Goodwin Procter LLP
Reuters recently obtained a letter dated February 6, 2009 from Kohlberg Kravis Roberts & Co. (KKR) in which one of the world's biggest private equity firms told its investors that it would be communicating more with them this year. This letter addressed to KKR's limited partners from founding partners, Henry Kravis and George Roberts, is indicative of these times in which private equity firms are finding it necessary to devote more time and resources toward pleasing and appeasing investors. Investors, on the other hand, are considering their options as their portfolios are suffering from the denominator effect and dismal returns.
Recent economic events have raised a host of allocation and liquidity issues for investors in private equity and venture capital funds ("PE/VC funds"). First, many investors are now over-allocated to PE/VC fund investments because those investments have not been written down in value to the same degree as public investments (the so-called "denominator effect"). Second, many investors have suffered losses that significantly depleted their liquid capital reserves. Third, many PE/VC funds are making fewer or smaller distributions due to a lack of realization opportunities. Finally, many PE/VC funds must make additional capital infusions into their portfolio companies to help them through this difficult period.
Taken together, these factors suggest that some investors will be asked to contribute additional capital to PE/VC funds at exactly the time when they (i) prefer not to do so for asset allocation reasons and (ii) lack sufficient liquid capital to comfortably make the contributions even if they wished to do so.
Not surprisingly, PE/VC fund sponsors have begun to receive investor requests for relief. These include requests that the fund sponsor:
The purpose of this alert is to highlight selected issues that PE/VC fund sponsors should consider when evaluating any such requests and to provide some thoughts on potential ways in which PE/VC fund sponsors may be able to address their fund's capital needs while being responsive to investor liquidity constraints.
What Should A Fund Sponsor Consider When Responding To Such Investor Requests?
It is critical that, prior to discussing alternatives with investors, a fund sponsor be well-versed in what it is permitted to do and the consequences of various actions under:
Each of these areas is discussed in more detail below.
While this alert is focused primarily on legal issues, fund sponsors also must confront the political and precedential effects of their actions.
In general, fund sponsors will desire to maintain the goodwill of their investors and, as a result, will be motivated to address their investors' concerns. The second portion of this alert describes a number of alternatives which fund sponsors could consider in this regard.
In any specific case, however, addressing one investor's concerns may create problems for another investor or for the fund as a whole. For example, even if allowing one investor to withdraw or reduce its commitment does not trigger a contractual "most-favored-nation" right on the part of other investors (as discussed below), other investors may nonetheless expect similar treatment and the fund sponsor may feel compelled to offer all investors the same rights of withdrawal or reduction in order to preserve investor goodwill. Permitting all investors to elect to withdraw a portion of their interest or reduce/defer a portion of their commitment may raise significant concerns with respect to the stability of the fund (e.g., whether there will be a "race for the exit") and whether the fund will have sufficient resources to carry out its investment program and meet its obligations to portfolio companies or other third parties. Alternatively, refusing to provide sufficient relief may encourage investors to exercise "no fault divorce" or other rights under the fund agreement that lead to a far greater disruption than a more measured response.
Underlying the fund sponsor's consideration of investor requests is the consideration of potential investor defaults in satisfying their capital commitments. Fund sponsors should assess the ability of the requesting investors to satisfy future capital calls if their requests are not honored and should carefully review the default provisions in the fund's organizational documents (including the enforceability of such default provisions). Under many fund agreements, the implementation of default remedies is at the election of the fund sponsor; accordingly, a fund sponsor could agree not to exercise the fund's default remedies with respect to an investor for some period of time to help alleviate the investor's immediate-term liquidity constraints. Because any agreement not to enforce default remedies with respect to an investor has the same effect as an interest-free loan from the fund (i.e., from the other investors) to that investor, it raises many of the same concerns discussed elsewhere in this alert regarding fiduciary duties, most favored nation provisions, precedent, etc.
While many of the issues discussed in this alert are relevant to defaults, investor defaults also raise additional issues which are beyond the scope of this alert.
Fund Organizational Documents
The fund's organizational documents should be carefully reviewed to determine whether the fund sponsor has discretion to take any of the contemplated actions. For example, the fund agreement may not allow for capital calls other than on a pro rata basis and may not permit specific investors (as opposed to all of the investors) to reduce their commitment and thereby be overfunded relative to their revised commitment. The fund agreement may provide that investor withdrawals are prohibited except in limited circumstances, such as to avoid ERISA violations or to prevent the fund from holding ERISA plan assets. In some cases, the fund agreement may provide that if an investor (such as an ERISA investor) is permitted to withdraw a portion of its interest, then all other investors of the same type (such as all ERISA investors) may also be permitted to withdraw a pro rata percentage of their interests.
While the fund sponsor typically will have authority to permit transfers, the fund's organizational documents likely will contain provisions limiting the ability to effect a transfer if the transfer would adversely affect the fund's tax, ERISA or other status, and the fund sponsor will be subject to the fiduciary duties and liabilities discussed below in determining whether to permit a transfer. In addition, the fund agreement may grant other investors a right of first refusal in respect of the transferred interest.
Any proposed reduction in the capital commitments or contribution obligations of one or more investors may raise issues for a fund if the fund's partnership or operating agreement provides for liquidating distributions to be made in accordance with capital account balances. Unless amended as part of the reduction, the limitations inherent in these forms of agreements may prevent the investors from fully achieving the intended economic result of the reduction, potentially leaving too high or too low a balance in some investors' capital accounts vis- -vis others. In other forms of partnership or operating agreements, reductions in capital commitments of some investors may result in an immediate "capital shift" and/or may require future income allocations to be made in a manner that adjusts the investors' capital accounts to be in proportion to their new commitment percentages (assuming the reduction is intended to apply to both pre-existing and future investments). Any capital shift could be immediately taxable or, if not, may cause additional taxable income to be allocated to either the investors that are having their commitments reduced or the remaining investors, depending on the circumstances. Any such adjustments may require amendments to the fund's organizational documents and therefore may require investor consent. Furthermore, withdrawals by certain investors at a discount to fair market value could raise tax issues for the non-withdrawing investors in the fund that are similar to those raised by reductions in commitments.
Legal Considerations: Fiduciary Duties, Broker-Dealer, Confidentiality, Disclosure
A fund sponsor is subject to fiduciary duties to the investors in its fund. The nature and scope of those duties are in large part defined by the laws under which the fund is organized and the terms of the fund's organizational documents. In addition, in the unlikely event that the fund's assets include "plan assets" subject to ERISA, the fund sponsor's decisions with respect to investor requests will be subject to the ERISA fiduciary standards applicable to such a fund. As a general matter, when considering a request from any investor in this context, the fund sponsor should consider the interests of the fund as a whole. As a result, in considering whether to allow a particular investor to reduce its commitment or withdraw, to defer capitals calls, to waive default provisions or to permit a transfer, the fund sponsor should consider the effects of these actions on the other investors and on the fund as a whole, such as:
Because specific investors may be in different positions with respect to their own allocation issues and liquidity constraints, fund sponsors may receive conflicting requests for relief (or even requests that no relief be granted at all). In this regard, fund sponsors should consider all of the facts and circumstances and bear in mind their fiduciary duties to the fund as a whole.
In considering whether to allow a particular investor to reduce its commitment or withdraw, to defer capitals calls, to waive default provisions or to permit a transfer, the fund sponsor should not consider its own interests, such as the impact of such actions on the fund sponsor's ability to raise its next fund or the fund sponsor's personal relationship with a particular investor.
Broker-Dealer; Investment Adviser
In the case of transfers, fund sponsors need to be careful not to act as a "broker," which generally would require registration with the SEC and/or implicate state law requirements. Fund sponsors that rely on the exemption from SEC registration as an "investment adviser" available to investment advisers with fewer than 15 clients also need to be careful to avoid being deemed to provide investment advice to either the transferor or the transferee in connection with the transfer such that neither the transferor nor the transferee is deemed to be a "client" for purposes of such exemption. Accordingly, fund sponsors should consult with their counsel to address these issues prior to becoming involved in any transfers.
In connection with a proposed transfer, the fund sponsor generally will be asked to agree that the transferor can disclose certain confidential fund information to the transferee. It is important to narrowly and precisely define the extent to which the transferor is permitted to disclose confidential fund information to the transferee and to require that each prospective transferee enter into a confidentiality agreement with the fund sponsor whereby it agrees to protect all such information it receives. The fund sponsor should also consider whether the transferee is subject to the Freedom of Information Act or similar laws that could require it to disclose confidential fund information notwithstanding the confidentiality agreement.
Disclosure Requirements; Anti-Fraud Provisions
In evaluating any of the investor requests discussed in this alert, fund sponsors should consider any resulting disclosure obligations to prospective and existing investors.
A fund sponsor is liable under federal and state securities laws if, in connection with selling securities, it makes an untrue statement of a material fact or omits to state a material fact that is necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading. Thus, in considering any investor request, the fund sponsor should consider whether granting the request would make it necessary to supplement the fund's private placement memorandum or other marketing materials. For example, a significant reduction in commitments to the fund may require a fund sponsor to disclose to prospective investors that the existing fund size and/or target fund size has changed. Moreover, a fund sponsor would need to consider how such a reduction in commitments and the prospect of a "race for the exit" may affect the future stability of the fund's resources and whether the actual and/or potential impact of these changes is a material fact that should be disclosed to prospective investors. Any agreement to defer capital calls from investors for a period of time, or to permit transfers of a substantial portion of all fund interests, would require a similar analysis. Any such disclosure may have a detrimental impact on fundraising efforts.
Investment advisers (whether or not registered) are subject to certain anti-fraud provisions under the Investment Advisers Act. With its adoption of an anti-fraud rule in 2007 targeting investment adviser conduct with respect to pooled investment vehicles (including registered funds and certain unregistered funds), the SEC served notice that it will be devoting particular attention not only to the conduct of fund sponsors and disclosures made in connection with fund offerings, but also to fund sponsor conduct and disclosures with respect to existing fund investors. Given the SEC's heightened sensitivity and the rule's relatively high standard of conduct (mere negligence may result in a violation), fund sponsors will want to consult with their counsel to analyze their proposed responses to investor liquidity needs in light of these anti-fraud provisions. For example, a fund sponsor that is subject to these anti-fraud provisions would need to consider whether a reduction in fund size or any agreement to not call capital from investors for a period of time or any other response to investor requests should be disclosed to existing investors. Any such disclosure may cause investors to consider exercising their rights (such as a no-fault divorce right) under the fund agreement or to request other relief.
Certain fund investors may have side letters containing "most-favored-nation" ("MFN") provisions which enable such investors to elect to receive rights similar to those granted to other investors in their side letters (subject, in some cases, to size or other limitations). Those MFN provisions must be carefully considered when a fund sponsor is faced with a request from an investor in this context. Depending on the nature of the MFN provisions, permitting an investor to withdraw, reduce its commitment or transfer may allow other investors to exercise similar rights under their MFN provisions. As noted above, even if an investor is not able to elect a right to take similar action based on an MFN right, fund sponsors should also carefully consider the precedential effect of permitting an investor to take any of these actions and whether it will lead other investors to seek similar treatment.
Bridge Credit Facilities
Fund sponsors should review the terms of their bridge credit facilities to determine whether any of the requested actions could result in a default or breach of covenant under such credit facilities.
ERISA And Tax Considerations
Fund sponsors should carefully consider the effects of any proposed action on the fund's ERISA or tax status, or on any intended tax benefits.
A proposed commitment reduction, withdrawal or transfer of an interest should be evaluated from the perspective of the fund's ERISA status. In particular, if the fund is relying upon the "less than 25% benefit plan investors" exception from plan assets status, the fund sponsor should take appropriate measures to ensure that the reduction, withdrawal or transfer will not threaten compliance with such exception. Any assignment documents should contain representations designed to confirm such compliance.
Under the "venture capital operating company" (or "VCOC") exception from ERISA, at least 50% of the fund's assets must constitute "good assets" for at least one day during the applicable annual testing period. A fund that is relying on the VCOC exception may hold a majority of assets which are not "good assets" with the expectation that it will acquire a sufficient amount of good assets by the testing date in order to satisfy the exception. The fund sponsor of any such fund should consider the potential effects of commitment reductions or withdrawals on the fund's strategy to acquire the requisite amount of good assets in time to satisfy the VCOC exception and more generally in respect of compliance with the VCOC exception.
In addition, transfers to or from an ERISA plan can potentially constitute a prohibited transaction under ERISA which, in turn, would typically require rescission of the transaction. Accordingly, fund sponsors should consider including representations in the transfer documents from both the transferor and the transferee to the effect that the proposed transfer will not give rise to a non-exempt prohibited transaction under ERISA or Section 4975 of the Code or constitute a violation of any comparable law applicable to government plans.
Reductions in commitments, transfers and withdrawals all need to be evaluated in light of the fund's tax-related transfer restrictions and any other potential tax impact on the fund or the other investors in the fund (including the fund sponsor). The nature and extent of the potential tax issues will depend on the structure of the fund and the terms of its organizational documents. Fund sponsors should carefully review the tax implications of any such actions with their tax counsel and accountants.
For any fund that is organized as a partnership, transfers should be evaluated in light of the "publicly-traded partnership" rules and any transfer restrictions related thereto in the fund's organizational documents in order to ensure continued treatment as a partnership for federal income tax purposes. The applicable regulations provide certain "safe harbor" exemptions from the publicly-traded partnership rules, some of which are tied to the size of individual transfers and the nature of any intermediary used to facilitate fund transfers. Given the severe tax consequences of a fund losing its treatment as a partnership for federal income tax purposes (i.e., potentially being subject to corporate taxation), fund sponsors should carefully analyze each transfer to determine whether it qualifies for one of the applicable safe harbors or would otherwise affect the partnership's status as a partnership for federal income tax purposes.
If the fund has a built-in loss on its assets (i.e., its adjusted tax basis in its assets exceeds their fair market value), a transfer of interests in the fund may require the fund to adjust the tax basis of its assets under Section 743 of the Internal Revenue Code. To the extent the fund is a "fund of funds," invests through joint ventures or in operating partnerships or LLCs, or otherwise holds its investments through lower-tier partnerships, any such lower-tier partnerships may also be required to make a "743 adjustment" with respect to transfers of fund interests. These adjustments could result in significant additional accounting costs and complexity for the fund and for the lower-tier entities. Depending on the terms of any lower-tier partnership agreement, the fund may be liable for any such additional costs incurred by the lower-tier partnerships. In most fund agreements, the fund-level costs will be passed along to the transferee, but fund sponsors should review their fund documents carefully to understand the exact extent to which they may be entitled to pass along such costs, especially as it relates to lower-tier partnerships, and should discuss any potential 743 adjustments with their accountants.
Fund sponsors may consider utilizing, or increasing their utilization of, bridge credit facilities in order to defer the need to call capital from investors. The longer any borrowing on a credit facility remains outstanding, the greater the potential for the borrowing to result in "unrelated business taxable income" (or "UBTI") for U.S. tax-exempt investors. Fund sponsors should carefully consider the potential UBTI issues associated with borrowings under credit facilities, including a review of any limitations on the incurrence of UBTI that may have been agreed to in the fund's organizational documents.
For fund sponsors that utilize a capital contribution waiver/fee offset, any reductions in commitments may result in additional risk that the fund will not generate sufficient gains to permit the fund sponsor to fully recover the waived fees. Any such arrangements should be carefully evaluated with tax counsel based on the applicable situation to determine the potential impact on the fund sponsor.
What Can A Fund Sponsor Do To Address Investor Liquidity Constraints?
There are a number of potential alternatives available to PE/VC fund sponsors to address investors' allocation and liquidity concerns. The following briefly highlights some of these alternatives; each alternative involves business and legal considerations that fund sponsors should carefully review and analyze with their advisers, including, in many cases, a number of the issues described above. These alternatives will be more or less appealing to specific fund sponsors depending on their particular circumstances and a fund sponsor may consider utilizing a combination of two or more of the following alternatives.
Jonathan Axelrad: firstname.lastname@example.org
Jonathan Axelrad is a partner in the firm's Business Law Department and a member of the Private Investment Funds Practice. He joined Goodwin Procter in 2007. Mr. Axelrad specializes in all aspects of the formation and operation of venture capital and other private equity funds, with a particular emphasis on issues involving partnerships, limited liability companies, tax, ERISA, the Investment Advisers Act and the Freedom of Information Act. He has extensive experience in the areas of international fund structures and "market" terms and conditions.
Matthew L. Giles: email@example.com
Matthew Giles is a partner in the firm's Business Law Department. He participates in Goodwin Procter's Securities and Corporate Finance Practice and is a member of the firm's Private Investment Funds Practice and Real Estate Capital Markets Practice. Mr. Giles focuses his practice on real estate and private equity fund formation, public and private securities offerings and public and private mergers and acquisitions, with a focus on REITs and real estate capital markets. His corporate practice also includes public company corporate governance and securities law compliance and private company representation
Kenneth J. Gordon: firstname.lastname@example.org
Ken Gordon, a partner in Goodwin Procter's Corporate and Technology Companies Groups, has more than 17 years of experience representing privately held and publicly traded companies, investment banks, venture capital firms, and emerging and public growth companies. Mr. Gordon concentrates his practice in the areas of general corporate representation, corporate finance and acquisitions.
Rufus C. King: email@example.com
Rufus King, a partner in the firm's Corporate and Private Equity Groups, concentrates in corporate, partnership and securities law. He joined Goodwin Procter in 2005. Mr. King represents venture capital and other private equity funds, both in fund organization and in investment transactions. He has also represented public and private high-technology companies in all aspects of corporate operation and development. Mr. King has acted as issuers' and underwriters' counsel in public offerings.
David W. Watson: firstname.lastname@example.org
David Watson, a partner in the firm's Business Law Department and chair of its Private Investment Funds Practice, focuses his practice on public and private securities offerings, private fund formation, partnership law, public and private mergers and acquisitions, securities law compliance for public companies and general corporate matters. Mr. Watson also participates in Goodwin Procter's Securities & Corporate Finance, Real Estate Capital Markets and Private Equity/Venture Capital Practices.
Goodwin Procter LLP
Goodwin Procter LLP is one of the nation's leading law firms with 900 attorneys in offices in Boston, Hong Kong, London, Los Angeles, New York, San Diego, San Francisco, Silicon Valley, and Washington, D.C. The firm's core areas of practice are corporate, litigation and real estate, with specialized areas of focus that include financial services, private equity, technology, REITs and real estate capital markets, intellectual property, tax and products liability. Information may be found at www.goodwinprocter.com.
This article, which may be considered advertising under the ethical rules of certain jurisdictions, is provided with the understanding that it does not constitute the rendering of legal advice or other professional advice by Goodwin Procter LLP or its attorneys. © 2009 Goodwin Procter LLP. All rights reserved.