The spread of the coronavirus (COVID-19) continues to impact global financial markets and private funds. Institutional investors, funds-of-funds, family offices, and other investors in private funds should consider the economic exposure to their private fund investments from operational disruptions that may occur as a result of the pandemic.
Key issues to focus on and discuss with private fund managers:
- Has the fund manager reviewed its business continuity/disaster recovery plan in light of its fiduciary duties?
- Has the enactment of new laws or regulations in countries in which the private fund is conducting operations and investments had an adverse effect on those operations and investments, and are the private fund and its portfolio companies in compliance with all such laws and regulations?
- Has the fund manager considered the implications of COVID-19 on critical operational relationships with key service providers (e.g., custodians, administrators, brokers, sub-advisers, auditors)?
- Given that many private fund fiscal years end on December 31, will the preparation and disclosure of annual audited statements and tax information for 2019 be delayed?
- Have any key persons of the manager (including front office and back office) been unable to meet their obligations to the manager as a result of COVID-19? If yes, has this triggered a “key person event” under the fund documents; has this been communicated to the investors in a timely manner; and have any mitigation plans been communicated or discussed with any investor advisory board or the investors?
- Given the restrictions placed on travel, many private funds have held and are holding investor meetings by telephone and videoconference. Are investors being given sufficient notice and opportunity to attend these meetings? Are these meetings offering a sufficient opportunity for meaningful dialogue between investors and sponsors regarding operational and performance issues?
- Has the fund manager commented on whether there has been an impact on current transactions involving the sale or purchase of portfolio companies?
- If a private fund investment involves a liquid strategy, is the investor familiar with the redemption and liquidity terms, together with the circumstances under which redemption gates may be implemented or redemptions or valuations may be suspended?
- If a private fund has mostly illiquid assets or is in a post-investment period stage, has the fund manager provided an update to the investors with respect to the current and projected impact on performance of the fund’s portfolio companies and assessed the current and projected potential impact on the valuation of portfolio companies in certain industries that are adversely affected by the virus?
Key issues for institutional investors to focus on with respect to internal governance:
- Internal approval process – if in-person meetings are not permissible or advisable, are there alternate means available for investment committees and other internal approval bodies to meet and make and record their decisions?
- Document execution – are processes in place to ensure that signatories remain available even if offices are closed? If original signed documents are required to close a transaction, are there resources in place to ensure that originals may be transmitted between locations?
- Investment obligations – if offices are closed, will an investor still be able to satisfy capital calls and receive distributions in cash and in kind? If the ability to meet capital calls is restricted, close attention should be paid to the default provisions in relevant fund investment documents, including the cure provisions, if any.
- KYC/AML requirements – if an investor is required to provide KYC/AML documents in connection with an investment, are such materials readily available electronically, including certified copies if required?
- As global markets endure significant turmoil related to COVID-19, institutional investors with mandated alternative investment restrictions and alternative asset allocation caps should ensure that they continue to comply with these restrictions and allocation caps.
- Investors with force majeure clauses in their side letters or other fund documents should consider the implications of such clauses.
Key impacts in the private fund secondary market:
- Given the volatility in the public markets, institutional investors should review their portfolios to determine whether the public market decline has resulted in an over allocation to illiquid investments and, accordingly, whether a secondary sale may be warranted to rebalance their portfolios.
- Consideration should be given to whether investment restrictions apply only at the time of investment, or whether certain restrictions have continuous application.
- Traditional secondary transactions are typically priced as a percentage of a seller’s reported capital account in the underlying funds as of an earlier quarter-end date. Given the overall market volatility, fund managers may need to write down valuations in subsequent quarters. Furthermore, there is often a delay from the time a purchase agreement is signed until a transfer closes. Accordingly, buyers may seek purchase price protection to mitigate downside risk of any further market disruptions. This protection may take various forms, including the insertion of a “material adverse change” closing condition in the purchase agreement, performing additional due diligence at an earlier stage, and delaying the signing of a purchase agreement or effectuating a simultaneous “sign-and-close” (to reduce the impact of market declines after the signing of a purchase agreement and before closing).
- As a result of the recent market disruption, the execution risk of consummating a secondary transaction has increased. Sellers may consider ways to bind buyers at the letter of intent stage or to negotiate additional key terms of the purchase agreement prior to agreeing to any exclusivity rights in favor of buyers. Furthermore, sellers may seek additional diligence on the creditworthiness of buyers and whether they intend to finance the transaction through borrowings.
- Sellers and buyers may want to consider whether representation and warranty insurance is warranted, depending on the creditworthiness of the counterparty.
- Sellers that are owed any deferred purchase price payments pursuant to already-consummated secondary transactions should review their purchase agreements to determine whether any acceleration of any deferral has been triggered and should continue to monitor whether there is a possibility of default on payment.
- To the extent that deal volume increases after the market stabilizes, there is a potential that any backlog will lengthen the queue for transferring interests in funds maintaining compliance with certain safe harbors to avoid being treated as “publicly traded partnerships” for US federal income tax purposes.
- Given the recent volatility, to the extent that funds face difficulties in exiting investments, “GP-led” secondary transactions, including single asset restructurings, and other bespoke transactions may be useful in providing liquidity in the market. However, social distancing, flight cancellations, and other travel bans may impede buyers from performing the requisite diligence of any such portfolio companies.
- In the event that managers face difficulties in fundraising during this period of market decline, they may require buyers to make capital commitments to new funds as a condition to approving transfers in existing funds (i.e., there may be an increased use of “stapled” secondaries).
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. For further information, please contact any member of our task force or any of the following leaders of Morgan Lewis’s investment management practice.
If you have any questions or would like more information on the issues discussed in this LawFlash, please contact any of the following Morgan Lewis lawyers:
Christopher J. Dlutowski
Jedd H. Wider
Joseph D. Zargari
Sarah E. Connolly
Gregg S. Buksbaum
Courtney C. Nowell
Richard A. Goldman
Daniel A. Losk
Stephen C. Tirrell
Gerald J. Kehoe
Carrie J. Rief
Peter M. Phleger
Jarrod A. Huffman
William L. Nash III
Alishia K. Sullivan
Ayman A. Khaleq