Set out below are a number of key issues to consider over the medium term in order to adjust and respond to the COVID-19 crisis.
Liquidity and Risk Management
Analyse follow-on capacity for the fund
We are already helping clients with a lot of analysis on follow-on capacity for the fund and what ‘recycling’ is permitted under the fund documents. There may be some distributions that have been made historically which are, under the LPA, recyclable. Clearly, any GP needs to approach this in a responsible manner and be sensitive to the reaction of the LPs, but it may be possible to generate some additional liquidity without needing extra sources of capital.
Exchange rate fluctuations
We have seen increased volatility in foreign exchange rates. It will be important to look at existing arrangements (which could now be out of the money, perhaps significantly) as well as what arrangements should be put in place for the future (to lock in certainty, particularly if acquiring or disposing of an asset).
Check diversification limits
The fund documents may have restrictions on how much can be invested in different assets or geographies. As funds adjust to the crisis, it will be important to know what and where the fund can invest to comply with these requirements.
It may be necessary for a GP to consider extending the investment period for a particular fund, or the overall term of the fund to provide more time to exit the remaining portfolio. There will be different consents and requirements to do this, which will need to be checked in order to plan properly.
Active management of the portfolio
Increasingly, GPs are looking at options to sell particular investments, hive-off specific assets into other vehicles or consider longer-term liquidity solutions for the portfolio. Early analysis of these issues from a commercial and legal perspective is important. Don’t forget to think about the income based carried interest rules too: if you sell an investment sooner than expected, this could have an impact on the fund’s average asset holding period and this could be relevant to the UK tax rates that apply to carried interest returns.
Some of the mid-term planning may involve changes to fund documents. As a result, GPs are beginning to ask us about the process for making amendments. You should consider the thresholds for approvals and which groups of investors will need to be ‘on-board’ to approve changes. Should you be beginning to signpost your proposals to amend the LPA, for example with the LPAC? Are there any third-parties that would also need to give consent, e.g. lenders?
With talk of second and possible third peaks in the COVID-19 pandemic over the next 12-18 months, it is likely that there will be additional periods of enforced restrictions or lockdowns. You should continue to monitor if key staff have the right resources and equipment to work remotely during this period. Asset management teams are often drawn from across the globe: if the head office is dispersed for the medium or long-term with individuals working from their home countries instead of from your usual base (e.g. a London head office), then this could trigger local tax and regulatory headaches. Also, it would be appropriate to check with service providers (lawyers, accountants, auditors, fund administrators) how their systems have coped with the lockdown.
Speak to investors
Speak to investors about the timing and frequency of future capital calls. This will reduce surprises both for the GP and the LPs. If there is a risk that an investor may default, there are various strategies that can be implemented e.g. putting in place a subscription facility, delaying or reducing some investment activity or permitting LP transfers. In 2009, there were very few significant defaults by investors, partly because GPs and LPs worked together to get through the crisis.
Depending on how the crisis develops, it is possible that for certain funds the carried interest arrangements will be ‘underwater’. This may necessitate a debate between the GP and LPs on whether to re-calibrate the scheme to provide the necessary incentives.
Given the continuing travel restrictions and the need for social distancing, it is likely that the number of face-to-face investor meetings will decrease. This will give rise to challenges when organising due diligence meetings with existing or potential investors (which previously would have entailed on-site visits), to holding LPAC meetings through to hosting annual investor meetings. Investors will come to expect virtual solutions, but GPs will need to ensure they offer a technologically sound and robust solution (including understanding privacy and confidentiality restrictions). At the moment, it seems unlikely that these solutions will be a temporary fix for the next couple of months but rather could be needed into 2021 and, if travel becomes less frequent for investors, possibly beyond.
From talking to institutional investors, it is clear that there is a degree of optimism about the investment opportunities over the next 18-24 months. Analysis shows that alternative assets have generated strong returns during and after prior downturns and investors will not want to miss out. GPs should, therefore, be carefully planning their next fundraising, laying the groundwork with investors and making sure there is an allocation for the next fund.