Since the Securities and Exchange Commission has recently taken an increasingly closer look at the activities of private equity and venture capital fund managers, it is more important than ever for fund managers to understand when conflicts of interest are likely to arise and how to manage them properly. The SEC has expressed concern about conflicts of interest inherent in the private equity business model and has brought several enforcement actions against private equity fund managers in the last couple of years that mostly focus on direct and indirect compensation to managers or advisers that were not properly disclosed to the fund’s investors. Since the SEC takes the position that fund managers and advisers owe a fiduciary duty of loyalty to act in the fund’s best interest, fund managers must keep a close eye on potential conflicts of interest and employ best practices like consulting advisory committees whenever possible conflicts arise.
How Conflicts of Interest Arise in Private Equity and Venture Capital Funds
Whether a fund is raising capital commitments from investors, investing in portfolio companies, or divesting its assets, conflicts of interest issues can arise. Since fund managers are in the business of providing asset management services, they often manage more than one investment vehicle at a time. In those situations, regulators are prone to take a closer look at whether the adviser is complying with its fiduciary duty to act in the best interest of each fund and its investors. Although it would be very difficult to identify all the scenarios where fund managers may face conflicts of interest, some of the most common include:
- Fundraising – A conflict of interest can arise between a fund manager that seeks to maximize the size of the fund in order to increase the amount of management fees generated by the fund and the fund’s investors that seek to limit the size of the fund to ensure that the capital raised is deployed more selectively.
- Valuation – The methodology used for valuing portfolio companies can affect the amount of management fees the fund manager receives as well as affect fund performance numbers, so the fund manager can face significant conflicts of interest when making decisions regarding the selection of such methodologies.
- Co-Investment – Co-investment situations arise where the fund manager, individual investors in the fund, or other funds affiliated with the manager have the opportunity to separately invest in one of the fund’s portfolio companies. If the terms under which the fund manager or such other investors invest differ from the terms under which the fund invests, significant conflicts of interest can arise in the course of negotiating the fund’s investment.
- Competing Funds – When a fund adviser is affiliated with more than one fund, it must determine which investment opportunities will be offered to which fund and when, and determine which fund gets priority at any given time.
- Navigating Affiliated Transactions – Transactions might arise between the fund manager or its affiliates and the fund itself or its individual investments. The fund manager would face a conflict of interest if it approved such transactions on behalf of the fund.
- Fees and Expenses – A fund manager must be careful to allocate transaction expenses and broken deal expenses between the fund, the fund manager, and any co-investors in accordance with the fund’s limited partnership agreement and in accordance with reasonable investor expectations.
- Inter-Fund Sales – When a fund exits an investment, it’s not uncommon for that fund to sell its assets to another fund that shares the same fund manager, creating a potential conflict of interest for the manager in determining the terms of such sale.
- Dealing with Investor Defaults – If an investor is unable to make the investment after the manger makes a capital call, the manager typically has discretion in determining what remedies the manager will use against the defaulting investor. The fund manager’s relationship to that investor may cause the fund manager to face conflicts of interest in the enforcement of such remedies.
Strategies for Managing Conflicts
Fund Limited Partnership Agreements
The scenarios where conflicts of interest can arise are varied and unpredictable; therefore, it is essential to have the proper mechanisms in place to handle such conflicts. Procedures for handling conflicts should be established before the fund is formed in the fund’s limited partnership agreement. The limited partnership agreement – or operating agreement if the fund is structured as a limited liability company – is the foundational document governing the relationship between the fund and its manager and outlining the manager’s duties with respect to the fund. A well-drafted limited partnership agreement that establishes appropriate mechanisms for resolving conflicts can assist in attracting sophisticated investors that look for certain provisions in fund formation documents. For example, on the issue of competing funds, the limited partnership agreement may lay out certain exclusivity terms that will curtail the fund manager’s activities with competing funds during the fund’s investment period. It can also establish priorities for when and how managers offer investment options to competing funds, or set forth guidelines for handling certain affiliated transactions. The limited partnership agreement can also avoid potential conflicts surrounding fund-raising by including an agreed-to cap on the size of the fund going in.
Limited Partner Advisory Committees
Perhaps the best tool a private equity or venture capital fund can establish to manage its conflicts of interest is an limited partner advisory committee, which is a group of fund investors, or investor representatives, that represent the interests of the investors. The fund’s limited partnership agreement establishes the existence and authority of the limited partner advisory committee, and fund manager can rely on this tool for guidance in handling any issues or conflicts that might arise. When conflicts arise, the fund manager can disclose the nature of the conflict to the committee, and if the committee approves, the manager has the certainty it needs to move forward with contemplated activity. Issues for the committee to weigh in on include related-party transactions, valuation methodologies, management fees, and setting uniform procedures for imposing default fees.
Given the nature of the private equity/venture capital fund business model, it’s not possible to foresee and prevent all possible conflicts of interest that might arise over the lifespan of a fund. However, through a properly-drafted limited partnership agreement and the creation of a limited partner advisory committee, funds can make great strides toward implementing a structure for dealing with potential conflicts that will alleviate the risk of possible regulatory scrutiny down the road.
© 2017 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.