The small print on alternatives
Pension schemes spare no expense buying ‘proper advice' on investment matters - but often neglect to seek it on their investment vehicles. Winston Penhall outlines the legal niceties of private equity and hedge fund investments
European pension scheme trustees are required to invest pension scheme assets in accordance with the prudent person rule set out in the IORP Directive (Directive 2003/41/EC) and the statement of investment principles of the scheme. In exercising their investment discretion, pension scheme trustees are required to:
• Act in the best interests of members and beneficiaries;
• Secure the security, quality, liquidity and profitability of the scheme's portfolio as a whole;
• Invest predominantly in securities admitted to trading on regulated markets, with other investments being kept to prudent levels;
• Allocate investments with a view to diversification.
In the UK, trustees are required under Section 36 of the UK Pensions Act 1995 to take "proper advice" in making investment decisions, which is accepted to mean advice from an actuary, financial adviser or investment manager. While pension schemes will appoint law firms to advise on pensions law, structuring and corporate law issues, they do not, as a matter of course, appoint them to review legally structured investments. As a legal review will generally not include commentary on the viability of the investment thesis of the investment manager or its past performance, some schemes may take the view that a legal review is not required.
This article seeks to provide scheme professionals with an outline on what a legal review of private equity and hedge fund investments (‘alternative funds' for the purpose of the article) encompasses and some of the issues that may arise from that review. Trustees of pension schemes should assess on a case-by-case basis whether a legal review of an investment is desired.
There is no internationally accepted definition of a hedge fund. However, in broad terms, a hedge fund is a non-retail, non-UCITS open-ended fund, often structured as a corporate vehicle or limited partnership, typically established in a low or no-tax jurisdiction, which can employ leverage and trades assets comprised of a mix of listed, unlisted and over-the-counter instruments.
Private equity funds share a number of characteristics with hedge funds, in that they are not UCITS funds, are usually structured as companies or limited partnerships, are usually unregulated onshore and employ leverage. However, for the purposes of this article, the principal differences are that private equity funds:
• Are ‘closed ended';
• Usually do not require full investment on closing. Investors agree to make a capital commitment which will be drawn down, usually on 10-14 days' notice, during a 3-5-year period called the ‘investment period'. Investors may be required to make capital contributions after termination of the investment period to fund follow-on investments, advisory fees, costs and expenses and indemnification liabilities;
• Subject investors to draconian penalties if they default by failing to comply with a drawdown notice or breach the terms of the fund's constitutional documents. This may include forfeiture of the entire investment or a compulsory sale of the investor's interest in the fund at a significant discount;
• Invest predominantly in unlisted assets or listed shares of trading companies with a view to taking the company private. As the underlying fund assets are usually unlisted, they are usually carried at book value until a disposal or deemed disposal occurs; and
• Can be established as a limited partnership in the UK.
The documents that legal counsel will review are similar for both categories of alternative funds and comprise the fund's prospectus; constitutional documents (the limited partnership agreement or memorandum and articles of association); and subscription agreement for shares or limited partnership interests.
The financial advisers and investment professionals of a scheme will typically conduct due diligence on the investment manager of the alternative fund, its strategy and service providers to assess the overall risk of the investment. Their review may lead to the negotiation of commercial terms like preferential management and performance fees or reporting rights.
Hedge funds are open-ended so their constitutional documents and prospectuses will not be directly negotiated or amended on each dealing day. The investor and its counsel may consider negotiating additional terms that may include:
• A ‘most favoured nations' provision to give comfort on preferential terms granted to others;
• Comfort on liquidity provisions;
• Comfort on the fund making redemption or liquidation payments to investors in securities rather than cash;
• Disclosure of material events such as changes to fund documents, litigation or regulatory action against the investment manager;
• Negotiation of the subscription indemnity granted by the investor. Sponsors of pension schemes that are insurers and who will be subject to the Solvency II Directive might be sensitive to uncapped liability or indemnification indemnifications.
The commercial and legal approach to a private equity investment is different to a hedge fund allocation for a number of reasons:
• The investor cannot withdraw or redeem if it is unhappy with the way the fund is operated. The commercial and legal review and any side letter therefore need to be comprehensive;
• Investors subscribing at first closing will typically negotiate the limited partnership agreement or memorandum and articles of association in detail. These documents are lengthy and ideally should be reviewed by in house or external counsel;
• The investment manager and its affiliates may receive fees such as break, deal and underwriting fees in addition to the advisory fee and carried interest. Investors may want to negotiate a partial or entire offset of these additional fees against the advisory fee;
• Investors may wish to restrict the ability of the investment manager to launch successor funds that compete with the fund;
• The fund's investments will often comprise unlisted portfolio companies that carry out a trade or business. As a result, a scheme may want to structure its commitment to avoid the scheme having to file a tax return in the country where the trade is carried out and/or obtain a side letter right to the information it needs to complete tax returns.
For both categories of alternative funds, any additional negotiated terms will be documented in a side letter between the investor, the fund (or its general partner in the case of a limited partnership) and/or the investment manager. Either in-house or external counsel should review the side letter to ensure that it is legally enforceable, accurately captures the commercial deal and incorporates comfort on material issues arising from the legal and commercial reviews.
While this article deals with direct investments by a scheme into an alternative fund, it should be noted some investment managers will run managed accounts for large allocations of $50m or more. The principal document governing a managed account is the investment management agreement between the investment manager and the investor. This agreement will set out in detail the permissible investments, investment restrictions, standard of care and bespoke fee terms that the scheme and its advisors negotiate with the investment manager.
Pension schemes should deal with a side letter (or investment management agreement in the case of a managed account) and any changes to a fund's constitutional documents or subscription agreement in accordance with its general legal policy on entering into contracts. If scheme trustees usually instruct counsel to review and negotiate service provider and operational contracts (where the potential for loss to the scheme may be relatively small), then it seems to the author that trustees might find it difficult to justify taking a more flexible approach to investments that constitute a substantial portion of the scheme's assets.
Winston Penhall is a senior associate in the investment funds team at Reed Smith, a London-based law firm