The spread of the coronavirus (COVID-19) continues to impact global financial markets and private funds. Private investment fund managers should consider—in addition to the potential economic exposure from unsteady financial markets—numerous risks to their businesses and the funds they manage from operational and other disruptions that may occur as a result of the global pandemic.
KEY ISSUES FOR PRIVATE FUND MANAGERS
While fund managers are focusing on the impact of the COVID-19 virus on their portfolios, they should also keep in mind the range of industry-specific issues that have arisen as a result of this pandemic. In particular, managers should consider taking the following non-exclusive list of actions:
Monitor Business Continuity. Make sure that portfolio management, operations, and compliance functions can be seamlessly performed remotely
- Test the internet connections in each remote location to ensure they are robust enough to carry trading instructions and data as effectively as from the office trading desk.
- Test the office VPN to confirm it is handling the additional load of remote access.
- Test the security of internet connections to avoid data breaches.
- Test the power supply to ensure it continues to be adequate for a full working load, and obtain generators as needed.
- Confirm that data service licenses such as Bloomberg and other research services permit access from remote locations and extend permitted locations/users as needed.
- Designate back-up personnel who can substitute for all members of trading, back-office, reporting, and management teams.
- Review employment agreements and personnel manuals to determine the requirements, conditions, consequences, and other issues related to working remotely. Consider, in particular, issues relating to personal privacy and confidentiality and how regulatory recordkeeping requirements will be satisfied.
- Confirm that all personnel have the equipment necessary to perform their responsibilities and are able to access all programs and necessary files.
- Personnel responsible for testing and monitoring aspects of business continuity plans should periodically discuss how the business continuity plan is functioning and make suggestions for enhancements.
Prepare to Address Investors’ Concerns. Be ready to answer questions and have the following in place to field investor concerns:
- Designate a point person for coordinating all investor/public communications and appoint a spokesperson to handle all such communications.
- Prepare a script for responding to inquiries from investors who want to know what measures are being taken to keep operations, compliance, and portfolio management functions running smoothly.
- Prepare a script for responding to inquiries from investors regarding the health and availability of portfolio managers and other key employees. Certain laws may prevent full disclosure of confidential health information.
- Make sure, as in-person meetings are no longer permissible or feasible, that contracts are in place for hosting virtual meetings and that back-up solutions are available in case primary means are not functioning properly due to, for example, system overload.
- Consider more frequent communications to all investors to keep them updated.
Review Key Person Provisions: It will be important to review “key person” provisions in management agreements, partnership agreements, offering materials, and side letters to ensure that working remotely or potential illnesses to key persons do not trigger notification requirements and either suspension of the investment period or accelerated withdrawals. We recommend the following actions:
- Verify that if portfolio managers and other key persons test positive for the virus that they will still be able to perform their functions adequately and will not be considered “incapacitated,” as that term is defined in the applicable key person provisions. Note that the mere fact of a COVID-19 diagnosis of a key person (absent extended incapacitation) would not typically give rise to a key person triggering event requiring notice to investors.
- Prepare a script for response to inquiries from investors on whether key person provisions have been triggered and determine when written notification to investors is required or otherwise advisable.
- If circumstances so require, fund managers may also consider discussing with investors or investor advisory committees the feasibility of seeking approval of additional or replacement key persons, or succession plans to avoid or remedy, as applicable, the occurrence of a key person event and, if applicable, to lift the suspension of the investment period.
Confirm Service Provider Business Continuity. Confirm that the business continuity plans of key service providers are functioning properly in order to continue to deliver uninterrupted services and have fully shared contact data and authorization for accepting calls, emails, and other correspondence from remote locations. Key service providers include the following:
- Independent Directors (particularly to confirm their availability and keep them updated as needed)
- Prime Brokers, Clearing Firms, and Custodians (particularly to ensure that International Swaps and Derivatives Association (ISDA) master agreements, repos, and other essential financial arrangements are not terminable as a result of the coronavirus, and negotiate waivers if there are any doubts)
- Administrators (particularly to ensure that NAV will be calculated and reported accurately and on a timely basis)
- Auditors (particularly to ensure that audited financial statements will be issued on a timely basis)
- Tax accountants (particularly to ensure that tax reporting will be made on a timely basis)
Assess Valuation and Liquidity. Consider the following issues associated with portfolio assets:
- Determine whether the market prices for liquid assets are reasonable, or if certain assets should be fair valued to provide a more realistic valuation.
- Ascertain whether certain liquid assets should be reclassified as a result of the current crisis.
- Review fund governing documents for side pocket provisions, including whether there are caps to consider. Consider whether existing internal policies regarding illiquid assets are adequate if illiquid assets are increasing as a percentage of the fund portfolios.
- Review fund governing documents and side letters regarding redemptions and determine what tools are available if restrictions need to be imposed (e.g., gates, distributions in-kind and suspensions).
- Consider whether accepting subscriptions should be temporarily suspended, including due to uncertainty about the markets and valuation.
Private Equity, Venture Capital & Other Closed-End Funds
- Review clawback terms, particularly for interim clawback and escrow provisions affected by portfolio valuations.
- Review capital-call default provisions in anticipation of investors facing their own liquidity issues.
- Review in-kind distribution provisions and related side letter provisions given to investors to determine the character of securities that can be distributed (i.e., marketable vs. non-marketable) during a particular point in the lifecycle of a fund and the mechanics for dealing with such distributions, as disruptions in the markets may have an impact.
- Review terms for the extension of the commitment period if capital deployment stalls, the fund term if liquidation events are delayed, and fundraising periods if commitments slow down.
Furthermore, fund managers may be required to seek exit opportunities for illiquid investments for a variety of reasons (including, in the case of a closed-end fund, upon the expiration of such fund’s term, or, in the case of an open-end fund, to satisfy redemption requests). During a time of market disruption, sales of such investments may be unattractive, as they can yield lower prices. Managers should therefore consider whether to engage in “GP-led” secondary transactions or other bespoke transactions to provide liquidity to current investors, while allowing remaining investors and/or the managers to capitalize on the future upside of an investment. These transactions can take various forms, including single- or multi-asset spinouts into new vehicles.
Assess Potential Delay of Financial Report Delivery. Review all reporting requirements set forth in fund offering and governing documents and agreements such as side letters in order to determine whether
- investors will need to be advised that delivery of quarterly and annual reports, audited financial statements, and tax reports may be delayed due to the impact of the crisis on service providers and/or, if applicable, delay in the receipt of financial information from any portfolio company; or
- waivers or extensions of delivery timeframes need to be sought, as set forth in these documents and agreements.
Consider New Risk Factors for Offering Documents. New launches and updates to existing offering documents should include one or more risk factors relating to the effects of COVID-19 on private funds and their managers. Managers should also consider supplementing existing offerings with risk factors. Risks could address, among other things: (1) The impact of the virus and market volatility on fund performance; (2) the possibility of significant breakdowns, delays, and other disruptions to the economy, systems, and reporting; (3) governmental interventions implemented on an “emergency” basis, including potential limits on certain trading, including short sales; (4) liquidity constraints; (5) potential difficulties to source, conduct diligence on, monitor, or exit investments; (6) potential insolvency of counterparties; and (7) the possibility that working remotely will not be effective.
Existing risk factors in offering documents should be reviewed and updated as necessary in light of recent events. Most registered managers are in the process of filing their annual Form ADV amendments. Consideration should be given to including COVID-19-related risk factors in Part 2A, Item 8.
Review Material Agreements. Material agreements with trading counterparties, key service providers, seed and other strategic investors, and investors generally (including side letters) should be carefully reviewed. We recommend the following:
- Prepare a list of items that could trigger a default or accelerated termination and periodically review the list.
- Review agreements with investors to determine under what circumstances investor rights may be triggered (e.g., notice or accelerated withdrawal rights could be triggered in the case of hedge funds, and covenants to provide compliance statements in the case of private equity funds).
- Review agreements to determine whether the COVID-19 crisis constitutes a “force majeure” event (For more on this issue, read our February 2020 LawFlash, Can Companies Invoke the Force Majeure Clause in the Context of COVID-19?).
Assess Compliance Infrastructure. Review compliance policies and procedures and ensure that designated persons are able to continue to perform these important functions:
- Review filing deadlines and determine if extensions have been granted by applicable regulatory authorities and the conditions for such extensions (see below discussion).
- Confirm that all personnel have remote access to compliance policies and procedures, codes of ethics and restricted lists, and are able to continue to timely submit forms, including quarterly reports and pre-clearance forms, and ensure that the manager continues to monitor compliance with these policies.
- Ensure that, if compliance policies and procedures provide for meetings of various committees (e.g., risk, valuation, and compliance), such meetings will occur by phone or videoconference, that proper materials are provided in advance, and that minutes of each meeting are prepared.
Gauge the Ability to Meet Regulatory Filing Requirements. Managers will need to consider how to comply with certain regulatory filings and related requirements in light of potential COVID-19 business disruptions.
Note that the US Securities and Exchange Commission (SEC) recently issued an order granting relief relating to the Form ADV and Form PF filing and delivery requirements. In issuing this relief, the SEC stated that it recognizes the challenges registered investment advisers and exempt reporting advisers (Advisers) may face as a result of COVID-19, including disruptions to transportation and the imposition of quarantines around the world that may limit access to facilities, personnel, and third-party service providers.
The relief provided under the Advisers Act (Advisers Act Order) provides up to an additional 45 days for Advisers to satisfy the filing and delivery requirements for the items set forth below, provided that, among other conditions, reliance is necessary or appropriate due to circumstances related to the current or potential effects of COVID-19:
- Amendments to Form ADV required to be filed by registered investment advisers under Rule 204-1 of the Advisers Act, or reports required to be filed by exempt reporting advisers on Form ADV part 1A under Rule 204-4
- Amended brochures, brochure supplements, or summaries of material changes required to be delivered by registered investment advisers to clients under Rules 204-3(b)(2) and (b)(4)
- Form PF filings required to be made by registered private fund advisers under Section 204(b) and Rule 204(b)-1 of the Advisers Act
The Advisers Act Order also requires that an Adviser relying on the order promptly provide the SEC via email at IARDLive@sec.gov (with respect to the filing of Form ADV or delivery of its brochure, summary of material changes, or brochure supplement) or at FormPF@sec.gov (with respect to filing Form PF) the following:
- Notice that it is relying on the order
- Brief description of the reasons why it could not make the required filing or delivery, as applicable, on a timely basis
- Estimated date by which the Adviser expects to make the required filing or delivery, as applicable
In addition, an Adviser relying on the Advisers Act Order with respect to the filing of Form ADV or delivery of its brochure, summary of material changes, or brochure supplement must disclose the aforementioned information on its public website (or if it does not have a public website, promptly notify clients and/or private fund investors).
Note: This relief is limited to filing or delivery obligations for which the original due date is on or after the date of the Advisers Act Order but on or prior to April 30, 2020.
In addition, the staff of the SEC’s Division of Investment Management (SEC Staff) issued a FAQ indicating that Advisers are not required to update either Item 1.F of Part 1A of Form ADV or Section 1.F of Schedule D to include temporary teleworking addresses of its employees, so long as the employees are temporarily teleworking as part of the firm’s business continuity plan due to COVID-19.
The SEC also stated that it will continue to monitor the current situation and may be willing to extend the time period for relief or provide additional relief as circumstances warrant. To the extent you have questions or would like us to raise particular issues with the SEC Staff, please let us know.
ADDITIONAL ISSUES FOR PRIVATE FUND MANAGERS TO CONSIDER
In light of COVID-19, private fund managers must consider whether annual fund audits may be delayed, which could impact a manager’s ability to comply with Advisers Act Rule 206(4)-2 (Custody Rule). While neither the SEC nor its staff have issued relief or guidance with regard to audits to date, we are hopeful they will provide additional deference to managers (and their accounting firms) that may find it impracticable to complete audits and distribute audited financial statements in a timely manner in accordance with the Custody Rule, in light of COVID-19-related disruptions. The SEC Staff has already updated its Custody Rule FAQ to address one COVID-19-related issue. Specifically, Custody Rule FAQ II.1 was updated to state that to the extent an Adviser inadvertently receives funds or securities from clients at an office location that is temporarily closed due to the firm’s business continuity plan in response to COVID-19, the SEC Staff would not consider the Adviser to have received client assets until firm personnel are able to access the mail or deliveries at that office location.
Each manager should consider whether the manager and any fund administrator has the technological capabilities and appropriate procedures for investors, manager personnel, and administrator personnel to complete subscriptions, process transfers and redemptions, and execute fund agreements using electronic signature capabilities, and whether existing powers of attorney may be utilized for certain purposes. In particular, managers should consider whether their procedures would comply with the Electronic Signatures in Global and National Commerce Act (E-Sign) and applicable state law. Given the potential unavailability of notaries, managers should also review whether any notary requirement can be waived.
Many managers of private funds already have robust and tested business continuity plans that permit their personnel to continue to manage assets remotely in an uninterrupted manner. Others with employees working in an office, to the extent permissible, may have implemented policies to seek to prevent the spread of COVID-19. In any event, there are business considerations and legal requirements (often at the state and local level) that managers need to be mindful of with respect to their employees, including antidiscrimination and privacy laws, safe workplace obligations, potential business travel, and potential furlough and layoff issues. Visit our Coronavirus COVID-19 resource page for information about employee-related issues to consider.
As credit facilities are typically a key source of liquidity for funds, fund managers should be fully aware of any limits, covenants, and other obligations with respect to the fund's credit facilities. Even for funds that do not regularly use their credit facilities, but simply have them in place for unforeseen situations, the COVID-19 global pandemic may be such a situation, and fund managers should understand any limitations that may be in place for accessing such facilities.
In considering a fund's short-term and long-term liquidity needs (including situations where a fund may want additional liquidity to take advantage of opportunities in the market), fund managers should review the fund's credit facilities to determine what, if any, action needs to be taken or considered in light of anticipated liquidity needs. Managers may want to pay particular attention to whether
- the credit facility is committed or uncommitted and whether the lender has any discretion in determining when (and if) to lend. To the extent the credit facility is uncommitted or discretionary, the fund may want to consider approaching its lender to determine if switching to a committed facility (so that it is assured the lender will fund requested borrowings so long as the fund is in compliance with its obligations under the documentation) is feasible or may want to consider borrowing in anticipation of future needs;
- the maturity date of the facility or any other trigger provides the lender with rights to demand repayment of the loans or terminate the facility prior to a set maturity date. If a maturity date is approaching, the fund manager may want to consider requesting an early renewal so there is certainty that the facility will remain available to the fund;
- any provisions exist in the credit facility that may limit availability, including borrowing limitations tied to a valuation of the fund's assets or other funds’ performance (including NAV triggers) or, in the case of a private equity fund, tied to the rating or other creditworthiness of investors;
- covenants exist that, if breached, could result in no additional borrowing availability and an acceleration of outstanding obligations. To the extent a fund expects it may have trouble complying with certain covenants as a result of the implications of the COVID-19 pandemic, the fund manager may want to consider proactively discussing these concerns with the lender and possibly obtaining covenant relief if issues do arise;
- any other provision appears in the loan documentation that may relieve a lender from its obligation to lend and/or may give the lender the right to accelerate. These would include covenants and defaults tied to a "material adverse change" or events that could be expected to have a "material adverse effect" on the financial condition of the fund, or a force majeure clause; and
- the credit documentation provides the fund any ability to retire the fund's debt at a discount or use loan proceeds to make what the fund believes to be opportunistic investments (and, if not, determining whether to approach the lender to request the ability to do so).
Derivatives and Counterparty Arrangements
Managers should consider the repercussions of COVID-19 on both cleared and uncleared derivatives transactions. For both cleared and uncleared derivatives transactions, managers should be in frequent contact with their counterparties and futures commission merchants to understand how the impact of the virus may affect a party’s ability to perform under the relevant contract or even its ability to communicate. In order to appropriately address events related to the virus as they unfold, managers will need to avoid unintentional events of default and other termination events. Conversely, managers may need to be able to declare events of default and termination events with respect to the counterparty if necessary. Below are some recommendations for managers:
- Ensure that the notice provisions contained in the transactional documents are current. They should also be aware that not all notice provisions permit a notice to be delivered by a means other than physical delivery and that physical delivery may not be possible in some circumstances due to the virus and its possible effect on delivery services.
- Consider how performance would continue under a contract if a particular office of the manager or a counterparty were to close.
- Refresh your understanding of force majeure and illegality clauses so that they can anticipate whether those clauses might apply, thereby preventing or delaying contractual performance. Even if a contract does not contain such clauses, managers should understand the relevant common law doctrines of force majeure, impossibility, impracticability and how those might affect contractual performance.
- Understand that, for futures and cleared swaps, clearinghouses may unilaterally increase margin requirements and may require the transfer of additional margin prior to the end of the day that the margin call is made. Frequent communication with the futures commission merchant will be imperative to stay current with margin requirements as they change due to changes in volatility in the underlying market. For uncleared derivatives transactions, margin requirements may also change unexpectedly, especially in cases where margin is based upon portfolio margining structures.
- Review, if able to negotiate lock-up provisions in prime brokerage arrangements, the terms of those provisions to see under what circumstances the lock-up may disappear. Managers should consider the negative impact that the loss of a lock-up could have on its desired trading activity.
- Consider the preferred action plan—where contracts contain credit rating triggers—if such triggers apply. In some cases it may not be beneficial to exercise termination rights if such triggers apply. In other cases the manager may have no choice but to exercise termination rights if such triggers apply.
- Keep in mind that not all counterparties may be able to withstand severe market stress and may fail. Accordingly, managers should understand how the insolvency of a counterparty might unfold and what the rights against an insolvent counterparty might be, including the nature of the proceeding and any stays of remedies that may apply.
CORONAVIRUS COVID-19 TASK FORCE
For our clients, we have formed a multidisciplinary Coronavirus COVID-19 Task Force to help guide you through the broad scope of legal issues brought on by this public health challenge. We also have launched a resource page to help keep you on top of developments as they unfold. If you would like to receive a daily digest of all new updates to the page, please subscribe now to receive our COVID-19 alerts.
If you have any questions or would like more information on the issues discussed in this LawFlash, please contact any of the following members of Morgan Lewis’s investment management practice:
Thomas V. D’Ambrosio
Christopher J. Dlutowski
Jedd H. Wider
Joseph D. Zargari
Gregg S. Buksbaum
Courtney C. Nowell
Marion Giliberti Barish
Katherine Dobson Buckley
Richard A. Goldman
Gerald J. Kehoe
Daniel A. Losk
Stephen C. Tirrell
Timothy W. Levin
Christine M. Lombardo
John J. O’Brien
Louis H. Singer
Ethan W. Johnson
Miranda Lindl O’Connell
Peter M. Phleger
Jarrod A. Huffman
Carrie J. Rief
Christopher P. Wells
William L. Nash III
Alishia K. Sullivan
Ayman A. Khaleq
 Order Under Section 206A of the Investment Advisers Act of 1940 Granting Exemptions from Specified Provisions of the Investment Advisers Act and Certain Rules Thereunder, Investment Advisers Act Rel. No. 5463 (Mar. 13, 2020).