The old Chinese curse wishes that you live in interesting times. Private equity fund practitioners in 2009 could be forgiven for asking: “Do they have to be quite so interesting?”
The debt crisis, collapsing public equity markets, failing financial institutions and an unprecedented governmental response have all had a particularly significant impact on the private equity industry. The drying-up of debt financing has resulted in buyout activity withering; the wider liquidity crisis and market decline have resulted in investors retreating from new commitments; and, consequently, the torrent of new fund-raising in the industry in 2007 has slowed down to a relative trickle. Not only that, but the private equity industry has found itself increasingly thrust into the public spotlight. Although it has had little or no role in causing the current crisis, the industry is contending with the prospect of substantially increased regulation and taxation. No one should be too confident about how the industry will emerge from these challenges, but we seek here to highlight some of the key issues and to tentatively suggest how these issues could shape the future of the industry for private equity fund practitioners and their clients.
PRIVATE EQUITY FUND-RAISING
The first and perhaps overriding observation is to note that private equity fund-raising levels have dramatically declined from the record levels of 2007. According to Preqin, in 2007 US$636 billion of new private equity commitments were raised, yet in the first half of 2009 the figure was just US$136 billion – a level last seen in 2005. Interestingly, private equity fund-raising levels in 2008, at US$618 billion for the year, held up remarkably well. However, it seems clear that, as with almost all markets, much activity ended abruptly upon the collapse of Lehman Brothers in September 2008. Those funds that did hold closings subsequent to the collapse had usually already garnered soft commitments prior to September 2008. Indeed, it seems likely that the success of private equity fund-raising even in the pre-September 2008 period was largely a function of the lag factor inherent in private equity allocations. Although problems with the debt markets had become apparent in 2007, existing allocations were there to be used up on fund-raisings that were already up and running, and the denominator effect on allocations caused by declining equity markets was yet to have its full impact. Whatever the proximate cause, by the end of 2008 the private equity fund-raising market had, by recent standards, largely gone quiet, and even into the third quarter of 2009 it has picked up only modestly.
The key question facing practitioners and their clients is whether this is simply a particularly strong cyclical adjustment or whether it reflects a structural change within the industry. The answer may be a little of both: certainly there is a very strong cyclical adjustment happening to fund-raising. But the industry has been through a number of fund-raising cycles and emerged from each poised for further growth. However, it does seem likely that, at least for the foreseeable future, the industry will look a little more like it did in the early years of this century. Investors have significant doubts about the viability of mega-buyouts in the new debt-starved world. Managers will need to be able to demonstrate proven operational expertise or a very solid track record of investment selections through the past few years if they are to successfully raise further capital.
The funds they do raise are likely to be smaller and invested in more equity-intensive deals; many managers will find that they are unable to raise any funds whatsoever. Doubtless there will be a shake-out of managers, and, indeed, this is happening already.
This in turn will place pressures on practitioners: with fewer attractive mandates available, practitioners will need to be on their game to win them. In a tough fund-raising environment it will be increasingly difficult for less specialised practitioners to win fund-raising work – managers are likely to expect their lawyers to have a proven track record in fund-raising work and a deep understanding of the market. No doubt there will be increased cost pressures too, which all lawyers will need to respond to. However, where the future of their business depends on successful fund-raising, managers are likely to focus more on hiring the most experienced fund practices whose lawyers have the widest and best resources available to support a fund-raising and add value for their clients. To that extent, those practitioners featured in this edition of The International Who’s Who of Private Funds Lawyers have a little less to worry about.
One of the consequences of the current fund-raising environment is that those investors still committed to the asset class will generally have increased leverage when negotiating fund terms. It will be interesting to see what impact this ultimately has. Theoretically the authors believe that current fund terms already do a good job of aligning investor and manager interests. Indeed, some of the more fundamental misalignments – notably the existence of deal-by-deal carried interest waterfalls lacking in sufficient clawback protection for investors – were largely sorted out during the prior downturn.
Nevertheless, it seems clear that investors will want to improve upon their gains in some areas. In particular, there is a widespread concern that managers have grown too wealthy on risk-free management fees and that managers’ “skin in the game” has been too little, or too easily funded through generous management fee or transaction fee provisions. Managers will argue that private equity is a particularly overhead-intensive business and that they need their fee streams to incentivise and keep high performers. To an extent they will be right, and so for many managers their established carry and fee levels will hold. But with so much excess demand for capital in the fund-raising market, it would be naive to assume that managers will be immune from pricing pressures.
Developments in fund terms are likely to make the next few years interesting for practitioners. It will be increasingly important to stay at the cutting edge of new developments in market standards. With a large pool of managers competing for scarce capital, they will want their advisers to be able to help them position their terms as accurately as possible to “clear” the market – that is, to recognise where investors’ demands can be met and where a line ought to be held. Again, this is likely to lead managers to appoint established fund-raising lawyers with the deepest knowledge of the market and the savviest negotiating skills. In turn, however, those practitioners need to be able not only to follow the market but also to lead it – suggesting new structures and provisions to meet new investor concerns, while also ensuring that managers continue to have a viable and well-protected business.
We believe that many of the developments in fund-raising are likely to go beyond the fine-tuning of existing terms and conditions. Some concerns are more fundamental and will likely lead to new structures being used (or often old structures revisited). Investors are increasingly wondering whether the typical 10-year fund term with a five-year investment period is an appropriate way to manage their capital – particularly as many are now overcommitted to funds that are not in a position to maintain their target pace of investing in current market conditions. Larger investors, in particular, are increasingly keen to have more direct control over their investments and reduce their cost of capital. Managers, on the other hand, when faced with these pressures often need to find supplemental sources of capital to keep their business running, without necessarily being in a position to raise a new conventional blind pool 10-year fund.
The result of this may be further top-up or annex funds, or, in some cases, new structures to incentivise investors by providing them with attractive co-investment opportunities alongside their commitments to new funds. Going forward, it seems likely that there may be a move towards more club arrangements or annual vintage schemes. A more straightforward approach may be to simply reduce target fund sizes and invest them over shorter investment periods, which would allow investors more flexibility in their allocation strategies. Within standard fund models, the industry will also see changes as investors seek to beef up investor governance rights and the oversight functions of advisory committees, and use their new-found negotiating power to protect themselves from key personnel changes and ensure that their carefully selected managers do not drift from their expressed strategies.
One fact the industry can take heart from is that, at present at least, it is widely perceived to have done a better job of aligning the interests of agents and principals than many of the models used within investment banks, public companies and the hedge fund industry. As such, it is no surprise that private equity fund technology is being applied to wider and wider asset classes. Brand-name larger private equity houses, perhaps recognising that even they will struggle to raise the same-sized buyout funds again, are increasingly diversifying their product mix. Managers are looking at raising special situations funds, distressed debt funds, credit opportunity funds and secondaries funds to exploit dislocated markets, whilst at the same time looking to the future with emerging markets funds, infrastructure funds and cross-over offerings such as public value funds or commodities funds.
Naturally, these developments create opportunities for practitioners to expand their businesses in new areas. A demand will remain for lawyers who have the technical flair to adapt fund structures to these new markets, and the commercial skills to steer their clients towards – and help them establish – appropriate new commercial terms. Infrastructure funds are a good example: closed-end private infrastructure funds are a relatively recent arrival to the private equity fund world, although it remains to be seen whether the established private equity fund terms, are, in the long run, going to be considered appropriate for this category of funds.
The current crisis will also create the potential for new stresses to result in disputes and litigation. During good times, the private equity fund world has generally steered clear of public disputes, and litigation has been rare. In a small market dominated by sophisticated parties, where reputations and personal relationships are important, it has been rare for disagreements to escalate.
With so little transactional activity requiring capital calls, overcommitted investors have had a brief respite in which to get their houses in order, but it is quite possible that potential defaults will now loom larger as markets pick up and money is drawn down. Some investors may have decided to withdraw from the market and may be prepared to look for ways to renege on their commitments.
Even investors without liquidity concerns may be revisiting their portfolios and looking for ways to reduce their exposure to the asset class or certain managers, carefully eyeing no-fault divorce and other suspension mechanisms. Where managers are performing badly they will be particularly vulnerable, and in the current market there are increasing numbers of managers whose portfolios look weak. Even where managers are left in place, it will soon become apparent that many will find it impossible to raise further funds. In these circumstances an important bond that joins managers and investors will be broken – and so disputes arising out of existing portfolios will be more likely.
Interestingly, however, it would seem that the trigger for the failure of many managers will not come from their investors, but from internal tensions. Succession planning, always difficult, will in many cases become next to impossible. How do you motivate and retain a junior team when the existing portfolio is too far underwater to generate carry or enable a successor fund to be raised? Who is blamed for this internally? And what if the appetites of the firm’s elder statesmen have waned? There have already been a number of acrimonious splits within teams, in some cases making future funds look untenable. Where such splits have triggered key-men provisions, such events have often served as an invitation to investors to claw back some of their capital or renegotiate fund terms.
Many managers have responded to investors’ liquidity concerns by allowing investors to scale back their commitments. Such scale-backs are not without difficulty; in addition to their complexity, the underlying dynamics that have led to such scale-backs often need to be handled sensitively to avoid potential conflicts of interest and other pitfalls. Not all investors will necessarily want the same outcome, and managers are rightly concerned to ensure that any such voluntary actions on their part do not jeopardise their businesses. However, well-handled scale-backs can cement relationships with investors and help to secure a private equity manager’s long-term business.
Finally, as if all of that was not enough, the industry is also waking up to the many new regulations being thrown at it, which will be difficult to avoid.
The proposed EU Directive on Alternative Investment Managers has been met with widespread concern, much of it justified. While it is difficult to know what the final Directive will look like, we can be fairly certain that it is going to have a massive impact upon the industry.
Of course, from the practitioners’ perspective, provided that the Directive does not, inadvertently or otherwise, kill the industry, it will provide an expanse of new work. But before we get there, we should all be deeply concerned about the extent to which the Directive may impose burdens and restrictions that undermine the viability of some parts of the industry. In addition, in its current form the protectionist effect of the Directive is clear, and it is likely that many non-EU managers will respond by avoiding European fund-raising altogether. In the United States, a similar impact is feared from current legislative proposals that would dramatically narrow the exemptive framework under the Investment Advisers Act for foreign private advisers who manage more than a minimal amount of capital from US investors. The risk from these regulatory developments is that a deep and active global fund-raising market becomes a thing of the past as managers increasingly retreat to their own domestic markets for new capital. In turn, such a move would result in a shrinkage of the industry, fewer options for investors and less work for practitioners in the major financial centres of the world.
THE TAX ENVIRONMENT
As the public mood hardens against the perceived excesses of capitalism, it also seems inevitable that the tax structures that the industry has relied on will receive greater scrutiny. In the UK, tax authorities are looking closely at offshore management structures, and the ways in which they are used to avoid VAT charges and to keep fee income outside the UK. Practitioners will need to work increasingly hard to ensure that such structures are as robust as possible – and in many cases, it seems likely that managers will decide it is easier to simply stay (or move) onshore. Given recent G20 protocols and the mood of global public opinion, it seems likely that increased scrutiny of offshore structures will extend far beyond the UK revenue authorities.
Managers will also need to adapt to a world in which the favourable tax treatment of carried interest is no longer taken for granted. Fiscal deficit pressures, disproportionate benefits earned by managers during the good years and, in the US, a change in party control of Congress and the White House have all undermined political support for the current favourable tax treatment of carry. While there are many good arguments to support existing carry arrangements, it seems likely that in the US. and many other jurisdictions it will become ever more difficult to maintain capital gains treatment and other allowances in respect of carry payments. Times will be interesting for tax practitioners too!
The authors believe that the Chinese curse will remain with us, and that the next few years will remain very “interesting” for all industry practitioners. What the industry will look like in five years time, however, remains less clear than ever before. A former premier of the PRC, Zhou Enlai, provides us with the relevant insight here. When asked about the significance of the French Revolution, he responded that it was “too soon to tell”. That certainly remains true of the significance of changes in the private equity fund industry taking place around us today.