By Michael Lawson, Michael Mellon, Andrew Stone, Nicholas Schaefer
Minter Ellison
The COVID-19 pandemic will doubtlessly stress fund arrangements at all levels. In this article we highlight where the major stress points may lie to help Managers successfully navigate their way through difficult market conditions.
Capital Management
1. Capital calls
During the investment period
There should be no issues in calling capital into a standard private equity fund during the investment period on the standard call notice of 10 business days. Managers should follow all the technical requirements of the call process, as during the GFC investors closely monitored call technicalities. Managers may consider calling earlier than the required period, where permissible, and keep communication open with investors. Private credit, real estate, and infrastructure managers will typically be more constrained in making capital calls.
Post investment period
Calls post investment period are usually limited. Some funds require the Manager to provision for capital at the end of the investment period and cancel any capital not required. Managers should be aware of these rules if they are concerned about having insufficient uncalled capital. In the current circumstances, Managers may be entitled to seek additional investor capital, and this may be subject to investor approval.
Co-investment structures
As co-investments generally call all capital upfront and invoice investors directly for any costs, the rules governing how subsequent equity capital raises may occur may permit offering interests in co-investment vehicles to external investors if existing investor(s) decline to participate. Regular communication with investors is key, particularly to update them of any capital management changes or challenges.
2. Debt
Capital call facilities
Many Managers have obtained, or are obtaining, capital call facilities to provide additional capital that can often be drawn faster than a call. If the fund becomes distressed it's likely the call facility will be suspended. Further, as lending tightens funds will likely strike deals with more conservative capital structures with a greater proportion of equity.
Debt finance and insolvency
If asset values are impaired, Managers must ensure financing arrangements are monitored, particularly with financial covenants. Particularly in the real estate and infrastructure sectors, Managers must ensure LVR covenants are not breached, and should engage valuers proactively should financiers raise queries. As in the GFC, Managers may consider whether equity capital raisings may be required to resolve any breaches.
Portfolio company pressure may lead to tightening cash flows, threatening cash flow ratio and interest cover ratio covenants. Managers must take care to ensure public policy cash flow enhancement measures are utilised. Broader strategic reviews of operations are also useful. Open communication between Managers and debt financiers will ultimately assist.
3. Retention
The retention clause allows the trustee to keep amounts which would otherwise be distributed for foreseeable matters, allowing for spare capital if required. We recommend Managers retain as much spare cash as possible for the future.
4. Investor credit status and defaults
During the GFC there were examples of investors who defaulted on capital calls. Managers should be aware of any investors experiencing credit stress – communication is key. An investor default will take time to resolve, as the investor's interest in the fund is forfeited and offered to other investors or third parties. Depending on the secondary market, full recovery may not be possible. Meanwhile, the Manager will need to make an additional call on remaining investors to meet the shortfall or draw down on the fund's facility. We recommend calling funds earlier than required, if fund documentation allows.
5. Redemptions and liquidity
Lessons were learnt during the GFC to tighten redemption regimes. Many funds have no redemption facilities or limited programmes where the Manager exercises very significant control. If the economic downturn is prolonged, some investors may want to sell their interests. Usually Managers have complete control over approving such transfers and terms of such transfers. Funds with more permissive redemption mechanisms will be required to balance the interests of redeeming investors with those who remain. Liquidity may be highly constrained. This has been seen in the fixed income and private credit space, and may ultimately affect real estate as well. Tailored solutions will be required.
6. Redraws and carry clawbacks
Redraws and carry clawbacks will come into play in the future as divested investments are subject to sale price reductions (for example, net debt / working capital adjustments and warranty claims).
7. Investor communication
We are seeing Managers being pro-active in their communications with investors. A well-considered investor communications protocol is helpful to minimise mixed messages. It is preferable for communications to be addressed to the entire investor-base, rather than to selective investors. Managers must ensure investors are not selectively briefed. Managers should also be aware that the delivery of information from portfolio companies may also be delayed, which may affect the fund's ability to report to investors.
8. Terms
Due to the extenuating circumstances, Managers may consider whether it is necessary to extend the Investment Period to make the investments intended by the Fund. Closed ended funds typically permit the term to be extended either by the Manager or with investor approval, though Managers should be aware of regulatory constraints that may apply to certain PE funds, for example VCLPs.
General Impacts
9. Key Person Event
Key Person Events apply during the investment period and generally result in the suspension of investment activities. Although the impact on funds may be minimised if they will not be making investments whilst COVID-19 persists, opportunistic funds will be significantly compromised by being locked out from making investments as a result of the illness or death of a key person. The Key Person Event can often be cured through advisory committee or investor approval, but the investors would require a plan of action to solve for the loss of that key person.
10. Business continuity plans
Managers may have BCP provisions in their mandates, particularly for superannuation funds, and need to be aware of how these operate as normal business practices are being compromised during this period. BCP plans often have valuable processes to assist Managers running the business through difficult times.
11. Investment Committees
Managers should check their fund documents in relation to attendance and quorum required for investment committee meetings. If the investment committee is required to be constituted by name individuals, then there is a risk that COVID-19 infection may disrupt decision making. There are actions managers may take now which can address these issues, for example appointing alternate members and having a charter governing operation.
12. Valuations
Managers may be challenged when valuing their assets appropriately where the market is in turmoil. Investors may also challenge valuations where they do not accord with their expectations. Being on the front foot with investors and explaining why a valuation may not reflect the true value of the underlying asset is one solution where a valuation is compromised by current economic conditions.
Positioning for the Future
13. Successor funds
If Managers are contemplating further investment vehicles to take advantage of any opportunities they should check their existing fund documents and mandates to see that they may do so.
Conclusion
Alternative asset funds will be taking steps to insulate their portfolio companies from an extended cashflow disruption, but the prevailing market conditions are only a temporary disruption. Although there are a number of areas as outlined above that Managers should be aware of, the current climate will also present opportunities to utilise dry powder for investments over the medium and longer term.