Private Equity in the United States: Frequently Asked Questions - Part II

Amy Johnson-Spina and Joseph Romagnoli, Torys LLP

Continued from Part I in last week's BOTW.

9. Why is due diligence so important in relation to investments in private equity funds?

Investments in funds require a long-term commitment (e.g., a 10-year term with the possibility of extension). Generally, few exit options are available because the secondary market for investments in funds is limited, and transactions in that market require the consent of the investment team. In addition, the nature of investments in funds is that investors hire an investment team and give it a large amount of discretion to invest their money (subject to any applicable investment restrictions). Accordingly, it is important for investors to perform proper diligence on the investment team to ensure that its members are trustworthy; have a good reputation, good experience, good track record and extensive deal accessibility; and are people that the investors will want to be associated with for the foreseeable future.

It is also important for investors to perform proper diligence on the team's investment strategy and its historical performance, to attempt to determine the likelihood of the fund's success. Investors should understand the culture and values of the fund as well as its proposed market. In addition, investors should find out whether the fund follows a proper process to ensure that there is sufficient investment sourcing and analysis to seek out the best deals, that there are both an institutional approval process to review all deals and a clear method of identifying where value can be added and how investments will be managed. Ideally, investors should implement a diligence protocol that will enable them to approach each investment unemotionally. Key sources of information for the investors will likely include the following: material provided by the investment team, including presentations and interviews; informal and formal references from other investors and industry contacts; and other general industry information.

10. (a) When considering an investment in private equity funds, what factors should an investor consider (e.g., business and legal)?

The answer to this question will vary from investor to investor as the investment strategies of each will differ. For example, an insurance company or bank may invest in certain funds to benefit from exposure to certain members of the investment team or the opportunity to bid for other work. On the other hand, some investors may be motivated to invest in certain funds because of the opportunity to co-invest with such fund. Regardless of the reason for the investment or its strategy, investors should ensure that the fund's proposed investments correspond with their own investment strategy and risk tolerance. In addition, investors should ensure that (i) their limited liability is protected (e.g., investors should not be on the hook for the fund's general liabilities); (ii) they understand their tax filing obligations resulting from the investment (e.g., will they now have to file tax returns in a foreign jurisdiction because the fund will make its investments there?); and (iii) they are comfortable with the terms of the agreement for the foreseeable future and have some protection if things do not go according to plan.

(b) How does the decision-making process to invest in a private equity fund differ from the process of investing in public securities?

Companies with public securities are obligated under applicable securities laws to disclose certain information to investors. In addition, regulators, including the relevant market administrators and the SEC, oversee the various filings of such companies to ensure compliance. As a result, investors benefit from increased disclosure and regulatory oversight. In investments in funds, access to information is generally more restricted because disclosure is only required in accordance with the fund agreement, and all offering documents are private.

Perhaps the most material difference relates to the consequences of investment. As discussed earlier, the exit opportunities for investments in funds are very limited compared with investments in public securities. So to limit their risk exposure, investors should spend extra time and effort in deciding whether to invest in a fund; they should also actively monitor their investments once in the funds.

11. (a) Over the course of an investment in a private equity fund, how will investors obtain sufficient information to monitor their investment and to enable the investors to make an informed decision when exercising their consent rights?

Investors generally negotiate for the fund to disclose certain information. Typically, investors attend formal annual meetings at which the investment team discusses both the fund's performance and the fund's portfolio. The investors may also be able to obtain information through informal discussions. Investors usually receive quarterly and annual financial statements and other disclosures regarding the fund (e.g., statement of the investor's capital account and unpaid capital commitments; identification of companies in the portfolio, including the cost and current value; statement of consummated transactions and summary of any significant decisions by the investors and/or the fund's advisory committee or any significant litigations or proceedings since the previous statement). Generally only annual financial statements are audited in accordance with applicable generally accepted accounting principles. Investors that have representatives on the fund's advisory committee may obtain additional information, depending on the terms of the fund agreement.

(b) What impact have U.S. freedom of information laws had in this regard?

The U.S. Freedom of Information Act (FOIA) (and the various related lawsuits brought thereunder) may require certain investors to publicly disclose information about their investments in funds. Accordingly, funds are sensitive about the information that they are required to disclose to such investors and, with increased frequency now, funds (i) limit the information they are required to disclose to investors subject to FOIA or similar legislation; (ii) require investors to advise the fund of changes to their FOIA status; and (iii) retain the right to withhold information from any investor. See Q&A 4 for additional discussion.

(c) What steps can be taken by an investor to protect its interest?

To attempt to protect its interest in a fund, an investor can negotiate to include in the fund agreement a combination of the following: (i) an excuse right that would relieve the investor from being obligated to make capital contributions to the fund if the investor's continued investment would violate the applicable laws or regulations; (ii) a right to remove the investment team with the consent of other investors (e.g., for "cause" - generally, fraud, willful misconduct or bad faith; for "no cause"; or if certain key members of the investment team are no longer involved in the fund's management); (iii) a right either to terminate the period within which the fund can make investments or to dissolve the fund (e.g., for cause; or for "no cause"; or if certain key members of the investment team are no longer involved in the fund's management); (iv) a right to transfer interests in the fund (a) to affiliates without the consent of the investment team and (b) to others with the consent of the investment team, which will not be unreasonably withheld; and (v) limitations on exculpation and indemnification provisions to ensure that indemnified members of the investment team will not be protected by the fund for bad acts or internal disputes.

To protect the dilution of its interest in a fund, an investor can negotiate that the fund agreement contain a cap on the aggregate amount of capital commitments. This cap, combined with a limitation on the length of time during which additional investors can be admitted to the fund, ensures that investors know the minimum interest that they will hold in the fund. These provisions also serve the purpose of ensuring (i) that the fund size does not become too large and therefore exceed what the investor determines to be the fund's capabilities, and (ii) that the investment team does not spend too much time raising capital (as opposed to investing it).

To prevent the investment team from taking actions that could adversely affect the interests of the investors, often investors will negotiate certain approval rights - for example, that amendments to the fund agreements cannot be made without the approval of a certain proportion of the investors (e.g., 50%, 66⅔% or unanimous). If the investment team has made substantial capital commitments to the fund, investors often request that approvals be made on a disinterested basis (e.g., by excluding the capital commitment of the investment team). This is particularly relevant in the area of conflicts.

Certain key economically significant amendments to the fund agreements, including altering the investors' commitments or reducing their share of distributions, generally require unanimous consent of the investors and the investment team. In addition, amendments to the provisions of the fund agreement that affect a certain class of investors (e.g., ERISA, tax-exempt investors or banks) generally require the unanimous approval of those investors. The fund agreements will also provide for investor approvals for certain actions not covered in the Advisory Committee approval provisions. These may include any of the following: waiving periodic fund meetings, terminating a suspension period after a key-person event, replacing the investment team following a cause or other disabling event, dissolving the fund after a cause event or on a no-fault basis, assigning/transferring the investment team's interest in the fund or making in-kind distributions of non-marketable securities or co-investments with sister funds to the fund.

Investors can also protect their interests in the fund by ensuring that the investment team does not receive distributions that exceed their entitlement under the fund agreement's waterfall provisions. The inclusion of a clawback mechanism ensures that if the investors have not received a preferred return (if applicable) or the investment team has received too much carried interest, the parties are "trued up" as of the clawback determination time. See Q&A 12 below for further discussion regarding distributions and clawbacks.

Performance of Investment

12. (a) Which key provisions govern the relationship between an investor and a private equity fund?

Fund agreements will vary from fund to fund; however, some of the more material legal provisions to consider are fees and expenses; waterfall distributions; clawbacks; Advisory Committee and investor approval rights; investment team duties to the fund and the investors; indemnification and investor giveback; and changes in governance.

The fund is generally responsible for picking up certain expenses, including the management fee. These expenses are then passed on to the investors by way of required capital contributions. In calculating the management fee, most funds pay the manager a fixed percentage (often 1.5%-2.5%) of capital commitments (some larger funds may reduce the percentage if capital commitments exceed certain breakpoints). There is often a reduction (based upon a reduced percentage and/or a reduced amount - e.g., invested capital contributions) following the expiration of the investment period or upon the investment team's raising of a successor fund.

The management fee is generally paid in advance quarterly or semi-annually and is offset by some percentage (e.g., between 50% and 100%) of ancillary fees generated by investments. These ancillary fees may include directors' fees received by the investment team as well as transaction fees and break-up fees (often to the extent that break-up expenses were borne by the fund). It has become increasingly common for a portion of the management fee to be waived and, in lieu thereof, for investors to be directed to contribute an equal amount to the fund on behalf of the investment team in the form of a capital contribution. As a result, the investment team will be entitled to receive any profits generated by such contribution according to the waterfall. This mechanism allows the investment team to gain a tax advantage by recharacterizing the management fee. See Q&A 4 for further discussion of the management fee waiver.

As a general principle, the fund bears the expenses of fund formation (e.g., organizational expenses such as legal and accounting expenses and fundraising expenses up to fixed cap); acquiring and holding investments; operating costs (e.g., audit expenses, tax-preparation expenses, reporting expenses, negotiation expenses, insurance costs, interests costs and Advisory Committee expenses); broken-deal expenses; and all other deal-related costs. On the other hand, the investment team typically bears office and employee expenses (e.g., overhead, salaries and benefits) and expenses incurred in sourcing deals for the fund (including travel and entertainment). Any placement agent fees are generally ultimately borne by the investment team but, due to tax and timing considerations, may first be paid by the fund with a corresponding reduction to the management fee.

The waterfall determines how proceeds from the disposition of portfolio investments will be distributed to each partner and is thus heavily scrutinized and negotiated. It is typically calculated on a deal-by-deal basis or on an aggregate basis. See Q&A 12(b) for further discussion.

The inclusion of a clawback with respect to amounts received by the investment team resolves (i) the investors' concern that the investment team may get inflated returns under the premise that the "home run" investments may be sold early in the life of the fund, while the "dogs" may not be sold until the end of the life of the fund; and (ii) the desire of the investment team to share in the profits of the fund as soon as possible.

In its simplest form, the clawback causes the carried interest payment to be calculated at the end of the fund, aggregating all the disposed-of investments to ensure that the agreed-upon profit split is actually made. With the clawback, the investment team can be required to return (i) distributions received by the investment team that exceed the carried interest to which it is entitled; (ii) distributions received by the investment team that either exceed the carried interest to which it is entitled or are sufficient to cause the investors to receive a return of their capital contributions and a preferred return; or (iii) distributions received by the investment team that exceed what would have been distributed to the investment team as of a determination date if they had been made on an aggregate basis.

Generally, amounts required to be returned by the investment team (regardless of the clawback formulation) are calculated (i) net of taxes payable by the investment team (calculated at an assumed rate) plus (ii) net of distributions received in connection with the capital contributions of the investment team. The clawback obligations can be calculated at the end of the life of the fund and/or periodically before then (e.g., at the end of the investment period or at periodic intervals). Generally, investors require that the carried interest recipients in the investment team each guarantee that they will be liable for the amount of carried interest that they have received in the event of a clawback obligation. Investors may also consider requiring an escrow account to be established, in which a percentage of the carried interest distributions is required to be deposited.

Other key terms of fund agreements relate to investor consent rights and an Advisory Committee. An Advisory Committee is usually composed solely of investor nominees (generally, each of the investors with the largest capital commitments has the right to appoint a member to the Advisory Committee). The purpose of the Advisory Committee is to consent or otherwise deal with a variety of matters that are likely to arise during the life of the fund and to alleviate the administrative burden of rounding up investor consents.

Typical Advisory Committee powers include resolving conflicts of interest, reviewing and resolving valuations of investments, waiving certain investment restrictions in the fund agreement, substituting investment team members, terminating the investment period early in certain circumstances and settling indemnity claims. Most fund agreements provide that the fund will indemnify the members of the Advisory Committee and the investors that such members represent in connection with the administration of their duties. Investors often request that the fund agreement provide that members of the Advisory Committee do not owe a fiduciary duty to the fund or to the other investors in the fund, but instead such members are permitted to act solely in the interests of the investors that they represent (or, alternatively, owe only a duty of good faith). As discussed in Q&A 11(c), certain approvals may require the investors' consent, not just the consent of the Advisory Committee. Generally, investor consent (rather than Advisory Committee approval) is required for certain amendments to the fund agreement, termination of the suspension period, removal of the investment team and/or dissolution of the fund.

Other key terms of fund agreements relate to the duties of the investment team to the investors and the fund (and corresponding indemnification of the investment team) and the ability of the team to require investors to return distributions previously made to them by the fund. With respect to duties of the investment team, the following or similar provisions may be contemplated for inclusion in the fund agreement: (i) a requirement that designated members of the investment team devote substantially all their business time to the fund until the end of the investment period, and thereafter, such time as deemed reasonably necessary to manage the affairs of the fund; (ii) a requirement that all investment opportunities within the scope of the fund strategy first be offered to the fund (alternatively, approval of the Advisory Committee is required if such opportunities are not to be first offered to the fund); (iii) a limitation that successor funds (e.g., funds that are substantially similar to the fund or, alternatively, any fund) cannot be raised by the investment team until a fixed percentage (e.g., 66⅔%-75%) of the fund's capital commitments have been invested; and (iv) a requirement that all non-third-party transactions be on an arm's-length basis and/or approved by the Advisory Committee.

Generally, provided that the investment team members do not act in material breach of the fund agreement or their acts (or omissions to act) do not constitute gross negligence, fraud or willful misconduct, the members will be exculpated and indemnified from liability. As discussed in greater detail in Q&A 4, if fund assets are inadequate to satisfy fund obligations, investors may be required to return prior distributions they received.

Finally, other key terms of funds relate to the investor exiting a fund. These provisions are discussed in greater detail in Q&A 11(c) and include the following: a key-person clause (e.g., if designated members of the investment team cease to devote the requisite time to the fund); a bad acts clause that allows investors to remove the investment team or take other action regarding the governance of the fund; and a no-fault clause that enables investors to either terminate the investment period or end the life of the fund.

(b) How, typically, will the agreement provide for distributions to be made to the investors?

Fund agreements contain two general types of distribution waterfalls: deal-by-deal waterfalls and aggregate waterfalls.

In deal-by-deal waterfalls, distributions are generally made in the following order: first, to the investors and the investment team until they have received their capital contributions back with respect to the disposed-of investment (and any previously disposed-of investments, including capital contributions for any organizational expenses, fund expenses and management fees as allocated to the disposed portfolio investment and any previously disposed-of portfolio investments); second, to the investors until they have received a preferred return on such disposed-of investments (calculated at a specified rate of return − often 8%, compounded annually); third, to the investment team until it receives a "catch-up" of its carried interest (e.g., 20%) on the distributions previously made to the investors as a preferred return (calculated commonly at a rate of 50%, 80% or 100% such that carried interest is calculated on the entire amount of profit, allowing the investment team to share in the profits at the first dollar and therefore catch up to the investors; by reducing the percentage under the catch-up provisions, investors receive their share of profits more quickly and are able to delay the time when the investment team shares in the fund's profits); and fourth, to the investment team at the carried interest rate and the remainder to the investors (e.g., 20%/80%). Many U.S. buyout and distressed debt funds have a deal-by-deal waterfall distribution scheme.

In deal-by-deal waterfalls, investors often request that a partial or complete writedown of a portfolio investment constitute a disposition event. The investment team may argue that writing down too frequently, without the ability to write up portfolio investments, can be an administrative burden. On the other hand, investors may want to ensure that valuations of portfolio investments are as accurate as possible for purposes of their reporting but also for determining when they should be eligible to receive a return of their capital contributions with respect to such investments.

In aggregate waterfalls, distributions of carried interest to the investment team are delayed until either all the portfolio investments have been disposed of or the investors have received back all their capital contributions (including capital contributions for any organizational expenses, fund expenses and management fees); distributions are then made to the investment team at the carried interest rate and the remainder to the investors. A variation on aggregate waterfalls is used in many venture capital and real estate funds, whereby investors and the investment team receive their capital contributions back with respect to the investment being disposed of and then remaining proceeds are distributed to the investment team at the carried interest rate and the remainder to the investors, so long as the capital accounts reflect a net asset value of at least 120% of unreturned capital contributions.

The fund agreement may have different rules regarding the disposition of bridge investments and temporary investments (e.g., the disposition proceeds may be distributed outside the waterfall provisions). Although there is often a higher risk associated with bridge investments, investors may choose to forgo their preferred return on these investments to prevent the investment team from receiving a carried interest on them, thereby reducing the investment team's incentive to make such investments. Proceeds from bridge investments may instead be distributed to investors and the investment team on the pro rata basis of their capital contributions, as is generally done with respect to temporary investments.

13. (a) Are the members of the investment teams subject to any legal duties?

Investors generally negotiate with the investment team to ensure that the fund agreements do not reduce the legal duties of the investment team to both the fund and the investors. Under Delaware law, any implied duties that members of the investment team may owe (e.g., duty of loyalty) may be modified by agreement except with respect to the duties of good faith and fair dealing. An aggressive investor may negotiate for the explicit inclusion of increased standard of care, whereas an aggressive fund may attempt to limit such standard of care by expressly stating that the investment team may act in its own interests in the management of the fund without considering the best interests of the fund or its investors.

(b) What are common ways to align the interests of the investment team with the investors?

Investors argue that the more money that is contributed by the investment team, the more "skin" the investment team has in the game and therefore the increased likelihood that the investment team will act in the fund's best interests. In addition, the interests of the investment team and the investors are aligned with the (i) reduction of the management fee either at the end of the investment period or upon the raising of a successor fund (since the investment team's attention will not be as focused on the fund), and (ii) the offsetting of ancillary fees against the management fee (since these fees are earned as a result of the investors' investment in the fund and therefore the benefit, or a portion of the benefits, of such fees should arguably flow back to the investors).

(c) What is the most common way to motivate the performance of investment team?

The investment team is primarily motivated by its desire to return sufficient profits to the investors to ensure that it receives a portion of the profit under the applicable waterfall scheme (e.g., the investment team's "carried interest"). In addition, if the investment team is successful in returning profits to both the investors and to itself, there is an increased likelihood of successful fundraising to establish a successor fund once the current fund has been fully or substantially invested. We note that although the management fee was historically designed to cover the investment team's overhead expenses, given the recent substantial growth in the size of many funds, it is arguable whether the management fee in some funds is an additional way to put money into the hands of the investment team in excess of these expenses.

14. What restrictions are likely to apply to the amount and period of investment, and to transferability of interests in private equity funds?

The investment restrictions that may be included in fund agreements will vary dramatically according to the fund's strategies. Generally, there is a restriction on the amount that can be invested in one entity (e.g., 15%-20% of capital commitments), but this amount may be increased if bridge investments (which are also generally capped) are made or the Advisory Committee's approval is given; there may also be a maximum amount that may be invested outside the main strategy of the fund (e.g., if the fund's strategy is to invest in companies in the communications industry, the amount that may be invested outside that industry is capped). In addition, there may also be restrictions on the geographic areas where a fund may invest (e.g., only 15%-20% of capital commitments can be invested outside a specified region) and on the types of investments that a fund can make (e.g., investments in public securities, investments in "hostile" transactions or investments in other funds).

Moreover, a fund may be limited with respect to the amount of indebtedness that it can incur and its ability to invest in puts, calls, straddles or other derivative instruments. Depending upon the investors and other investment restrictions, the fund may also agree to restrictions on investing directly in oil or gas reserves, real estate or companies engaged primarily in the business of manufacturing or selling alcohol, tobacco or firearms.

The period in which the fund can make capital calls for investments is generally limited to the first four to six years of the fund. After this period, the fund can require investors to make capital contributions only for fees and expenses, with respect to investments in progress prior to the end of the investment period, investments subject to a written commitment or with respect to follow-on investments (e.g., subsequent investments made in existing portfolio companies or investments that are or will be under common control with existing portfolio companies).

As a general rule, investors' interests in the fund are not transferable without the consent of the investment team. An investor may be able to negotiate a transfer right regarding a desired transfer to its affiliate (e.g., an entity that is controlled by the investor, an entity that controls the investor or an entity that is under common control with the investor) whereby either the consent of the investment team is not required or such consent will not be unreasonably withheld. Generally, the investment team does not pre-approve any other transfers (including those to be made on the secondary market).


15. What are common strategies to exit an investment in a private equity fund? What considerations need to be taken into account?

There are three basic ways in which an investor can exit its investment in a fund: (i) through the secondary market; (ii) through the normal course exit at the end of the life of the fund; and (iii) through early termination of the fund, including by a vote of the investors to remove the investment team without replacing it.

During the life of the fund, an investor that wishes to liquidate its investment in the fund can attempt to find a buyer for its fund interest. If the fund is unsuccessful, the investor may be unable to find a buyer and/or may be required to accept a substantially discounted purchase price for its investment. As discussed in greater detail in Q&A 14, a sale on the secondary market will generally require the consent of the investment team. With such consent, the transferee would typically assume any obligations to make remaining unfunded capital commitments.

Each fund agreement provides for the disposition of investments at the end of the life of the fund (e.g., 10 years from the date of formation, which can be extended by the GP or with the consent of the Advisory Committee or the investors) and its subsequent liquidation. The fund may have the authority to distribute non-marketable securities to investors.

Finally, as discussed in greater detail in Q&A 11(c), investors often negotiate for the ability to exit the fund and/or cease making otherwise required capital contributions, including when (i) continued investment would violate applicable law; (ii) a certain proportion of the investors decide to remove the investment team and do not subsequently appoint a replacement investment team; or (iii) a certain proportion of the investors decide to dissolve the fund. In the cases of (ii) and (iii), the fund's assets would be liquidated and/or distributed in kind, thereby providing an exit for all the investors.

Thank you to Peter Keenan, Darren Baccus, Andrew Beck and Mark Tice for their contribution in answering these frequently asked questions. We also acknowledge Mondaq's contribution in providing the questions.

Amy Johnson-Spina is an associate in the firm's New York office, concentrating in corporate law with an emphasis on private equity transactions. Amy advises private equity fund managers and institutional investors on a broad range of issues, including acquisitions and investments (direct and indirect).

Jay Romagnoli is a member of the Torys' Executive Committee and the head of the firm's Private Equity Group in New York. His practice focuses on private equity, mergers and acquisitions, and financing transactions for public and private companies, equity sponsors and financial institutions. He has represented private equity clients in a broad range of corporate transactions, including their consolidation programs and venture capital investments. He has also advised debt and equity financiers in numerous transactions, including leveraged buyout transactions, secured credit facilities and leveraged recapitalizations.