Who's Who Legal brings together five of the world's leading private funds lawyers to discuss recent developments from the perspectives of Germany, Ireland, Hong Kong, the USA and Guernsey.
P+P Pöllath + Partners
Weil Gotshal & Manges
Who’s Who Legal: What has been the impact on fund managers and investment levels as a result of the introduction and proposal of legislation related to the regulation of private funds in your jurisdiction? Which countries are more attractive to investors as a result? How has this affected the nature of your practice?
David Dillon: For me the most challenging issue is to try and facilitate an informed debate with regulators and policy makers over the future direction of regulation of alternative products including private funds. The politicising of the discussion has made it very difficult to have rational debate about the issues. The AIFM Directive is an obvious case in point. There are a number of aspects to that Directive which, if implemented, could make the logistics of running a private funds strategy very difficult, not to mention the impact on third country access.
As regards developments that have been implemented, these have been mainly at the regulatory level and in some respects they reflect a change of emphasis by the regulator. The regulator is interacting with those they are regulating more than in the past. Fund promoters are receiving more communications requesting information and confirmations in relation to the regulator’s requirements. An example is in the area of corporate governance.
The impact at this point has not been too disruptive and the regulator still engages with industry on the development of products. Persuading the regulator to make policy changes to facilitate these developments is more of a challenge, but this I feel just reflects the changing attitude of policy makers worldwide.
The establishment of structures is more labour intensive and requires more patience on the part of the promoters. To put this in context however the typical structure used in Dublin is a Qualifying Investor Fund which can be established very quickly and so we are still very busy. The QUIF works on the basis of self-certification and so the timeline is not regulator dependent. Interestingly the regulator will be reducing the thresholds to qualify as a QUIF to bring it more in line with other jurisdictions.
Rory Gallaher: David hits the spot as usual. One point I would add is that there has been a breakdown of trust in the financial services industry generally since the global financial crisis which has spilled over to affect the fund management industry out of all proportion to its contribution to the crisis.
Andreas Rodin: The implementation of the AIFM Directive will have a very significant impact on the private funds industry in Germany as private equity managers as well as private equity funds have been unregulated in Germany. They will have to get used to a regulatory environment, which will include appointing custodians, having risk management teams in place, obtaining an authorisation, reporting towards regulators, etc. If no grandfathering is foreseen in the Directive, existing funds and managers will have to meet such requirements as well, which will have a significant impact on the costs to be borne by the fund and of course the manager. Whereas authorisation and manager compliance costs will have to be borne by the manager, custodian and fund-related reporting costs are typically costs to be borne by the fund (hence the investors). It is difficult to foresee the exact range of such costs at this stage, so investors can only be informed that costs may increase due to upcoming legislation. This may explain why currently there is a tendency to set up funds in Luxembourg as countries like Luxembourg already have regulation in place for private equity funds. Although AIFM relates to regulation of the manager some of the new costs are to be borne by the fund and in a Luxembourg structure they are – to a certain extent – already considered today (eg, custodian costs). We expect that transition will be easier for those countries with regulated private equity fund (and manager) regimes already in place than for countries that are completely unregulated.
Jeffrey Tabak: There has not been any noticeable impact in the United States on either managers, fundraising or deal activity as a result of the recently enacted Dodd-Frank Act and other current legislative or rule-making initiatives. Both fund managers and legal practitioners have been anticipating increased regulatory oversight for the past few years. Although many large private equity investment managers that have been able to remain exempt from registration with the US Securities and Exchange Commission will be required to register, this will not, by itself, affect their ability to raise funds or invest capital. There will, however, be more time and greater expense involved in complying with the new regulatory requirements.
Ben Morgan: There has been no impact on fund managers and/or investment levels as a result of the proposal of institutional funds legislation in the UK. We haven’t noticed a change to what we do in Guernsey as a consequence of this although Guernsey might be in a position to attract investors who are looking offshore as a consequence of the proposed legislation.
Who’s Who Legal: Our research has identified that, in the current climate, investors have the upper hand as there is more competition for investors’ money. Is this the case in your jurisdiction? What difficulties does this create for private funds lawyers and how are they best solved?
David Dillon: Ireland is a product manufacturing jurisdiction and the level of business is dependent on the amount of money that promoters can raise for the products. It is true to say I think that many investors are still hesitant to commit a large amount of capital to any investment funds but particularly private funds. For this reason there are fewer small promoters active in the alternative space. This may change as confidence returns.
One development which might help Dublin is the changing sentiment in some quarters from less regulated jurisdictions to regulated jurisdictions. To capitalise on that Ireland has introduced redomiciliation legislation to facilitate the moving of funds to Ireland. Personally I think this will mean more business in the private funds space for Ireland but I still see the traditional unregulated jurisdictions continuing to prosper.
Andreas Rodin: We have certainly seen an increasing number of comments and specific requests coming from investors when we advised general partners in setting up German-based venture capital and private equity funds over the past two years. Given the rather difficult fundraising environment, general partners had a hard time rejecting or limiting such requests – even in cases where they were considered as rather unreasonable or difficult to accept from a business perspective. At the same time, we have seen the relationship between general partners and existing investors grow stronger. Since existing investors very often had a long-standing business relationship with general partners, they would rather rely on the basis of trust which had been developed over the years and not request excessive or unusual amendments to the fund documentation or side letter provisions which were out of market. Generally, we have seen a rising awareness of investors regarding certain investor protection rights, such as key men provisions, for cause or no-fault removal clauses and the way potential conflicts of interest are handled. These principles are now backed up by the ILPA principles which have triggered an increasing awareness of investors in respect of specific investor rights.
Jeffrey Tabak: It has been interesting to see whether the negotiating power of limited partners would increase, given the downturn in the market. Last year, the Institutional Limited Partner Association published a set of principles for investors to use in negotiating terms of limited partnership agreements. Initially, we saw some limited partners ask their general partner relationships to describe how the general partners intended to respond to the guidelines in future fundraises. But, it appears as if the ILPA guidelines are being used on a very selective, not wholesale, basis, leading negotiations to be, as they had been in the past, individualised and based more on historic relationships between limited partners and the general partners, how the prior funds were structured, what terms had previously been agreed to and how the performance of the prior fund had been. We are seeing limited partners asking for more transparency and general partners have been more willing to accommodate such requests.
Ben Morgan: It is certainly the case in Guernsey that people are renegotiating fees and wanting side arrangements and more transparency in their investments. Fund managers are entering into specific and bespoke arrangements where possible with their investors to ensure their funds remain attractive. They might even enter into co-investment arrangement terms around a fund. In the current environment, the parameters of arrangements, including legal fees, can often be heavily negotiated with the investors. I would not say there were any difficulties for Guernsey fund lawyers, certainly not for Carey Olsen. We have always been able to adapt quickly to changes in the demands of our clients and, in today’s climate, that means demonstrating a greater degree of flexibility and adaptability and recognising that there will be more time involved in negotiating the documents.
Who’s Who Legal: Many lawyers we spoke to stated that trusted fund managers and those that offer unique investments, in addition to sovereign wealth funds, are most active. Do you agree with this analysis? What types of funds are best suited to current market conditions? What novel issues do these funds present to lawyers engaged in this sector?
David Dillon: I would agree with that statement. Other areas attracting interest are distressed credit strategies and on the hedge fund side the long/short market and more market neutral strategies relating to equities.
Rory Gallaher: Fundraising is still very tight in Asia, but there is considerable interest in yuan related investments and exposure. The Hong Kong government has set its sights firmly on establishing Hong Kong as the international trading hub for the renminbi outside the PRC. The Hong Kong Stock Exchange is considering introducing a separate class of shares denominated in renminbi next year. Charles Li, the chief executive of the exchange, has said the exchange may create a renminbi pool to provide liquidity. Liquidity is the key, as the renminbi remains a tightly controlled currency. The pool of renminbi deposits in Hong Kong is now estimated at 140 billion renminbi and is growing as rapidly as PRC conversion restrictions will allow.
Andreas Rodin: We have seen that, even in the aftermath of the financial crisis, experienced fund managers with a successful track record are able to attract capital of both existing investors as well as new investors. Often such fund managers focus on a specific industry segment (eg, healthcare or small cap and lower mid-market companies) or a specific investment strategy (eg, turnaround or buy-and-build). In general, the more successful funds tend to sharpen their investment strategy over the years and fund generations. While they may have focused on a wider region, broader market segment and less-focused investment strategy in the past, they tend to develop a more focused core investment strategy over the years. This increases their industry know-how and market contacts and often allows fund managers to generate proprietary deal flow with less competitive pricing. A good example for this are funds with a buy-and-build strategy that are able to get attractive prices for add-on acquisitions that might not be attractive stand-alone investments, but when added with other companies with complementary products under the umbrella of a holding company, such an investment ideally creates a situation where the value of the whole conglomerate is larger than the sum of its parts. Such buy-and-build funds bring along some novel German tax issues on which there is currently no guidance from the German tax authorities. Other successful funds are distressed funds as there is still a huge demand for post-crisis restructuring. Such funds (in particular if focusing on debt investments) sometimes trigger German regulatory issues (eg, bank licensing rules) that have to be addressed with caution. Foreign sovereign wealth funds do investments in Germany, but they tend to invest in public companies and are not as active in private equity deals as in other countries. This is often a matter of the size of an investment as such funds prefer larger investments due to the size of their portfolio.
Jeffrey Tabak: Funds with long-standing relationships in the limited partner community and with generally positive performance results in their prior funds continue to generate the most loyalty from their investors – not only in existing funds (in seeking amendments), but also when the sponsor starts to raise money for the next fund. We continue to see different strategies in the marketplace, but clearly there is a large focus on distressed funds.
Ben Morgan: It absolutely stands to reason that trusted fund managers are most active. This is always the case but in today’s market even more so. Those fund managers offering unique investments and who have a trusted reputation will naturally be more successful. We are certainly seeing more esoteric propositions coming forward such as student property or wind farms. This might partly be a result of investors being burned by some fund products – debt exposure, for instance. However, innovative fund managers are coming up with new ideas in terms of asset classes and law firms that are able and willing to adapt and meet the new requirements will thrive. While there is a greater demand for transparency from investors and a need for more flexible documentation, the new types of investment do not present any novel challenges for Guernsey’s legal services sector. Different models for how the funds are structured means we are looking at the work differently, adapting the documentation to meet the new demands and that’s interesting legal work rather than presenting any difficulties. Certainly the terms might be different in order to convince investors to invest but this isn’t an issue for us.
Who’s Who Legal: How have you maintained a successful private funds practice in difficult times? How have you sustained a strong client base? What kind of law firm is best suited to the current economic climate?
David Dillon: On this topic the ingredients for a successful practice have not changed. You need to be able to help clients develop new products, be responsive and you need to be adaptable. Clients expect you to be a lot more proactive and they expect you to keep them updated on industry developments in real time. There are so many changes taking place on the regulatory side as well as the business and investment side that planning is a constant challenge.
Andreas Rodin: In difficult but also good times it is of major importance to adapt a legal practice to the client’s needs. In order to understand the client’s needs it is important to have a hands-on approach. The requested products change rapidly and it will be the law firms which recognise the changing needs early enough and which are most flexible to reflect such needs in their daily practice. We believe in a “product related” approach; in other words, it is eventually the product which generates the practice which needs to be developed by the lawyer.
Jeffrey Tabak: When the emphasis has been less on quick fundraises and more on operational issues and negotiations over terms, the law firms with more experience (and often, as a result, better judgment) have continued to do well. And those with more established sponsors that have tended to be ones able to raise successor funds, continue to have a healthy pipeline of fundraises. In addition, our platform is to represent funds not only in formation and fundraising, but in deal execution (including mergers and acquisition, financings and capital markets), so our lawyers are sensitive to all the issues a client must deal with. And with offices around the world, we are able to offer additional expertise in whatever markets the private equity fund chooses to invest.
Ben Morgan: There is no question things have changed. Now more than ever law firms need to be utterly sensitive to clients’ pain. Very few major firms will not have clients experiencing some degree of impact from the global economic crisis. Clients need to be able to rely on advisers with whom they have a genuine relationship and that those advisers have sincere empathy that goes beyond fees and workload. Clients want to see lawyers who are prepared to go the extra mile, particularly if the fund is suffering or even in its death throes.
Sustaining a strong client base is a matter of ensuring the firm has the level of expertise needed and a breadth of experience across a range of funds. Carey Olsen has held its dominant market share in Guernsey funds work despite the challenging economic climate, has been involved in all major Guernsey fund launches throughout the period of uncertainty and has developed a reputation for high calibre work on a range of funds from the traditional to the new “clean tech” funds and emerging market work. Our strategy has always been to recruit the best to ensure we offer our clients a full service across all practice areas. Indeed, we have just recruited a partner in what is considered the biggest hire in Guernsey in 2010.
Who’s Who Legal: How will the private funds industry develop in the coming years? What difficulties do private funds lawyers face in the future? How will you respond to these challenges?
David Dillon: At this point the future will be determined by the outcome of the regulatory debate and the impact of the AIFM Directive and the Dodd-Frank Act. Unless there is some cooperation between the many regulatory points of view especially between Europe and the US the industry could be the meat in sandwich.
Hopefully the hysteria will die down and a more balanced approach will be adopted.
Rory Gallaher: I think our biggest challenge is that we are facing politically driven regulation which will have long lasting consequences which those sponsoring the legislation are either unable or unwilling to recognise.
Andreas Rodin: Higher costs will possibly lead to bigger funds as small fund managers may not be in a position to bear the substantial costs that arise in connection with the additional regulation. Also on the fund side, costs will increase. There will certainly be additional needs for advice in such a highly regulated environment. Especially in the years immediately following the implementation of the Directive there will be a number of uncertainties on how the new rules will be applied and interpreted in practice. This becomes even more severe in the absence of grandfathering. Hence, in future, a constant exchange with the regulators will be required locally but also internationally as funds and their managers operate typically on a cross-border basis.
Jeffrey Tabak: I believe that the private equity asset class is based on a sound economic model that will survive and prosper in the future. There continues to be significant capital to be invested for potentially higher returns than might be obtained over the longer term in the public markets. Smart entrepreneurs will continue to develop strategies that will attract institutional capital, and I have every confidence that the private funds industry will continue to grow in the coming years. It may, however, be the case that we see some shake-out and consolidation among private equity sponsors, so from a law firm perspective maintaining relationships with the principals at each fund is critical as is continuing to build a diversified client base. Of course, superior client service and reputation will continue to set service providers apart.
Ben Morgan: The biggest challenge for the future is regulation. It does look as if regulation will adversely impact on the ability to operate a fund in a fiscally efficient manner – keeping costs and regulation and taxes low. The impact of the AIFM Directive is yet to be known but we do know the environment will be more challenging for our clients and therefore for the law firms. We will respond to these challenges by consistently applying the model that appeases the regulator and meets the demands of fund managers.