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Investing in venture capital funds - legal issues for investors

As an investor in private equity, it is advisable to make sure your interests are fully served in the legal agreement. Here Deacons suggests some of the main issues you need to consider.

Issues Specific to the Investor

These issues concern the investor's ability to invest in the venture capital fund and/or legal issues that could affect the desirability of an investment in the fund.

(a)      Tax issues

What are the tax consequences to the investor of an investment in the venture capital fund? What taxes will the investor be subject to if the investor receives income distributions or capital gains from its investment in the fund? Can the investor's investment be structured in a way that minimises the potential tax liability?

(b)     Investment powers

Does the investor have power to invest in the fund? An investor's investment powers may be restricted, as a result of regulatory requirements, the terms of its constitutive documents or otherwise e.g. investment may be restricted to listed securities, investment in certain sectors may be restricted or prohibited.

(c)     Other issues

Investors may require that venture capital funds in which they invest have special features to enable them to comply with particular statutory or other obligations e.g. an investor that has restrictions on the amount of voting securities it can hold in any one fund may require the ability to convert all or part of its investment to non-voting securities.

Issues relating to the fund

The best funds are structured in a way that most fully aligns the interests of the fund's promoters with those of the fund's investors throughout the life of the fund. The goal is to achieve the highest possible return for all parties. A fund's legal documents should include appropriate mechanisms to ensure that these interests are aligned.

Significant investors in a fund are often able to negotiate with the manager/general partner to improve their position under the fund's documents if they are given the opportunity to review drafts of those documents.

Points for investors to consider when reviewing a fund's legal documents include the following:-

(a)      Investment in fund by fund promoters

Are the fund's promoters investing in the fund? How much are they investing and is it being made in cash or in kind. It is preferable from an investor's point of view that the fund promoters' investment is made in cash?

(b)     Restrictions on the fund's investments

Is there a defined investment period - normally, the first three to four years of the life of the fund? To exert some discipline on the manager, investors may require that a term is included that capital can only be called within a certain period, say the first four years of the fund. Any capital that remains uncalled after that time cannot be called and is no longer available for investment.

Can the fund make follow-on investments in existing portfolio investments after the expiry of the investment period? If so, are there any restrictions on such follow-on investments (e.g. total follow-on investments not to exceed 10% of aggregate capital commitments)?

What are the specific investment and borrowing restrictions for the fund? Investors should review the investment and borrowing restrictions carefully. The aim is to achieve a balance between the manager's discretion to invest the fund and protections for the investor to ensure appropriate diversification and removal of unwanted risk.

(c)     Co-investment rights

Do investors have co-investment rights? What is the nature of these rights? Do others have priority where co-investment opportunities arise?

(d)     Distributions

Distributions are usually made once the fund has realised an investment. The fund's documents should specify the time period within which distributions must be made (eg, within 14 days of receipt of realisation proceeds in cleared funds).

Investors generally prefer distributions in cash. If a fund has power to make distributions in specie rather than in cash, exercise of this power should either be subject to the consent of the investors or be at the request of investors. It should also be subject to the securities being liquid securities (ie, readily saleable on receipt by the investors).

(e)      Capital calls

The fund's documents will set out the process for making capital calls, restrictions on making capital calls and the consequences for investors who fail to meet capital calls.

Investors need to ensure that they are given sufficient time to meet capital calls, particularly if they must satisfy internal approval processes before making payment.

Investors should require a provision that they are excused from meeting a capital call if to do so would breach a statutory obligation to which they are subject. In this situation, the fund's documents need to set out how that investor's interest in the fund is to be treated in comparison to other investors who have met the capital call.

(f)      Carried interest

Carried interest is designed to give the manager/general partner an incentive to increase the value of the fund. There are a number of issues with carried interest provisions and they need to be reviewed carefully.

• Basis for measurement: How do you measure the increase in the value of the fund? Do you include interest earned on deposits held pending investment? From an investor's point of view, the answer should be no because the manager does not add value by placing the fund's spare money on deposit. A manager may also seek to have the carried interest measured on an investment-by-investment basis rather than on the fund's performance as a whole. Again, investors should resist this approach.
  
  
• Issues with clawbacks: Carried interest provisions often contain a clawback in case the amount that the manager receives as carried interest during the life of the fund is more than originally intended. This can occur, for example, if all the fund's profitable investments are liquidated first, with poor-performing investments liquidated at a later date. From an investor's point of view, a clawback is not ideal because it may be difficult to enforce in practice. As a result, a clawback provision may be combined with additional protection:
  
  
  • payment of part of the carried interest into an escrow account, to be held until termination of the fund
    
    
  • an additional condition before payment of the carried interest, such as the value of the fund after payment of the carried interest must exceed committed capital at the time of payment (to provide a cushion to cover losses on the realisation of subsequent investments of the fund)

(g)     Conflicts of interest

Conflicts of interest can arise in a number of situations:

• where the manager acts as manager for more than one fund and/or advises other clients on investments similar to those of the fund
  
  
• where the manager or its associates have invested in the fund
  
  
• where the manager or its associates co-invest with the fund in some or all of the fund's investments
  
  
• where the manager proposes that the fund invest in an entity in which the manager or its associates already have a financial interest
  
  
• where the manager or its associates provide services to the companies in which the fund invests
  
  
• where the manager or its associates wish to establish another fund with similar or competing investment objectives

The fund's documents should set out how these potential conflicts will be dealt with. Common provisions include the following:

• the manager will allocate investment opportunities between different clients in a fair and reasonable manner, having regard to the interests of the fund and investors
  
  
• where the manager or its associates invest in the fund, they cannot vote on matters in which they have an interest e.g. such as approving changes to the management fee
  
  
• where the manager or its associates co-invest with the fund in some or all of the fund's investments, such investment must be approved by the advisory board, must be made at the same time and on the same terms as the fund and cannot be realised prior to the fund realising its investment
  
  
• investment in an entity in which the manager or its associates has a financial interest is either not permitted or can only be made after prior approval of the advisory board
  
  
• the manager and its associates share with the fund some of the fees (e.g. corporate finance advisory fees, underwriting fees) they receive when acting for companies in which the fund has invested
  
  
• the manager and its associates are restricted from establishing a fund with similar investment objectives for a certain period of time e.g. for the first four years of the life of the fund or prior to the fund being substantially invested

(h)     Transferability of interests in fund

Investors should seek to include a term in the fund's documents that an investor can transfer its interest to another entity within the same group as the investor without prior approval, as long as the transfer does not give rise to legal or regulatory issues for the fund.

(i)      Advisory board

Is there an advisory board and, if so, is the investor entitled to representation on it?

Advisory boards are a common feature of funds and are designed to enhance investor protection and promote investor interests.

Investors should consider whether the role of the advisory board offers sufficient protection. Common areas that require advisory board consent include:

• a subsequent issue of shares in the fund
• calling capital in excess of a specified amount in any one year
• calling capital after a specified period
• investing in companies where the manager has a financial interest
• extending the life of the fund

(j)      Removal of manager/general partner

Investors will want to retain the right to remove the manager/general partner in certain circumstances.

• for 'cause' eg, where the manager has been convicted of fraud, is in liquidation etc
• where specified persons fail to devote sufficient time and resources to the fund ('key person' provisions - see below)
• at any time where a specified percentage of investors vote for removal (not all managers will agree to this power)

(k)     Duration and termination of fund

Investors should have a say in whether the term of a fund is extended beyond its original term. Extension should require investor approval, either directly or through the advisory board.

Investors should also have power at any time to dissolve the fund if a sufficient number agree to do so.

(l)      Key person requirements

Where investors are investing in a fund based on the skills, expertise or reputation of a particular person or people within the manager, it is common to include a 'key person' provision. A key person provision will identify the particular individual and will usually require that the key person devote a significant amount of time to the fund. If the key person dies, leaves the manager or otherwise ceases to be involved with the fund, investors will usually be given the right to vote either to cease further capital contributions to the fund or to terminate the fund.

(m)    Most favoured nations clause

A most favoured nations clause is intended to ensure that all investors are treated equally. It states that any additional benefit that is provided to one investor (eg, extra accounting information) must be offered to all the other investors, even if those other investors decide not to take advantage of that additional benefit.

Conclusion

Investing in venture capital and private equity funds is a specialised activity. It should be undertaken with care and with a clear understanding of the investor's rights under the fund's documents.

	Scott Carnachan is an associate at Deacons. His expertise includes authorisation requirements for the carrying on of investment business in Hong Kong, establishment and marketing of institutional and public collective investment scheme structures, provident fund schemes, MPF schemes and approved pooled investment funds for MPF investment.
	Deacons is one of Asia's leading corporate law firms, providing an extensive range of legal services to local and international corporations. The firm has business interests in Hong Kong, People's Republic of China and across Asia.

© Deacons 2001