In a shoot-from-the-hip interview with the New York Times recently, Fred Forstmann was extremely candid when asked for his views on the modern private equity industry. The legendary buyout investor bemoaned the steady march towards institutionalisation and a concomitant tendency to activism on the part of investors in private equity funds.
The target of Forstmann's ire was, unsurprisingly in light of recent events, public pension fund managers and specifically the Connecticut state pension fund. In September, Forstmann Little – the buyout house Forstmann co-founded in 1978 – agreed a $15 million settlement with the institution after an acrimonious court battle in which the firm had been accused of failing to stay within the confines of its agreed strategy when making telecom investments that ultimately tanked.
In purely financial terms, Forstmann Little came through the episode relatively unscathed. The final settlement was way below the $125 million the pension fund had hoped to retrieve – its estimate of what it lost as a result of the alleged malpractice. Nonetheless, the firm was adjudged to have made inappropriate investments in two companies, and was only spared a harsher verdict by what was seen as Connecticut's “acquiescence” in the decisions, the implication being that if the pension fund felt the investments were misguided, it should have made its reservations known at the time.
Regardless of whether the case produced a winner – the most persuasive interpretation seems to be that neither side triumphed – the process by which the dispute was resolved was undoubtedly a source of personal angst for Ted Forstmann. So much so in fact that he confided to the New York Times he would put “a gun in his ear” if all he had to do in future were invest money on behalf of pension funds.
One hopes that few of Forstmann's peers will share that particular sentiment, but it would seem harsh to blame US-based general partners for fretting at the thought of being dragged through the courts should an investment implode. While such trepidation is understandable in the US, where litigation runs rampant and limited partners may see Forstmann Little as a test case, isn't there less reason for apprehension in Europe where, it could be argued, conciliation rather than confrontation remains the guiding principle?
If this is so, GPs do not appear to be taking it for granted. Consider the results of a recent survey titled “Private Equity Management Liability” and sponsored by global risk and insurance services firm Marsh. The survey of 100 private equity professionals at firms in the UK, Germany, France, Spain and the Nordic countries found not only that a vast majority thought legal action against them would either increase or stay the same in the next two years, but also that limited partners were expected to be the most likely group to bring such action.
There is in fact some evidence that this anxiety is not entirely without cause. Marsh cites an anonymous case involving European limited partners who decided to take action against a private equity firm for writing down an investment that appeared to breach the threshold set out in the limited partnership agreement (LPA) of one of the firm's funds for the maximum amount of capital that the fund could invest in a specific geographic territory. The LPs alleged the LPA had been breached and cited negligence in making the investment, even though it had originally been referred to the fund's advisory board.
CLAUSE WITHOUT CLAWS
If such examples indicate that LPs are now more likely to be heard exclaiming “see you in court!”, some GP groups could be caught unprepared. In its report, Marsh points out that historically, most private equity firms have not purchased professional indemnity (PI) insurance to protect themselves against claims resulting from any wrongful behaviour as an investment manager, because they believed they were sufficiently covered by indemnification clauses contained within the LPA.
However, this would not be a wise assumption today. Sources canvassed by Private Equity International claim to have witnessed a subtle but significant change in the wording of some recent LPAs.
Failure to address issues is not an effective long-term solution and can prove costly
To quote an extract from a standard definition of an LPA indemnity clause found on the British Venture Capital Association (BVCA) website: “[A]ny indemnified party … is not liable for any loss incurred by the partnership (except where this has arisen as a result of wilful neglect or gross negligence)”.
Practitioners interviewed for this article say that in some LPAs, “gross negligence” has been substituted with “negligence”, a measure that may serve to make the indemnification safety net just a little more threadbare.
Christian James, a private equity specialist at Marsh, insists that the need for some form of external PI policy is now widely recognised and acted upon in the GP community. Still, it would not be surprising to find some unwitting GPs in an unnecessarily vulnerable position.
And this at a time when LPs appear more inclined than ever to stiffen the sinews and beat the war drum. This was amply demonstrated in July this year when investors in a fund managed by London-based Albemarle Private Equity got together to force out the management team and replace it with Nova Capital Management. John Daghlian, partner in the European private equity practice at US law firm O'Melveny & Myers, says the Albemarle spat is the most public of a number of disputes between investors and general partners: “Most of these disputes happen behind the scenes. In a number of cases, LPs have gone to see lawyers but not much of it leaks out into the public domain”.
KEEP IT PRIVATE
Daghlian's point about LP activism being carried out largely behind closed doors is an important one. In theory, there is nothing to stop an LP from taking radical pre-emptive action. According to David de Ferrars, a partner in the commercial disputes group at international law firm Taylor Wessing, it is not uncommon in other forms of partnership (for example those governing law or accountancy firms) to find clauses providing that mediation must be sought prior to legal action. The private equity partnership, on the other hand, commonly contains no such clause.
In practice, particularly in light of Connecticut's stance having been compromised by its “acquiescence” in Fortsmann Little's original investment decisions, the message is clear: voice your concerns early and negotiate firmly rather than sitting in silence and waiting to see how bad things get. “LPs should make it clear when in their view a GP has acted inappropriately, they should act immediately – thereby putting the GP on notice. Failure to address issues is not an effective long-term solution and can prove costly”, says Grant Roberts of Newgate Partners, which acted as an adviser to LPs in the Albermarle case. “Non-alignment is one of the single biggest threats to a fund”, he adds.
Lawyers say Europeans may in any case find it tougher than they think to achieve their desired result in front of a judge. Daghlian maintains that in European LP agreements, restrictions placed on the investment activities of GPs tend to be less well defined than in the US. The reasons why European GPs appear to have been given a freer reign than their US counterparts are unclear, but the upshot is that it makes it harder to prove that the agreement has been breached.
With this in mind, should one assume that European GPs living in fear of legal action brought by investors – and perhaps busily swotting up on the extent of their PI cover – have got it all out of proportion? In comments made in its survey, Marsh points out that there is no evidence at the current time that a wave of litigation is about to hit the European market: “While LPs and investors are viewed by private equity professionals as being the most likely parties to make a claim, the frequency of actual claim notifications in Europe does not mirror this perception”, it says.
The view expressed by Marsh is that – in Europe at least – actions are still far more likely to be undertaken by purchasers of portfolio companies on the back of poorly drawn up sale and purchase agreements, and by minority shareholders of portfolio companies, whose power and importance appear to have increased, particularly in take-private transactions.
European fund managers who share this view will probably have a much more relaxed attitude towards pension fund investors than Ted Forstmann. But for some reason, a goodly number of them appear to believe something distinctly different. If the Marsh survey is an accurate reflection of GP sentiment, it is their opinion that there are plenty of aggrieved LPs out there. And what's more, they're spoiling for a fight.
BETTER SAFE THAN SORRY
As private equity spreads its wings into new territories and faces up to corporate governance reforms, the price of failing to take D&O insurance seriously could be high
If the statistics are to be believed, no one need lecture private equity executives on the importance of taking out directors and officers (D&O) insurance to cover themselves against claims arising from the discharge of their duties as portfolio company board members.
Of the 100 European private equity professionals canvassed by Marsh, 70 percent said D&O insurance is purchased for all portfolio companies. What is more, if one includes those firms that have cover for “most” portfolio companies, the total rises to 89 percent. Just five percent of those houses polled said none of their portfolio companies had any coverage.
Given their financial acuity, don't doubt that private equity pros would do away with D&O policies if they could. After all, due partly to a series of high-profile corporate scandals, premiums for D&O insurance have risen markedly over the past two years.
But fund managers know that to do so would probably be reckless. Consider the fact that private equity investment in Europe today is increasingly cross-border in nature: this brings with it a frequent need for investment directors to join boards in unfamiliar jurisdictions, thus heightening their vulnerability and the possibility of mistakes arising from a lack of familiarity with local regulations.
“Liability arising from sitting on the boards of portfolio companies is something most GPs are concerned about and they normally make sure they've put measures in place to deal with it”, asserts Simon Witney of the London private equity team at law firm SJ Berwin.
But Witney adds: “In terms of whether they have formal processes in place to assess and mitigate risks depends on the size of the house – some of the smaller ones tend to be rather informal in the way they approach the issue”.
Indeed, a lack of formal processes is something the Marsh survey also highlighted. In a summary of responses on the issue, the firm concludes: “Private equity firms do not generally adopt a formal approach to risk management, nor is there a consistent approach across firms. However, with changes in corporate governance, private equity firms cannot afford to ignore the increasing importance of risk management”.
In other words, while most firms have policies, a lack of formality in decision-making presents the danger that the type of policy or level of cover in place may be inappropriate for a particular firm's needs. Marsh says that while some firms referred to group procedures, manuals and risk committees in determining the precise nature of the risk to which they were exposed, others cited “day-to-day discussion” and “a common sense approach” as their means of assessing exposure.
Such laid-back attitudes are in some ways understandable: at the end of the day, private equity managers have many other competing priorities. Equally though, while corporate governance has so far been seen as more of an issue in the public rather than private sector, the growing institutionalisation of private equity is undoubtedly bringing in its train more far-reaching responsibilities for professionals serving on the boards of portfolio companies.
Says Paul Thomas, chief operating officer at UK private equity firm Gresham: “Ten years ago, everyone was pushing hard to get private equity recognised as an asset class because that was seen as the way to attract funding. But once you are recognised as an asset class, you have to play by all the rules and regulations that entails”.
For the private equity industry, corporate governance is like a slow train coming round the track. This is recognised by 42 percent of respondents to the Marsh survey who agreed with the proposition that recent corporate governance changes will have a “significant effect” on private equity firms.
The survey also found that some respondents were thinking about beefing up their D&O liability coverage as a result of corporate governance reforms. Their reasoning is that though the price of having such a policy may be high, the cost of not having it could be higher still.