In light of the rapidly changing coronavirus (COVID-19) situation, Troutman Sanders and Pepper Hamilton have postponed the effective date of their previously announced merger until July 1, 2020. The new firm – Troutman Pepper – will feature 1,100+ attorneys across 23 U.S. offices. Read more.
The spread of COVID-19 and its impact on the global economy has presented a seemingly endless list of complications for enterprises across a number of industries. Fund managers are as affected as anyone by the coronavirus shutdown and the extraordinary impact we are seeing in real time in the markets. Whether you are a manager of private portfolio companies, real estate or public securities, or other alternative assets, you are no doubt seeing the need for both crisis management and opportunity.
To help all of our clients weather these disconcerting times, the Private Funds Services Group at Pepper Hamilton wanted to provide a compilation of some of the considerations that we have been asked about in the past few weeks as the virus impact has swelled.
Tax Issues Relating to Investing in Distressed Companies
Carried Interest Waivers
End of Investment Period or Fund Term
Ability to Claim Tax Losses With Respect to Investments
Business Continuity Plans
Lines of Credit
Capital Call Defaults
Access to Service Providers
Firm Personnel/Remote Working
Suspension of Withdrawal Rights
There is no exception for the obligation to fulfill your duties of care and loyalty, etc. in times of crisis. And — just for the record — no one actually asked us that specific question. What managers have asked is whether how they act in respect of those duties should change. The answer to this is going to be different for every strategy, every firm. The key to protecting the firm is to (1) be consistent in how you approach issues and (2) document the rationale for decisions. In times of crisis, the best protection against second-guessing with the benefit of hindsight is fulsome documentation in real time. Connection with your investors over important issues will also go a long way to assuage insecurities that investors reasonably have at this time. (Back to Top)
COVID-19 will likely have a large impact on fundraising efforts, but the impact may vary depending on the strategy of the fund and will no doubt trigger opportunities for certain strategies. From an operational perspective, fund managers should consider the impact that COVID-19 will have on planned in-person meetings and prepare to arrange for video and teleconference pitch meetings. Fund managers should ensure that their technology infrastructure is able to support these meetings and reach out to their IT vendors as needed.
In the course of fundraising, it may be worth giving consideration to whether any terms should be adjusted during the fundraising period as opposed to requiring an amendment down the road. For example, a fund at the end of its fundraising period may want to consider extending the period to afford investors, now distracted with COVID-19 related issues, the time to complete their underwriting and subscription process. Investor consent may be required to do so. In addition, managers may want to consider extending the investment period if there is uncertainty around the ability to deploy new capital.
No doubt, fund managers can use this as an opportunity to demonstrate to investors that the fund manager prioritizes the needs of its investor base. For example, a fund can lengthen the notice period for capital calls to ease the worries of potential investors who are concerned about liquidity restraints. (Back to Top)
Investment opportunities are often plentiful in times of economic dislocation. A host of questions arise with respect to investments in distressed securities, including issues related to U.S. trade or business, effectively connected income, UBTI, and phantom income. (Back to Top)
Fund valuations also impact fundraising. For closed-end funds that have already made investments, it may be difficult to secure commitments from new investors who (1) expect that the fund’s investments have experienced a significant decrease in value and (2) under the fund governance documents, will not only be asked to invest as if this value has not decreased but also be required to pay interest on their capital contributions from the date of the initial closing. The interest component can usually be waived without the obligation to always waive it. If the fund managers remain confident in the portfolio company’s fundamentals and its management team, fund managers may also consider waiving or deferring carry on the later investor’s capital to entice them to come in notwithstanding the valuation decline. This can then be made up if the investor earns a negotiated level of return. Most-favored-nation (MFN) provisions may make this undesirable, so caution is warranted here. (Back to Top)
With valuations likely continuing to decline, fund managers should examine where they are relative to clawback risk and what obligations they have if, on paper, they are in a clawback position. These may include (1) as noted above, notices to limited partners, (2) deferral of future cash distributions of carry until unrealized losses turn around or are realized, or (3) interim clawback payments. (Back to Top)
Fund managers may receive inquiries with respect to the timing and/or amount of their management fees charged during the periods in which COVID-19 acutely impacts the day-to-day functioning of the manager. A manager may want to consider the following with respect to management fees:
If a manager is due to call management fee either in connection with an initial closing or otherwise, deferring the call of management fee may be worthwhile. While it may not be an option based on business need, deferral may be impactful to both the early performance of the fund and investor morale. Consider this in light of how well-informed your investors were of the impending capital call. Those who anticipated liquidity needs well may have sufficient cash reserves, but those who did not may not be able to meet the call in a timely manner.
If a manager is in the fundraising period, it may be worthwhile to amend the post-investment period step-down date (assuming a stepped management fee) in order to account for the impact of the shutdown and potential loss of time and resources.
If the manager is managing a fund that is later in its life, it may want to seek an amendment to extend management fee in order to allow for an additional period for the market to correct and business to resume.
Where post-investment period management fee is based on “invested capital,” managers should look carefully at the definition now and map out its impact on management fees. If permanent write-downs are part of the calculus, managers should be documenting now why declines in value are or are not permanent and conferring with their limited partner advisory committee (LPAC) (or other limited partner representative body, if you have one) about their conclusions. This will go a long way to protect decisions made now when and if they are reviewed later by regulators. (Back to Top)
The IRS has long expressed concerns about carried interest waivers by a general partner where it is substantially certain that the fund has future gains to allocate to the general partner that would offset any amounts waived. One positive consequence of COVID-19’s extraordinary impact on the markets is that it may serve as proof that the ability to receive waived amounts in the future from current portfolio assets is, in fact, subject to substantial uncertainty, and that, in waiving, the general partner is indeed taking on significant risk. We expect that general partners that have waived allocations and distributions of income will be giving further consideration to the priority that may be given to allocating and distributing make-up amounts to offset any previously waived amounts. This will, of course, turn on the specific structure and language of the waiver and the assets in the fund. (Back to Top)
Consistent with the fiduciary duty discussion above, and at the risk of triggering LPAC fatigue, managers are considering running more decisions that affect investment assets by the LPAC — or even their largest LPs — to gain their perspective on the decision. Doing so will be protective in the event a decision is later second-guessed with the benefit of hindsight. Of course, just as with management fee discussed above, the benefit of doing so is only as good as the completeness of the disclosure you make to the LPAC about the matter. LPAC decisions made on the basis of full disclosures are very valuable — not only as a liability reducer, but also for investor relations. (Back to Top)
Should managers include a coronavirus risk factor in their Form ADV Brochure? If it is affecting portfolio investments, yes. Here is a sample of one that we have used:
Coronavirus and other public health risks
The recent outbreak of the novel coronavirus (COVID-19) in many countries is adversely impacting global commercial activity and has contributed to significant volatility in financial markets. The global impact of the outbreak has been rapidly evolving and has created significant disruptions in global demand and supply chains. Government and self-imposed quarantines and restrictions on travel may continue for a long period of time. Such actions are adversely impacting a wide range of different industries. [IF RELEVANT: Impacts are most acute in the travel, entertainment, restaurant and hospitality industries.] While the longer-term scope of the potential impact of the novel coronavirus (COVID-19) on global markets cannot be known at this time, the coronavirus outbreak and any other outbreak of any infectious disease or any other serious public health concern, together with any resulting restrictions on travel or quarantines imposed, are likely to have a profound negative impact on economic and market conditions and trigger a period of global economic slowdown. Any such economic impact could adversely affect the performance of the Fund’s investments as well as valuations of fund investments in predecessor funds. As a result, the novel coronavirus (COVID-19) presents material uncertainty and risk with respect the Fund’s overall performance and financial results may also be materially and adversely affected.
Inserting a coronavirus risk factor in the ADV Brochure will not be sufficient for any investor that has already invested but it does give them information about material risks that can help them manage the investment. Therefore, ADV Brochure inclusion of a risk factor is advisable if your fund is affected adversely and you consider it a material risk.
If the manager is currently fundraising, then inserting such a risk factor in the PPM would also likely be appropriate. PPM supplements for this purpose should not be considered a negative.
Managers should also consider adding a risk factor that large-scale infrastructure disruptions to internet and telecommuting capabilities may undermine business continuity planning. Disclosing the risk factor, however, does not absolve managers of factoring in low-tech redundancies necessary for business continuity. (Back to Top)
In light of the measures that the United States and many companies have taken in response to COVID-19, fund managers should review their funds’ governing agreements and any side letters they may have with investors to determine if any notifications or other special measures are required. While it is generally considered best practice to keep investors informed of any situation that may materially impact their investment or the fund manager, the fund managers should pay particular attention to their contractual obligations. They may be specifically required to account for, or to inform investors of, certain developments that may otherwise have an impact on the fund. Some of these matters may include:
any event that is likely to have a material adverse effect on the fund or any of its portfolio companies
any delays in reporting or the issuance of financial statements, especially with many funds having a December 31 year end and being required to issue audited financial statements in the near future
a suspension of redemptions or withdrawals (for open-ended funds) or the imposition of any gates
any requirement to notify investors if a portfolio holding exceeds a specified percentage of the fund’s assets as a result of performance
borrowing events (for funds that choose to utilize lines of credit rather than rely on capital calls if there is a need for capital quickly or a manager wants certainty in case investors may be unable to wire funds)
any agreements with investors that address default in light of an inability to make capital calls due to office closures or any “force majeure” event
notification to investors of any capital call default by other investors
the implementation of any business continuity plan
any litigation that has arisen related to the fund, the manager or any portfolio company
reporting any potential clawback following a hypothetical liquidation at specified intervals.
Fund managers should also be cognizant of any investors that are subject to FOIA or public disclosure requirements, as such events may constitute highly sensitive information that the manager will likely not want to be shared publicly. Accordingly, managers should also review public disclosure side letter provisions and might consider changing their reporting formats with respect to such investors from their typical periodic reporting procedures. (Back to Top)
For closed-ended vehicles nearing the end of their investment period or their term, the market disruption caused by COVID-19 may pose a significant issue that will need to be addressed by fund managers. Those funds with significant amounts of undeployed capital near the end of their investment period many not be able to invest all or close to all of that capital as volatility has increased and the long-term impact on potential portfolio companies may not be understood quickly. However, the impact may be more pronounced for those funds near the end of their terms, which are deep in their harvest period and generally are seeking to exit their last portfolio companies and wind down the fund. Some funds may even have been actively involved in a sale process, which may grind to a standstill or even evaporate in today’s economic climate.
Funds nearing the end of their term have several potential options if they are unable to wind up during a stated period. First, many fund agreements provide for term extensions, and managers should consider declaring or seeking these extensions if consent is required, perhaps sooner than they would have ordinarily done so, as investors may be understanding of the need to do so in such a market. If a fund has reached the end of its extension periods or does not have an extension mechanism, the manager should consider whether to seek an amendment to its governing agreement to extend the term.
It is not necessarily a given that investors will agree to a term extension, especially in the current falling market environment. In that circumstance, a negotiation with key investors is likely. While investors may seek concessions from managers, such as the termination of management fees or an added clawback (or current clawback payment), when granting their consent to such an extension, investors may still decline to extend a fund’s term for a number of reasons. Some investors may need liquidity, may believe that the values of remaining portfolio companies may continue to decline, or may believe that sufficient devaluation is not currently priced into a company and any such extension will push out the true clawback even further without adequate interim clawback protection, if any. In these instances, a manager may need to seek an alternative path forward to unlock what they believe to be the full value of their portfolio companies.
A fund manager that believes one or more companies in its remaining portfolio have significant upside may seek to engage a third-party buyer to provide liquidity for investors that seek to exit in a “GP-led secondary” sale (or, if no buyer can be found and the manager has sufficient capital and a desire to do so, engage in a tender offer for such interests). A newly formed subsequent fund may even be the buyer. Such a process would allow investors that seek liquidity or that do not believe in the upside of remaining investments to exit the fund, permit investors that want to continue to participate to do so, and enable the sponsor to earn more carried interest through the future appreciation of the fund’s remaining portfolio.
Any such secondary process or tender offer has substantial inherent conflicts of interest. It will generally require consent to such a transaction and/or amendment of the fund’s governing documents; the engagement of an investment banker and law firm to find a buyer, structure the transaction and prepare transaction documents; and sufficient time to engage in these valuations and processes. Fund managers considering such a process should reach out to their bankers and attorneys as soon as they begin to consider any such transaction to ensure sufficient time to run an optimal process. (Back to Top)
We are seeing the beginning of a great deal of focus on the ability of funds to claim current losses for tax purposes with respect to the sale, exchange, abandonment or other write-off with respect to investments, as well as the character of these losses. In addition, we expect that many investors will be giving greater consideration to the limits on their ability to take losses that flow-through to them. (Back to Top)
There is a very real test going on of firms’ business continuity plans. Many firms are in remote-access-only working environments. Secondary platforms for connectivity need to be reviewed and ensured. CCOs should review business continuity plans carefully and often to ensure they are up to date and working for the current environment. CCOs should take note of and implement immediately any improvements to business continuity or disaster recovery plans. (Back to Top)
Virus pandemics are never expected, and their reach is unpredictable. The current one should definitely cause firms to review their succession plans. This is most acutely needed where one founder has a controlling or sole member position in general partners or the management firm itself. Making sure that the firm will continue to have signatories over bank accounts who will have access and capabilities is critical. CCOs should be behind this effort as part of business continuity planning. (Back to Top)
Subject to certain conditions, the SEC has granted an additional 45 days for advisers to make certain filings. Specifically for Form ADV and Form PF filings originally due between March 13, 2020 and June 15, 2020, (1) registered investment advisers have an additional 45 days from the original filing date to file their Forms ADV and Forms PF and (2) exempt reporting advisers have an additional 45 days to file their Forms ADV. For more info, see our client alert here. (Back to Top)
As of March 19, the SEC has indicated its Office of Compliance Inspections and Examinations (OCIE) remains fully operational. As such, we expect compliance examinations to continue. However, we believe components of examinations that can be conducted remotely, such as document production requests, may be favored over in-person examination elements, such as site visits and in-person interviews. In addition, for reasonable requests, our experience has been that OCIE has been accommodating on extensions of deadlines. (Back to Top)
Rule 204-2 of the Investment Advisers Act, relating to books and records required to be kept by an adviser, remains in effect. In addition to the books and records customarily kept by advisers, advisers should also be sure to maintain records relating to the coronavirus outbreak as it relates to their business. For example, if an adviser avails itself of the 45-day reprieve to file its annual updating amendment to Form ADV, it should maintain the required correspondence with the SEC. Likewise, if an adviser sends a note to its clients regarding the adviser’s operations during the pendency of the outbreak, that too should be maintained. In general, advisers are required to maintain books and records for a minimum of five years. (Back to Top)
Fund managers who have had their operations and revenues adversely affected by the coronavirus should review their business interruption or property damage policies to see if they are covered for any losses. Some policies may cover virus contamination that renders their property unusable even in the absence of direct physical damage, or where governmental authorities restrict access to the business. Similar issues arise with respect to the fund’s portfolio companies and should be investigated to see if any portfolio company losses can be mitigated. (Back to Top)
Lines of credit may be a useful tool for fund managers to bridge any liquidity issues in connection with their limited partners’ ability to meet capital calls due to the coronavirus. Managers with uncommitted facilities secured by investor capital commitments may want to confirm that their banks are still willing to provide funding despite potential adverse changes in the liquidity profile of certain limited partners, which may impact the bank’s willingness to fund. New York and other states have enacted laws that may stem actions making lines of credit unavailable. Managers must be knowledgeable about these before engaging with subscription line lenders. (Back to Top)
COVID-19 disruptions have also precipitated a concern that capital call defaults may occur. Fund managers should consider how they will address these, and review policies and procedures to ensure that actions are consistently decided (which is not meant to imply that every capital call default needs to be addressed in the same way) and are documented. On the bright side, default potential provides an opportunity for fund managers to demonstrate to existing and prospective investors the emphasis that such managers put on prioritizing the needs of their investor base and their ability to react and adapt in difficult circumstances.
Fund managers should keep in mind liquidity constraints that investors may be facing and, when possible, should consider lengthening the notice period for capital calls to longer than what is required under the governing documents. In addition, even when the manager is not aware of any imminent capital call, managers could proactively reach out to their investors, inquiring whether the investor is aware of any increased difficulty they may have in satisfying their obligations under a capital call should there be one in the near future. This could give managers a greater opportunity to evaluate their options in remedying any capital call defaults in order to, among other things, maintain their ability to fund investments and preserve relationships with their investors.
If the manager does not already have one in place, putting a subscription line of credit in place might also be an option to alleviate the stress.
Finally, fund managers should consider whether any investors have side letter provisions addressing capital call defaults that may be impacted by COVID-19. For example, investors may have side letter provisions that excuse the investor from a default in situations where they may not be able to wire money in a timely fashion due to restrictions on bank personnel. (Back to Top)
Fund managers should be proactive in evaluating what third parties (e.g., lenders, government agencies, service providers, etc.) provide services to the fund that are fundamental to ensuring the fund is able to maintain its operations in the ordinary course. Fund managers should consider maintaining an open dialogue with these third parties to ensure there are no unexpected issues that negatively impact the fund’s operations.
With respect to regulatory filings, fund managers should work with their counsel to make these filings as early as practicable. While certain regulatory agencies have already announced extensions to certain filing requirements (for example, the SEC has granted extensions to Form ADV filings), filing early will help ensure that deadlines are not missed despite potential delays and/or complications. (Back to Top)
Managers and their personnel are likely working from home and only using remote-access technology. Employment policies and practices are still applicable, and the manager’s person in charge of HR needs to be aware of obligations and adjustments that are precipitated by the coronavirus pandemic — here in the United States and abroad. Visit the Pepper Hamilton/Troutman Sanders COVID-19 Resource Center for news and insights on employment and labor law matters, as well as policy templates. (Back to Top)
Some managers of open-ended funds expect to see heavy withdrawal requests. The first step that all managers should take is to evaluate the firm’s cash demands, taking into account the firm’s expenses and margin requirements, and whether all withdrawal requests may be met, as required under the fund documents. Managers should be mindful of the fund’s liquidity in the future and whether payouts of withdrawal requests would leave investors that decide to remain in the fund with disproportionate amounts of illiquid assets. When a fund is not able to satisfy all withdrawal requests in accordance with the fund’s documents, the manager should evaluate other measures to address lack of liquidity. First, the manager should review the fund’s documents to determine how narrow (or broad) are the fund’s suspension provisions. Some funds have adopted very narrow suspension provisions that allow the fund to suspend withdrawals only under enumerated circumstances, such as market closures. Second, if the fund documents provide for investor-level gates or fund-level gates, the manager may invoke them, with the understanding that investors will undoubtedly question the manager’s actions, particularly when the fund-level gate provisions are invoked. Typically, the manager would prepare a written notice to investors explaining the fund’s liquidity concerns and how much cash the investors should expect to receive once the fund-level gate is up and how long the gate is expected to be in effect. Third, when the manager is concerned with leaving nonwithdrawing investors with illiquid assets in the fund, it may consider distributing illiquid assets in kind to satisfy withdrawal requests. While this allows the manager to treat all investors fairly, some investors may not want to accept such in-kind distributions and may have side letter provisions preventing the manager from distributing assets in kind. Last but not least, the manager should consider proposing to investors that they transfer their interests to other investment funds. Some investors may be open to waiting it out or may accept an assisted secondary transfer. (Back to Top)
The above list does not address all the things on managers’ minds these days. Whether you are a fund manager or investor, if you have additional concerns, we welcome the opportunity to hear from you. You can email or call any of the authors on this article at any time. In the meantime, we at Pepper Hamilton in the Private Funds Services Group hope that you and your families remain healthy and safe. All else, in the end, is just extra.
The material in this publication was created as of the date set forth above and is based on laws, court decisions, administrative rulings and congressional materials that existed at that time, and should not be construed as legal advice or legal opinions on specific facts. The information in this publication is not intended to create, and the transmission and receipt of it does not constitute, a lawyer-client relationship.