PRINT THIS PAGE Conflicts in private equity: respecting the rights of limited partners of private equity funds and shareholders of portfolio companies05/12/2007. Source: Dechert. Robert M Friedman 
Private equity fund governing documents generally permit a manager to commence investing a new fund ('Fund B') at the time an existing fund ('Fund A') has invested or used to pay expenses an agreed upon percentage of its committed capital (on average, approximately 75 per cent). After providing for future management fees, Fund A should have capital available for follow-on investments and possibly for additional new portfolio investments as well, advises Robert M Friedman, a partner at law firm Dechert. Therefore, in assessing an investment opportunity in a new portfolio company or a follow-on investment to an existing portfolio company of Fund A, the manager must determine how to allocate the investment as between Fund A and Fund B.
There is often general language committing the manager of a fund to offer to the fund all new investments meeting the investment parameters of the fund. In such a case, the investment must be offered to Fund A. Sometimes, however, the documents provide that Fund A be given priority as between Fund A and the manager in the allocation of investment opportunities. If the manager of Fund A has an economic interest in Fund B (which presumably the manager does through its carried interest), then the allocation of the investment opportunity to Fund B is indirectly placing the manager’s interest ahead of the partners’ of Fund A.
In order to avoid the allocation conflict, some funds provide for the allocation between an earlier and later fund to be made based on committed or available capital of the two funds. The difference between these formulations may be significant. Assuming Fund A and Fund B each has $500 million of initial commitments, but Fund A has only $100 million of commitments remaining uncalled, while Fund B has $400 million of commitments remaining uncalled, then, if a new investment is allocated based on committed capital, each fund will take half the transaction.
However, if the allocation is based on available capital, then Fund B would take 80% of the opportunity and Fund A would take 20% of the opportunity.
Another way to avoid the conflict is to close the investment period for new investments of Fund A when Fund B commences. Note that although this avoids the conflict on allocation of new investment opportunities, by closing the investment period of Fund A, the management fee calculation may then be made based on the reduced amount of invested capital under management rather than committed capital.
Follow-on investments present additional potential conflicts. As to allocation of the opportunity, one might provide that all follow-on opportunities for investment in portfolio companies of Fund A must be offered to Fund A. If Fund A did not have capital available to make the investment or to fund the entire amount, then Fund B could be offered the opportunity to invest. When Fund B makes an investment in a portfolio company in which Fund A previously has made an investment, there is the sensitive issue of placing “good money after bad.” Some funds either
flatly prohibit follow-on investments in portfolio companies of an earlier fund, or restrict these investments in circumstances in which the earlier fund owns a material percentage or otherwise controls the portfolio company.
Often funds do not prohibit such follow-on investments, but place safeguards to protect fund investors. For example, a follow-on investment in a portfolio company of an earlier fund might require an independent valuation (either by an outside expert or by the market check of a co-investor taking a significant percentage of the investment), and/or the review and approval of the advisory boards of the funds involved.
In each of these potential conflict situations, the manager is called upon to use judgment not only as to a fair price, but also as to the allocation of the investment opportunity based on the status of each fund. What factors should the manager consider in making this determination?
What covenants might the manager have agreed to with the limited partners of Fund A that govern? For example, although Fund A has capital remaining available, the manager must determine how much of that capital it would be prudent to retain for anticipated expenses (including
management fees) and other possible follow-on investments.
The time horizon for expected realization must be assessed. While it is true that investors in Fund A do not want to pass up a possibly lucrative investment opportunity, they also do not want to extend the term of their fund beyond its expected life. The manager must be sensitive both to
managing investor expectations as to timing of realizations as well as to the effect on the fund’s IRR of extending the term. In fact, some funds limit further follow-ons to a period of two or three years following expiration of the initial commitment period for this reason. The manager
also must consider concentration issues based on the total amount of capital being invested in the portfolio company or in the industry of the portfolio company.
Separate from the potential conflicts in allocating an investment opportunity between managed funds, there also are issues to consider relative to a portfolio company of Fund A if the new investment opportunity is potentially a natural acquisition for that portfolio company. Assuming
the manager has a representative on the board of directors of the portfolio company, then the director may have a fiduciary duty to provide the corporate opportunity to the portfolio company. This presumes, however, that the portfolio company is financially able to exploit the
opportunity. Assuming the manager brings the investment opportunity to Fund B which makes the investment, then the manager may have competing companies in the same industry, raising significant issues of how to manage the business of those companies.
For example, in any determination of the portfolio companies to pursue the same subsequent opportunity, the director representative of the manager would have conflicting duties to each of the portfolio companies. If, subsequently, the two portfolio companies sought to combine, the manager would have a conflict as it would be on both sides of the transaction.
Many of these conflict issues can be addressed in fund documentation pursuant to which limited partners acknowledge potential conflicts and waive them in advance, or agree upon objective parameters to be met before an investment presenting a conflict may be made. Similarly, corporations in Delaware may waive by charter provision or vote of its board of directors any interest or expectancy in, or being offered an opportunity to participate in, specified business opportunities or specified classes or categories of business opportunities. Transactions between
multiple portfolio companies in which the manager has an interest can be accomplished so long as the conflict is disclosed and the transaction is approved by disinterested directors or shareholders of each portfolio company, or the transaction is fair as to each portfolio company.
It would be prudent for fund managers to protect themselves by incorporating provisions in their fund documents and in documents of portfolio companies that would allow them to maintain flexibility in allocating investment opportunities, while at the same time complying with their fiduciary obligations to their managed funds, and for portfolio companies to follow proper legal procedures in approving transactions in which they are conflicted.
Dechert is an international law firm with over 700 attorneys. It provides practical business solutions to a diverse client base. For more information please visit www.dechert.com.
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