Disposal of an investment

Explanation

Establishing the appropriate point to dispose of an investment is a matter of judgment for the GP. Any decision to realise an investment involves a comparison of the present value of an investment, its potential future value and the opportunities to realise that value in the future. In making this consideration, the exit decision should take account of the broader context of the investment within the fund, including the cost of continuing to hold the investment for the fund’s investors and any factors arising from agreements with other shareholders, co-investors or the portfolio company and its management. While a divestment plan is usually considered at the time of investment, setting out the path to exit, this should remain a dynamic document reflecting developments in the portfolio company and the broader market as the investment progresses.

A change in ownership of a company may impact different stakeholders. The governance and shareholder provisions agreed with any other shareholders as well as financing arrangements and other agreements linked to ownership might be impacted by the change in control. Reaction with the company among its employees, customers and suppliers may vary. In general, there may be various ESG factors impacting the divestment and its timing.

Recommendation

The GP should, as far as is possible, dispose of investments at a time and in a manner that accords with any existing divestment strategy and maximises the return to the fund’s LPs. GPs should be mindful of the aim to divest the fund’s assets within the lifetime of the fund to the extent that exit opportunities permit.

In preparing for a portfolio company exit, the GP should also consider any ESG factors that may be relevant, either for the portfolio company itself or a future buyer of its shares.

Explanation

As the exit decision is a matter of judgment, it is important that the decision-making process engages the GP in the same manner as the original investment. Senior input is required to assess risks and opportunities from the decision. Where co-investors, from the fund or otherwise, are involved or control is otherwise shared, this may require agreement outside the GP and fund before launching an exit.

The exit decision also results in financial transaction, with funds moving between the parties. As a result, like an investment, an exit falls within the scope of anti-money laundering regulations.

Recommendation

The GP should establish a process for deciding whether and how to dispose of an investment. Wherever possible this process should mirror the process that is followed when considering an investment decision and any proposed divestment should be subject to equally rigorous checks. The GP must follow anti-money laundering procedures to verify the origins of the funds received in the sale process.

Explanation

A purchaser of a portfolio company may seek a range of warranties and indemnities from the fund. Negotiation over these will invariably be a key issue for the GP when disposing of an investment. During negotiations, the GP must consider the risks and detriment to the fund in giving such warranties and indemnities against any enhancement of return that they could bring.

When deciding whether to give a warranty or indemnity, the GP may also take into consideration the remaining life of the fund and the fact that it may be difficult to draw down cash or re-draw distributions from investors to meet liabilities in the event of a claim. The establishment of an escrow account or the use of a warranty insurance product are potential solutions to address this issue. Time limitations and financial caps can also be considered and negotiated.

Recommendation

GPs should normally only give warranties and indemnities on behalf of the fund on a disposal where this is expected to produce an enhanced return for investors, or the warranties relate purely to title to shares owned by the fund and authority to enter into the transaction documents.

The liability under such clauses should be capped in quantum and time and the GP should seek to ensure that the fund is able to meet these liabilities. An escrow account is commonly used to fulfil this purpose and could be set up at the time of the exit. In order to achieve an added layer of security that the fund will be able to meet any liabilities, the original fund documentation should contain an investor clawback provision, enabling a certain percentage of distributions to be clawed back from investors should this become necessary even after the end of the life of the fund. This provision should be limited in time and amount, as investors will otherwise not agree to it. The GP may also take out insurance to cover warranties and indemnities; doing so may help to meet the expectations of a potential purchaser and allow full distribution of the proceeds.

Explanation

A GP’s obligation is to seek the best returns from an investment for the fund and the GP must consider opportunities to effect non-cash disposals in light of this. It may be that, for example, there is no cash purchaser for an investment, or that a cash price is offered but at a lower valuation than a “share for share” swap into a quoted vehicle, or that the fund can participate in the future value of an investment through an earn-out. However, there are also the risks of falls in the market.

Any decision to accept a non-cash disposal is also likely to involve additional costs. For example, there will be a cost in safeguarding and administering any quoted investments held by the fund. Fund documents often include restrictions on the holding of quoted securities, which may limit the options available.

Cash returned is also an important measure of performance; LPs may also have concerns about or may be restricted from receiving distributions in-specie and there may be restrictions upon a holder’s ability to sell quoted securities, also known as “lock-up periods”.

Recommendation

GPs should carefully assess any non-cash offer consideration in an exit, considering any particular restrictions from the fund documents. The decision should balance the immediate value of any other cash offer; the life cycle of the fund; the need to return cash to LPs; the potential future value and exit opportunities in any securities offered; and the ability to hedge against downside market risks.

Explanation

Situations where funds managed by the same GP are transacting between themselves inevitably lead to conflicts of interest as each vehicle may have different investors and therefore different interests. Such conflicts are typically difficult to resolve and therefore in most circumstances are unlikely to be acceptable to LPs.

That said, there may be exceptional circumstances where such transactions can be countenanced, for example where it is the right time for one fund to exit (for example, because it is at the end of its life cycle), but where there is still future value which can be created in the investment and where there is a strong case that the manager is uniquely placed to deliver such value. In these circumstances, there will be conflicts of interest that need to be carefully managed and disclosed. Importantly, the price and warranties to be provided, if any, and the conditions attaching to them need to be defensible to both the buying and selling fund’s investors.

Recommendation

The sale of investments between funds operated by the same GP is generally not recommended as it leads to significant potential conflicts of interest.

In cases where such sales and/or co-investments between funds are contemplated, GPs should ensure that they discuss this transaction at the earliest opportunity with the relevant LPACs for the funds, the transaction is handled in accordance with the fund documents and that the LPs in both funds are made fully aware of the transaction. The GP should strictly adhere to the conflict management provisions set out in the fund documentation and also its own internal conflict management policy.

Whenever considering such a transaction, a GP must be able to demonstrate that no fund has been preferred at the expense of another (for example, by arms-length negotiation or obtaining a proper Fairness Opinion of the investment). Teams acting for each of the funds should either be separated, subject to appropriate information barriers, or GPs and LPs should be made aware of any potential conflicts of interest with regard to a common representation.

Explanation

There are a number of issues that affect the GP when it holds quoted investments. Dealing in such investments will often be subject to additional regulation (such as prohibitions on insider dealing and market abuse). The GP may also need to consider the impact on the market of its dealings in the portfolio company’s securities.

In many jurisdictions it is illegal to deal in securities issued by quoted companies when in possession of unpublished price-sensitive information relating to that company’s business. Where a GP has maintained a close relationship with a portfolio company after a flotation there are circumstances where the GP may receive such information. This may prevent the GP from selling an investment until that information is public.

Market rules may also prescribe certain periods in which the portfolio company directors may not deal in investments. These rules may also be relevant where an employee of the GP remains a director following a flotation. The risk of the GP committing an insider dealing offence is increased where the GP maintains a presence on the portfolio company board.

In many jurisdictions insider dealing is a criminal offence, punishable by imprisonment and substantial fines. Insider dealing may also allow anyone who has suffered a loss as a result of the GP’s conduct to recover any loss that they have suffered from the GP.

Recommendation

The GP should adopt appropriate policies on the management of quoted securities, including considering whether it is appropriate to retain a seat on the board.

The GP must ensure that it does not breach prohibitions on insider dealing and market abuse when managing quoted investments. Careful consideration should also be undertaken in all reporting and communication to the fund’s LPs to not disclose any price sensitive information that is not available to other market participants.

Where the GP retains a relationship with a portfolio company whose securities are quoted, the GP should ensure that it does not utilise any confidential information it acquires to determine or influence its disposal policy, unless that information is available to all of the portfolio company’s shareholders.

The GP should recognise and observe any applicable guidance and requirements concerning responsible investment management which are relevant to the listed securities markets in which the GP operates.