We are in an inflationary environment, with ongoing supply chain constraints, war and geopolitical tension, asset price adjustments and general uncertainty. At the same time, the private fund industry is embracing environmental, social and governance (ESG) considerations as part of a wider shift in the broader investment community to respond to climate change and other social challenges.
In these challenging times, we look at developments that superannuation funds and other institutional investors might see in domestic, private fund terms in the near future.
Reduced or alternative fee arrangements
It continues to be challenging for domestic private equity and venture capital fund managers to attract commitments from superannuation funds. Superannuation funds may be less willing to write comparatively smaller commitments and have a continuing focus on reducing investment-related fees and expenses, particularly in light of the forensic approach forced on trustees by ASIC’s RG 97 disclosure requirements.
In what could be a more challenging fundraising market in the next few years, domestic fund managers may look to overcome the possible reluctance of superannuation funds to make commitments to their funds by offering novel fee arrangements. For example, this may involve capping management fees at the lesser of the specified percentage of the base or the fund’s share of the fund manager’s actual operating expenses.
Exceptions to the fund manager indemnity and for-cause removal provisions
It is relatively common in offshore fund documents for the exceptions to a fund manager’s (or general partner) limitation of liability and indemnity to be limited to fraud, wilful misconduct and gross negligence and for those exceptions to require a final non-appealable judgment of a court of competent jurisdiction to apply.
We are increasingly seeing this model adopted for domestic private funds. We are also seeing ‘for-cause removal events’ defined by more serious conduct (e.g. fraud, wilful misconduct and gross negligence) and additional hurdles attached to a removal trigger – whether requiring a final non-appealable judgement of a court of competent jurisdiction, multiple investor votes, generous time periods to remedy unsatisfactory conduct or other hurdles.
The more fund manager-favourable cause terms that we are seeing in domestic private fund documents partly reflect the increasing sophistication of domestic fund managers and the influence of international private fund terms. The buoyant domestic private fund fundraising market of the last several years may also have contributed to the prevalence of those more fund manager-favourable terms. However, if the fundraising market is more challenging in the coming years and there is an appetite to attract superannuation fund and other institutional investors, domestic fund managers may look to wind back some of those terms in favour of investors.
Historically, fund managers have been reluctant to provide robust ESG warranties and undertakings, beyond potentially agreeing with select investors to exclude them from participating in specified prohibited investments and completing annual ESG, responsible investment or similar questionnaires.
We have observed a shift in the ESG warranties and undertakings fund managers are willing to give, particularly to superannuation funds and other significant institutional investors. This is in part driven by the insistence of institutional investors in requesting those warranties and undertakings and the commercial imperative on fund managers to meet the growing ESG expectations of institutional investors.
Going forward, we expect to see fund managers:
- adopting and agreeing to comply with (often subject to fiduciary and other obligations) specific ESG policies;
- agreeing to have regard to relevant international standards (such as the UNPRI and the UN Sustainable Development Goals); and
- giving expanded ESG and modern slavery-related warranties and undertakings (including with respect to reporting).
Over time, we expect that some fund managers may look to standardise their ESG-related warranties and undertakings, and eventually, in line with the standards coming out of one or more of the standard setting bodies that are currently under consultation (such as the International Sustainability Standards Board).
Superannuation funds will likely also pass onto fund managers additional measures that may assist the superannuation funds to meet stricter prudential requirements. In the near term, APRA intends to bolster Prudential Standard SPS 530 Investment Governance, particularly with reference to climate scenario related stress-testing and to extend ESG financial risk considerations beyond climate change financial risk.
Exclusion and excusal rights
It is less common to see exclusion or excusal rights in domestic private fund documents. These provisions either give the fund manager the right to exclude an investor from an investment or permit the investor to be excused, such as where participation could have a materially adverse effect on the fund or the investor or be a breach of applicable law by the fund or the investor.
Over time, we expect to see these rights incorporated into some domestic private fund settings as fund managers may be compelled to be more flexible to attract institutional investors. For example, investors may demand excusal rights that apply to investments not in line with their ESG policies. Accommodating exclusion and excusal rights will require a reworking of existing fund governing documentation.
Mirroring offshore trends, we expect to see more continuation funds (and restructurings of existing funds), to provide avenues for funds to retain control of desirable assets over the medium to long term.