Institutional investors both in Finland and abroad have been highly active in making investments in private equity funds over the past few years. At the same time, fund structures have become increasingly international and complex. Market practices relating to fund agreements are developing quickly, as fund managers are bringing new products onto the market and increasing regulation creates new requirements for investment activities. For example, private equity funds geared towards sustainability and social impact have developed at a dizzying pace.
As investment volumes grow and the operating environment becomes more complex, legal due diligence reviews of private equity fund investments require more extensive expertise and efficient processes.
In this blog, we take a look at legal due diligence reviews of private equity fund investments and at ways to complete them efficiently.
What Are the Goals of a Due Diligence Review?
Investments in private equity funds are long-term commitments, and investors should carefully assess the terms under which they are willing to make them. The terms of a fund can be compared to a marriage—both have to function in both good times and bad. With the increasing complexity in fund terms, particularly in certain foreign private equity funds, investors would be wise to pay even more attention to due diligence processes than before.
The regulation applicable to institutional investors and investors' own internal investment policies mean that investors have to review the legal terms of funds and report due diligence findings as part of their investment process. International funds seek to ensure that their fund agreements take into account the most common requirements of different investor groups, such as funds of funds. However, they don't necessarily take into account, for example, the regulation applicable to Finnish pension insurance companies and other financial institutions. A due diligence review allows investors to ascertain whether the fund investment fulfils the requirements of national regulation and their own investment policy.
It is also important that the due diligence review confirms that the fund's commercial and administrative terms are fair to the investor and are in line with customary market practice. Sustainability is also important to most investors.
Investors can respond to problems uncovered in the due diligence review by proposing changes to the fund agreement or by negotiating investor-specific special terms to the investment documentation. The end result is a compromise between the investor and fund manager that is determined to a large degree by the investor's position in negotiations. An efficiently and professionally conducted due diligence process has a particularly important role in achieving a successful result.
Sometimes the risks found in a due diligence review may lead to the the investor deciding not to make the investment. In our experience, these kinds of deal killers can be triggered, for example, by a deal-by-deal distribution model or a lack of key person provisions. On the other hand, some funds may be constrained by their own regulatory obligations and may not be able to offer terms that meet the regulatory obligations of a particular investor.
Focal Points for Legal Due Diligence
Due diligence processes are always tailored to the characteristics of the investor and the target fund. The contents of the review varies depending on the regulation applicable to the investor, the investor's investment policy, the fund's investment strategy and structure, and the composition of the fund's service providers including delegation arrangements.
Certain factors are considered to fall within the minimum scope of the review that should always be examined. These factors include:
- the distribution model
- the fees and expenses borne directly or indirectly by the fund and investors
- terms concerning the removal of the general partner or management company
- terms relating to key persons and resourcing
- limitation of the investors' liability and giveback obligations
- the investors' governance rights and the fund's reporting obligations
- tax issues relating to the fund investment
In addition to the above, it is usually important for the due diligence review to look at investor-specific regulatory requirements and factors relating to the sustainability of the investment and the investor's investment policy.
Typical Challenges in Due Diligence Processes
A typical challenge of due diligence reviews from the investor's perspective relates to the high variation in fund structures and terms along with the time and resources required to review them.
The documentation relating to international private equity fund investments is particularly extensive and complex. Funds operating with different investment strategies and in different geographical regions have their own market practices, and the terms of each fund are unique. The international regulation of funds is developing, and new fund structures are regularly being launched.
Identifying the key legal and commercial issues for investors in these situations requires comprehensive expertise and experience of fund structures.
Fund investments are most often made by small and dynamic teams, and not all investors have in-house lawyers to perform due diligence reviews. Even if in-house resources are available for reviews, they often have to be shared with other business functions. The challenge in those situations is there not being enough time left for business-critical tasks.
Streamlining Legal Due Diligence Reviews
Due diligence reviews can be streamlined by developing established tools and processes. We have collected a few good guidelines below.
Make Yourself a Checklist
Write down the key goals of the review, the requirements set by the regulation and investment policy applicable to the investor, and the commercial, administrative and operative terms that you want to examine in all fund investments. You can also set internal boundary conditions that due diligence findings must stay within.
Systematically applying the checklist formed by these factors will speed up the review of fund material and make it easier to react to any problems at an early stage of the process.
Start the Process Early
Legal due diligence reviews take time, so it is a good idea to start the review as early as possible in the investment process. By doing so, you can identify the most problematic issues relating to the investment in good time and find a solution with the fund manager before the fund's terms are locked in.
Open an Active Dialogue with the Fund Manager and Their Advisers
An active dialogue with the fund manager and their legal advisers is an important part of an efficient investment process. It is particularly important to go over matters of principle relating to financial and governance terms as soon as the due diligence process starts.
In our experience, the earlier discussions concerning problems are started with the fund manager, the easier it is to find a satisfactory solution for the investor.
Consider Whether Outsourcing Would Provide Efficiency
Recently, many investors have outsourced due diligence reviews to outside advisers. This frees up the investors in-house resources for other tasks that provide more added value for business. Outsourcing may not be necessary for all fund investments, but could be used, for example, for the more complex types of funds or ones the investor has no previous experience with.
One key reason to outsource is that many investors do not make fund investments frequently enough to have a full picture of the latest fund structures and market practices. This can lead to increasedlearning costs when investing in unfamiliar funds. In such situations, a legal adviser specialised in private equity funds will provide efficiency gains and cost savings.
Originally published 17/12/2021
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.