise in its use, and so LPs should inform themselves of the relevant terms of the LPA (or equivalent), in particular provisions around, among other things: (a) LP to GP notification requirements regarding appetite to participate and associated terms; (b) how the assets are valued for the purposes of such a distribution; (c) whether the LPs have an ability to refuse to accept such a distribution; and (d) whether the LPs can require the manager to realise the relevant assets on the best possible commercial terms and transfer the cash proceeds to them rather than the assets themselves.
LPAC and LP meetings and participation – we would expect LPACs and LPs generally to be engaged on an increasingly frequent and more interactive basis by GPs while the current market position remains as it is. For LPs, they will need to consider how they establish forms of engagement during this time. Technology will play a crucial role, and each LP will need to establish structures to communicate effectively, among relevant internal teams and advisers, in order to allow for the most efficient participation on the LPAC and in LP meetings.
In the current climate, LPAC members should consider carefully whether there is a need for external legal and financial advisers to be engaged on particular decisions that need to be taken by the LPAC, at the fund's expense, and whether the LPA provides for this.
Fund restructuring – in a worst-case scenario, managers may need to look to restructure the fund, creating a "bad fund", and/or considering arranging secondary GP-led transfers. This is a significant area of the industry that really merits its own article, or indeed series, on the volume of related issues to consider, but it would be remiss to not mention it in this article, not least because some of the key themes identified elsewhere in this article, such as GP transparency and communication, early LP action and advice to address the various, often time-critical, issues, are just as relevant in the context of a restructuring.
Concluding remarks
We hope that this article has provided a useful insight into some of the considerations that are likely to be relevant to existing LPs both currently and in the coming months. We will be issuing our second bulletin shortly. Naturally, we cannot cover all topics, nor can we cover the above topics in full, in an article of this nature – we would be delighted to explore any of the themes arising in or outside of this article in more detail with you.
