Although larger sponsors have been running PE funds simultaneously alongside credit funds for quite some time, over the last few years there has been a steady increase in the number of private equity firms expanding their product offering to include credit funds. A key consideration for a PE firm deciding to enter the credit space is how to address and minimize potential conflicts of interest that arise when one sponsor has funds investing in both equity and debt. In the fourth installment of our credit funds podcast series, our attorneys take up this topic in their discussion on how to implement walls, develop appropriate policies and procedures, and navigate disclosure in key conflict scenarios, such as handling material nonpublic information (MNPI), investing in different levels of a portfolio company's capital structure and allocating investment opportunities.
Catherine Skulan: Welcome everyone. I am Catherine Skulan, counsel at Ropes & Gray, and today I am here with partners Jason Brown and Jessica O'Mary. Jason is a private investment funds partner in our Boston office and Jessica is a private investment funds partner in our New York office. This podcast is the fourth in a series addressing issues related to credit funds. Our conversation today will supplement our earlier podcast on using fund documents and disclosures to mitigate conflicts. Today, we'll be talking more specifically about the legal and compliance issues that private equity firms face when they expand into credit. Jess, is the idea of running a PE platform next to a credit platform new?
Jessica O'Mary: No, definitely not. Many established PE managers have been running PE funds alongside credit funds for quite some time. But, over the past few years, given the increased interest in credit as an asset class of its own, we have seen in the market and represented, a number of private equity firms that are expanding their product offering to include credit funds for the first time.
Catherine Skulan: Why the uptick? What is the appeal of credit?
Jessica O'Mary: There are a number of reasons why branching into credit can be appealing for PE firms. Many of the common ones that we have seen are that:
- It diversifies a firm's asset class and income stream;
- It may be synergistic with existing investments and as a result have a modest start-up cost;
- Their existing private equity platform may be providing access to debt deals that they are not able to take advantage of in their current funds but the returns would be appealing to some investors; and
- Finally, private equity shops are seeing that many of their existing investors have an interest in credit, and they see the opportunity to capitalize on those relationships while expanding their business lines.
Catherine Skulan: So the business case is pretty clear. But on the legal and compliance side, there are complex issues to consider. Jason, how do you think about this?
Jason Brown: Every PE manager expanding into credit will have a number of things to think about, but three topics that come at the top of every list are: MNPI, or Material Non-Public Information; conflicts from investing in different levels of a portfolio company's capital structure; and allocation of investment opportunities. As mentioned by our colleague Amanda Persaud in a prior podcast, it can be helpful to think generally about a framework that addresses these conflicts through fund documents and disclosures. However, in addition, PE managers expanding into credit should also consider specific structural solutions to address the new conflicts that investing in credit pose.
Catherine Skulan: I understand that some managers address conflicts related to this type of new business line by trying to separate the PE and credit business lines?
Jason Brown: Yes, that's right. Many sponsors with PE and credit arms institute some form of what we call a "wall." Essentially, a wall system tries to mitigate the conflicts of a new business line by separating the businesses with respect to information flow and decision-making. However, walls are not a one-size-fits-all solution and can be highly tailored to a firm's business goals and organization. Walls can be two-way, one-way or have various mechanisms for crossing. It is common for a PE firm's wall practice to evolve as its credit platform grows. Many managers may start out without a wall and then develop a wall system as their credit platform grows and the conflicts become more numerous. It is common to modify a wall to address business issues over time, and, in some cases, managers have even removed walls where they have found the loss of synergies outweigh the benefits of reducing conflicts.
Catherine Skulan: So, it may not be operationally or financially feasible to implement strict walls at the outset. Jess, how do you see that play out?
Jessica O'Mary: That's right, Catherine. Few private equity sponsors implement much, if any, wall at the launch of their credit platform if the initial credit business is small or the business rationale of the new credit platform is to take advantage of synergies with the existing private equity platform, since walls require separate investment personnel and additional infrastructure, resources and procedures. Information walls can cause teams to become siloed and prevent other beneficial synergies from developing. For example, the credit side may wish to leverage the private equity side's work by using the private equity side's diligence on a company, but sharing this information across programs with a wall in place is much more difficult. However, without a wall, managers may find that conflicts arise between the private equity and credit arms that cause limitations on either the PE or the credit sides of the business, and when business people start to be impacted, then you tend to see questions about implementing walls.
Catherine Skulan: Bringing this back to the "MNPI" issue that Jason mentioned. How is that implicated here?
Jason Brown: So the concern here is that the acquisition of confidential or material non-public information in one part of a firm may require another part of the firm to forego certain investment activity. Operating with a wall is one way to address the issue. Or, sponsors can operate without walls and try to mitigate the MNPI issue by limiting receipt of MNPI from the outset. For example, sponsors may decline to serve on a creditors' committee or avoid engaging in reorganization discussions with debtors in order to limit the potential intake of MNPI. In addition, in the course of investing in certain debt instruments (for example bank loans), the sponsor may elect not to receive non-public information concerning the borrower (such as early financial projections). But this isn't a perfect solution – managing a portfolio on incomplete information is not ideal, and MNPI might still creep in.
Jessica O'Mary: That's right. Despite the synergies of operating without walls, many credit teams eventually find the restrictions on trading on MNPI to be overly burdensome, and business conflicts can result. At that point, it is not unusual for some form of a wall to be instituted as a credit platform expands. But the key thing to remember is that regardless of mitigation approaches taken, sponsors must institute procedures with respect to MNPI. These can include monitoring for its receipt, maintaining a restricted list (or in some cases a watch list) of securities, establishing detailed protocols for transmitting information from one side of the business to the other and training personnel to identify and respond correctly to MNPI issues.
Catherine Skulan: And how about other conflicts? Jason, you also mentioned the issue of investing in different levels of a portfolio company's capital structure.
Jason Brown: Yes. This is an important one, and enforcement actions like JH Partners and other ongoing SEC inquiries, as well as our own experience in numerous SEC exams, show that the SEC is focused on this issue. Common examples of conflicts that can arise are: ensuring arm's length terms of debt; differing priorities in investment decision-making, including in distressed situations; the appearance of debt being used to support the equity position; and as mentioned already – information sharing limiting the sponsor's ability to take actions.
Catherine Skulan: So, what should sponsors do to address this issue?
Jason Brown: First, sponsors should clearly identify in disclosures to investors how this conflict may arise. They should also describe the policies and procedures they have for resolving and mitigating the conflicts. Implementing a wall or even having separate business teams on the same side of a wall is one approach. For those without a wall, some sponsors avoid the problem entirely with a policy prohibiting the financing of portfolio companies in which the firm's PE arm has made an investment. However, many sponsors generally prefer the flexibility to invest a meaningful amount of commitments in debt of portfolio companies of the private equity fund. In that case, the sponsor has to take a more nuanced approach to addressing these conflicts. For example, on conflicts with respect to debt terms, a fund may be comfortable acting as lead arranger for other lenders extending debt to a company controlled by an affiliated private equity fund if third-party lenders are extending credit on the same terms, since this can validate the price.
Jessica O'Mary: That said, many sponsors avoid being the lead arranger for other lenders because there is a possible perception that the credit fund has access through its private equity fund affiliate to information about the portfolio company that is not made available to other lenders, or that the credit fund is being used to facilitate the private equity fund's acquisition of the target, support the private equity fund's equity position, or that the private equity fund is "giving" business to the credit fund. Rather, a number of sponsors that we've seen tend to be a minority lender in this situation – commonly 25% or 20%, or in many cases significantly less, of a tranche of debt, although we have seen that in some cases due to an investment strategy of a fund, for example, a strategy that is very focused on financing debt of portfolio companies of an affiliate, we have seen funds go up to 49% of the debt tranche. Some managers may also require another lender to purchase the debt on the same terms as Jason mentioned or, less commonly due to the operational burden, may require advisory committee limited partner consent to the terms.
Catherine Skulan: One specific conflict that comes to mind here is the one that could arise if the credit fund is called to vote as a creditor in a distressed or other voting situation.
Jason Brown: Yes. This is a good one to call out. Again, disclosure of policies is key. Though often, from a disclosure standpoint, sponsors maintain flexibility to use multiple procedures to address this situation. For example, some common approaches are voting proportionately to other creditors in a workout, separating teams and decision-making for each arm, or requiring LPAC approval of the vote. Some sponsors require the decision of an overarching conflicts committee, before which the private equity and credit arm each represent the interest of their respective fund. Less commonly, I've also seen managers call on an unaffiliated third party to make the decision or vote with the most senior tranche or abstain from voting.
Catherine Skulan: Interesting. Now, a final key conflict mentioned earlier was allocation of investment opportunities.
Jessica O'Mary: That's right. Given the risk and return profile of a typical private equity and credit fund investment, allocation issues may be less likely to arise between these funds than other types of asset class combinations. But that being said, many private equity firms have over time broadened their mandates to include some form of debt in their private equity funds, particularly higher returning or synergistic debt. Given the life of private equity funds and their time period, private equity sponsors should analyze their current fund documents if they're looking to launch a credit arm, and consider in advance the likelihood of a future credit platform and potential allocation issues.
Catherine Skulan: And would it be correct to think here that disclosure is just as important here as other situations we've talked about today?
Jason Brown: Absolutely. A sponsor should clearly disclose the potential for allocation conflicts among vehicles and accounts with strategies that overlap, even in part, with the strategy of other funds it manages. A manager owes fiduciary duties to all clients, and, in the absence of clear disclosure to the contrary, ultimate allocation decisions must be made by the sponsor on a fair and equitable basis. Importantly, allocation decisions should be made in advance, in as consistent a manner as possible, and documentation should be maintained of the allocation decision-making. Sponsors with a wall between platforms will have an easier time with allocation issues, but they need to disclose clearly that if opportunities are sourced on one side of the wall, they will not have to be offered to funds operated on the other side of the wall. All managers should also have clearly developed policies and procedures to address allocation conflicts.
Catherine Skulan: Thank you, Jason and Jessica. That's all we have time for today. Thanks very much for listening everyone. Please tune in to our other podcasts on topics of interest to credit funds. You can find them on our website at www.ropesgray.com.
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.