Investors in any business are always hungry for information that will help them answer the question, “How am I doing?”
Limited partners are no different, but until fairly recently, the industry standard of investor communication was either 1) “Send money” or 2) “Have some back.” In the meantime, private equity being private, general partners had neither the time nor the inclination to gush about how the investments were performing.
If there remains any legacy from the brief power shift from GP to LP following the market meltdowns of 2001, it is this: GPs are now far more willing to provide rich detail on the progress and problems of portfolio investments. In the face of diminished expectations, LPs didn't abandon private equity, didn't really demand lower fees or carry, but the one demand they all had was for more information.
The reasons for this had more to do with a desire to further embrace private equity than to nitpick. Institutional limited partners had to justify the asset class to their own supervisory bodies, and in the absence of any real data on underlying investments, this was difficult. Institutions needed to see how their interests in private companies fitted into an overall portfolio that included public debt and equity securities where the underlying business segments were known and analysed in minute detail. How much Asian exposure is in our private equity portfolio? How much of our capital is in the energy sector? What is the value of the assets we own in, say, Florida?
The past two years have seen a great number of private equity firms upgrade their communications facilities and personnel specifically to provide this more granular portfolio detail.
And yet a force unleashed in the name of transparency is having the exact opposite effect on this reporting détente between GP and LP.
The rash of open-records requests (frequently called FOIA for Freedom of Information Act) across the US has marked many public institutions as less-favoured LPs. To date only a few GPs – among them Sequoia Capital, US Venture Partners, Charles River Ventures and Sevin Rosen Funds – have barred from funds public institutions subject to open-records requests. This despite the fact that to date the only data exposed to the public has been top-line fund IRR numbers – confidential, yes, but most in the industry would now argue that the airing of these statistics has been inconsequential.
And yet the early adopters of the no-FOIA-money policy are more paranoid. They worry that fund IRR is the gateway drug to more hardcore thrills of portfolio company data exposure. They may be right. Last fall, the attorney general of Texas, Greg Abbott, ruled that the Texas Growth Fund must disclose portfolio company information after a local newspaper requested it. Texas Growth Fund is the target of scrutiny because it invests public money. Now the major LPs of Texas, including the University of Texas Management Company and Teacher Retirement System, are fighting to prevent their private equity programmes from being shunned like pariahs.
The battle, however, is far from over and it may yet be won by the advocates of private equity data protection (see “Battleground states”, p. 49). But the developments in Texas have caused jitters throughout the private equity community, whose participants look toward an uncertain future and imagine a worst-case scenario.
From a private investor's perspective, the consequences of portfolio company data disclosure could be dire, especially for early stage investors and especially now that general partners are being so much more descriptive in their investor communications. A company's valuation is certainly sensitive, but so too are the GP commentaries about how a company has been performing against its competitors, about prospective mergers and acquisitions, about plans for an IPO, about areas of weakness. GP desire to see any of this in a newspaper: zero.
General partners preparing for a new fundraising are faced with a number of choices. They can accept commitments from FOIA money on the expectation that the noise for portfolio company disclosure has reached its peak; they can refuse FOIA-exposed LPs altogether; or they can find safety through bespoke terms and conditions in the partnership.
Unless a local legislature has acted to update state open-records laws, for many LPs the third option will be the only hope of having access to many funds in the upcoming raft of fundraisings. And in many cases, the special terms surrounding the FOIA issue amount to this: “In case of emergency, blindfold me.”
Carl Metzger, a partner at Boston l aw firm Test a, Hurwitz & Thibeault, says he is aware of negotiations now between GPs and LPs that revolve around what to do if the LP is subject to an open-records request for information that the partnership categorises as undisclosable. The first task, Metzger says, is to determine exactly what types of information should be defined as off-limits, which is more difficult than it sounds in light of the many forms of communication that pass between GPs and LPs.
Even more difficult to negotiate are what Metzger calls the “self-help remedies if there is disclosure beyond the disclosable categories”.
These proposed remedies come in a range of severities. Some LPs have agreed to be entitled to receive less sensitive information from GPs should that information be subject to a FOIA request, the logic being that a public institution can only release to the public information that it has in its possession. More extreme, and to Metzger's knowledge not yet enacted, is an idea tabled by at least one GP that FOIA-vulnerable entities be removed from the fund should a nefarious form of disclosure rear its ugly head.
LOOK DON'T TOUCH
In brainstorming to prepare for a world where some limited partners will need to avoid possessing sensitive information, market participants have proposed various communication schemes that can only be described as absurd – absurd but perhaps necessary. There is the read-only secure website where an LP may review portfolio company information but neither print nor store the contents. There is the LP visit to a secure room where portfolio company documents are reviewed but not removed. Finally, and sadly, there is the partnership where FOIA-exposed LPs receive no portfolio company information, and that's that.
Of course, an investor's decision to forego portfolio information (albeit under very specific circumstances) brings up a new set of issues. “It's tough for limited partners to argue that they are upholding their fiduciary duty by accepting less information than other investors in the same fund,” says Ian Charles, a vice president at secondary advisor Cogent Partners in Dallas. In facilitating the transfer of fund interests, Charles says he has “heard both sides of the story” – LPs that agree not to receive sensitive information in order to gain access to a favoured fund, and GPs that propose not divulging sensitive information to certain LPs.
Paul Denning, the chief executive officer of San Francisco-based placement agency Denning & Company, says he too has heard some LPs express a willingness to forego certain types of information under special circumstances, but he warns that this could lead to unique PR problems: “Can you imagine the headlines?” asks Denning, who once served as a trustee of the San Francisco Employees' Retirement System. “‘; Such and such a county retirement system doesn't have access to information on an investment that's going south.’”
Some market insiders believe that the creation of portfolio-data withholding mechanisms may be an overreaction. Louis Singer, a partner in the New York office of law firm Orrick, Herrington & Sutcliffe, says that of the many LP clients he represents in fund negotiations, none have agreed to foreclose themselves from information, nor would Singer recommend it. “Putting Texas aside, there are no LPs that are disclosing portfolio company information,” Singer says, adding that for an LP to agree to a partnership that assumed such a scenario “wouldn't make much sense at this point”.
In a debate that pits advocates of open government against advocates of private business, the resulting convoluted policies may not make much sense to either side.