Fund managers in the highly competitive private equity industry are increasingly considering expanding their business lines so that they can offer investors a diversified set of products across the risk/reward spectrum. There are often real synergies which can be realised and be beneficial to both managers and investors. At the same time, fund investors are looking to manage risk by diversifying their investment portfolios and also to consolidate fund manager relationships. In this article we touch upon some of the fundamental legal and practical aspects a fund manager embarking on expansion will want to consider in launching a new product line.
The competing fund test. As an initial matter, the fund manager will need to determine whether its existing fund documents permit the formation of a new fund product under any “competitive fund” restrictive covenants. The answer will likely depend on whether the definition of “competitive fund” is sufficiently narrow to prohibit the formation of a new fund only if it has an investment strategy that is substantially the same or similar to that of the existing fund. Naturally, an entirely different product line (such as an equity fund manager diversifying into the debt fund space) is more likely to be permissible than a product line in the same space that is targeting different types of deals (such as a large cap equity fund manager diversifying into the middle cap equity fund space). With thoughtful precision and forward planning, this legal threshold matter rarely is a show stopper.
Team composition and key person constraints. If the fund manager plans to draw significantly upon the resources and time requirements of the existing team in managing the new fund product, careful attention will need to be paid to any existing key person covenants. Are such covenants nimble enough to allow the senior executives and investment professionals to divert their time from the existing fund without triggering a key person event or otherwise having negative implications for the existing fund’s investment programme? Where the new fund product is largely being managed by a new, or separate, team, these requirements will be easier to meet. In any event, the analysis will be highly fact-specific and is likely to involve careful consideration of legal documentation as well as discussion and transparency with investors.
Growing the pie without eating into existing fund deal flow. Investors in the existing fund and in new funds alike (and in many cases there is some level of commonality) will be keenly interested in how deals will be allocated among a fund manager’s various funds, where there is some overlap in investment focus. The closer the funds are in strategy, the more carefully this issue needs to be considered. We see three general approaches to provisions dealing with deal allocation: (i) provisions that require investment opportunities to be offered first to existing funds, (ii) provisions that provide a formula for the allocation of investment opportunities among funds, such as a pro rata allocation based on the available capital of each fund, and (iii) provisions that give the sponsor some degree of discretion to allocate investment opportunities in an equitable manner based on factors such as investment focus, manner of sourcing, principles of diversification/portfolio mix, expected hold periods and return targets. There is no one-size-fits-all solution and managers often end up with a hybrid approach tailored to their specifics. Taking a long-term perspective when crafting allocation procedures and maintaining flexibility in covenants with investors will be critical for a sound expansion strategy. Carefully building and operating a robust governance structure to consider allocation issues should be a key consideration for managers and is likely to be a core part of investor due diligence.
But the potential conflicts don’t end there. More fund products can mean potential conflicts in other areas. A key area of focus for investors will be whether an existing fund and new fund can invest in the same target, but perhaps at different levels of the capital structure. Such flexibility can create synergies that ultimately may yield greater returns to investors, although potential conflicts of interest clearly need to be carefully managed. Cross-transactions between funds are also an area of particular sensitivity. Ongoing dialogue and transparency with fund investors and robust internal decision-making and conflicts procedures are critical to effectively managing these potential conflicts of interest.
Track record relevance and portability. Where a product line is genuinely new for a fund manager, the lack of a developed track record in the particular investment strategy will be important. Some firms may want to develop a track record by starting with a separately managed account for a single investor or investing house money, while others may be able to seed the new fund with the help of a loyal investor. In some cases firms may find it easier to expand into a new strategy that is within or close to their existing wheelhouse, such as an industry focused fund that they have experience with in the flagship strategy or a more geographically focused fund within the same general strategy. Larger and more institutionalised firms may be better placed to expand by acquiring investment teams from competitors or organically building a team that has the sought-after expertise.
To the extent a new team is involved, the sponsor will need to consider the portability of the new investment professionals’ prior track record, both from a contractual and regulatory perspective. From a regulatory perspective it will, among other matters, be important to conclude that (i) the person or persons who will manage the new fund were also those primarily responsible for achieving the prior performance results, (ii) the nature of the track record and how it was achieved is sufficiently similar to the new fund strategy and its management and (iii) such track record can be substantiated and is not cherry picked in order to boost performance. There are stringent rules relating to the presentation of performance results and the offering materials for the new fund will need to contain extensive disclosures regarding the nature of the “acquired” track record.
As with any fundraising, marketing a fund strategy track record raises a number of legal issues that will need to be worked through. Fund managers are not permitted to use marketing materials that contain any untrue statement of material fact, or which are otherwise misleading. Appropriate disclosures must be made regarding the differences between the new and existing strategies as to, among other things, their respective risk/return profiles.
No end in sight for compliance. Additional issues such as obtaining regulatory licenses or filing for exemptions, building out insider trading protections and potentially creating information walls, background checks on new hires, compliance training of new hires, expanded ongoing reporting to regulators in multiple jurisdictions and maintaining internal compliance systems tend to lead to significant legal and other spend in connection with expansions and on an ongoing basis. Some of these compliance aspects can be gating items to launching a new strategy so working through the compliance landscape on a parallel track with developing the business strategy is recommended.
Straining the operational system. Expansion may also lead to a need to build out the back office financial, accounting and administrative functions. Different product lines may differ in systems and operational requirements as a result of the varying transaction profile and investment intensity. In an environment where investors are seeking more individualized reporting, fund managers need to focus on building flexibility and resource in their operational structures. Fund managers may want to consider outsourcing certain functions as their organizations grow.
And importantly, be open and transparent with your investors. Ultimately one of the most important aspects is that the fund manager’s investors understand the expansion strategy and that they see the positive synergies which can flow from the new product line. Convincing investors of the attractiveness of the new strategy will be an important part of its success. ?
Erica Berthou is a partner at Debevoise & Plimpton LLP. Peter Gibbs is chief operating officer at Permira Debt Managers.