Last year the private equity (PE) behemoth KKR acquired the Brazilian technology company Aceco TI from the PE fund General Atlantic and other shareholders. A sale to another PE fund was also GP Investimentos' exit strategy from its investment in the restaurant chain Fogo de Chão. Transactions like these, known as secondary buyouts, are becoming more and more common in Brazil.
The classic exit strategy for a PE fund is taking its invested companies public through initial public offerings (IPOs). However, given the lingering weak performance of the Brazilian stock market (IBOVESPA, which is the local main stock index, is currently at the same level it was in 2009), the environment for IPOs has been unfavorable. Thus Brazilian PE funds need to resort to different exit strategies. And in this strained scenario secondary buyouts are proving to be a particularly good alternative.
Nevertheless, transactions where both seller and buyer are PE funds may trigger a question of great relevance to the PE industry: how to deal with potential conflict of interests?
Large PE management firms often manage different funds with diverse investment policies. There is a possibility that, for example, one such firm runs simultaneously a venture capital fund interested in selling and an industry-consolidation fund interested in buying the very same company. In such situations, the risk of conflict of interest exists at least in theory, even though management firms usually appoint different individuals to lead each of their funds and the compensation scheme of these individuals encourages them to seek the highest possible yields for the funds they head.
Likewise, a growing number of PE funds in Brazil, especially those in which Brazilian pension funds hold equity interests (quotas), have set up investment committees. Such committees, whose members are appointed by quota-holders, are generally tasked with discussing and approving the manager's investment strategy. Therefore, secondary buyouts involving two PE funds in which the same individual holds investment committee seats poses a theoretical risk of conflict of interest (that being one of the numerous reasons why investment committees are not wellregarded by the international PE community).
In view of the foregoing, article 36 of CVM's Instrução 391, which regulates Fundos de Investimento em Participações (FIPs), the preferred vehicle for PE funds in Brazil, provides that, unless the majority at a quota-holders meeting authorizes otherwise, a FIP is not allowed to invest in securities where: (1) the FIP investment or administrative manager1; members of the FIP investment committee; holders of quotas in the FIP representing more than 5% of its net worth; or their partners or spouses: (A) severally or jointly hold more than 10% of the voting shares of the issuer company; (B) are members of the board of directors, the oversight committee or any other special committees of the issuer company; (C) are directly or indirectly involved with the issuance of such securities; or (D) are the seller of these securities; or (2) the seller of such securities is another FIP run by the same administrative or investment manager.
Additionally, Instrução 391 requires that documents related to the FIP, such as prospectuses and bylaws, disclose the risk of potential conflicts of interest, and imposes on investment and administrative managers, as well as on committee members a duty to disclose any concrete situation of conflict of interest. Failure to comply with such rules exposes the wrongdoer to civil and administrative responsibility.
Instrução 391 does not regulate whether quota-holders with a conflict of interest (and committee members appointed by them) are allowed to cast votes at meetings called to decide on investment strategy. There is no body of case law addressing the issue. Even if the rules on conflict of interest set forth in the Brazilian Corporations Act are applied by analogy to FIPs – which is questionable –, doubts are not cleared, since the CVM case law on the interpretation of such rules has swung between absolute prohibition from voting and partial permission with subsequent scrutiny of the fairness of transactions challenged by minority shareholders.
In this context, investment managers and investors should consider the risk of potential conflicts in drafting/negotiating organizational documents of FIPs and in deciding whether to set up investment committees. If a concrete conflict of interest arises, immediate disclosure must follow and a quota-holders meeting held to authorize the transaction. The risk of casting votes in conflict of interest situations should also be carefully weighed in view of the CVM case law at the moment. And it may also be prudent to set up a "chinese wall" and secure an independent third-party assessment of the fairness of transactions carried out in situations of conflict of interest.
1 Please see Issue No 3 of our newsletter for the differences between the roles of investment and administrative managers. Available at www.loboeibeas.com.br/publicacoes/informativos.
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