Increasingly complex fund structures and documentation mean that analysing how potential portfolio acquisitions interact with the fund at the top of any deal structure is more important now than ever.
Investor Excuse Rights for Environmental, Social, and Corporate Governance (ESG) Compliance
As investors focus on ESG compliance, requirements for “excuse rights” for non-compliant investments are expanding. Firms usually avoid the most obvious red flags with ease but in our view, restrictions on investing in businesses breaching environmental or anti-corruption standards are more problematic, as even blue-chip multinationals are not immune from these issues. Where an investor is excused, the GP must source cash elsewhere — ideally from remaining investors, who can often be required to increase participation to fill the gap. With many funds accepting commitments representing significant proportions of the total fund size from a small number of large LPs, sophisticated investors are increasingly concerned about the consequences of large LPs being excused from investments and have sought to mitigate such risks through negotiating restrictions on “topping-up” participation. Deal teams must engage in careful diligence early in the deal process and be cognizant of the impact of LP opt-out rights on a fund’s capacity to participate in a deal.
Recent proposals to change US tax laws, together with the OECD focus on Base Erosion and Profit Shifting, have brought tax structuring into sharper focus. Deal teams must be aware that while some portfolio company investment structures may improve returns at deal level, they risk creating “bad” income for LPs at fund level, significantly impacting fund returns. For example, income derived from using certain types of indebtedness may be taxable in the hands of investors who are otherwise tax-exempt, or a tax payment obligation may arise before the investment is realised. Whilst most fund agreements include an obligation to consider the interests of the fund as a whole, rather than each individual investor, Alternative Investment Vehicles (AIVs) can help GPs mitigate tax leakage that would occur if an investment were made through the main fund vehicle, (e.g., by blocking US Effectively Connected Income for non-US investors). However, a structure that works for certain investors may not work for others. As a result, it remains important that the fund’s tax advisers are kept abreast of proposed deal structures. Further, setting up an AIV can significantly add to the completion timetable. Forward planning by deal teams can help mitigate this.
Deal teams should carefully consider the impact of FX volatility on fund investors, given recent currency swings. Single currency denominated funds investing in multiple jurisdictions are susceptible, with Sterling-denominated funds particularly affected by recent FX volatility. Unfavourable currency swings can leave funds overexposed to certain jurisdictions and firms short on portfolio company commitments. Funds are able to hedge currency risk at various points in the investment cycle, but full exchange rate hedges can be prohibitively expensive. Deal teams therefore need to consider early on the funding of transactions in currencies other than the fund currency.
In our view, as LP-specific rights in funds expand, it is now more than ever important that those responsible for fund-level issues are looped into potential deals at an early stage.