GP’s internal organisation

Explanation

In the private equity environment, there are several layers of governance considerations.

First, the GP’s business should have its own internal processes and procedures concerning corporate governance, which should be kept under continuous assessment to ensure that they remain appropriate. The frequency and detail of review will be different for different GPs depending on their size, complexity, LP base, geographical reach and a range of other factors.

Second, governance at fund level should be taken into consideration by GPs both at the fund structuring stage and also during the life of the fund. LPs will not be involved in the management of the fund, but do however have a role to play in relation to certain decisions to be made, such as whether or not to remove the GP under the so-called fault/no-fault divorce provisions, to approve amendments to the fund terms, to terminate the fund, etc.

A number of LPs may also play a role as members of an LPAC (see the relevant section here). LPs sitting on the LPAC will usually be asked to consider issues concerning conflicts of interest, Key Person events, approval of valuations, etc. The LPAC has a role to play in governance, however, governance is not just limited to those LPs on the LPAC; as mentioned above, all LPs have a role to play.

Good governance implies that conflicts of interest should not be left to the discretion of the GP. Conflicts can arise in a variety of situations, including GPs (or GP staff) holding an interest in a company which the GP recommends for investment to the fund, co-investments by GP staff alongside the fund, the GP acting for multiple funds, deal allocation between different funds managed by the GP, etc.

Sometimes conflicts can also arise between LPs, such as when some LPs have more than one interest in funds managed by the GP, especially if those LPs hold a majority on the LPAC. LP conflicts of interest are considered in more detail in the “LP relations” sub-section in “Managing your relationship with LPs” (question 4). While LPs do not owe any fiduciary duties to one another, it is the GP’s duty to manage such conflicts when they arise and to treat all LPs fairly while acting in the best interests of the fund as a whole.

Third, the governance of a portfolio company needs to be considered by the GP. Once an investment is made, portfolio company governance should be kept under continuous assessment to ensure that it remains appropriate. However, the frequency and detail of review will be different for different companies. This is explored more fully in the “ESG and Responsible Investment” sub-section in “Management of an investment” (question 3).

Recommendation

The GP should implement and monitor corporate governance processes and procedures at the GP level. Oversight of the GP’s governance should encompass elements of independence, such as segregation of duties and reviews, proportionate to the size and nature of the GP entity. The processes should also be discussed with the LPAC and communicated to all LPs.

The GP should ensure LPs are involved in the governance of the fund by establishing an LPAC, conducting regular meetings with LPs and ensuring reporting to and communication with LPs is of a high standard.

As set out in the “ESG and Responsible Investment” sub-section in “Management of an investment” (question 3), the GP should also work with its portfolio companies to establish monitoring programmes, which, as a minimum, ensure that all elements of the corporate governance framework are reviewed at least annually.

Explanation

As part of the due diligence process of a GP by a prospective investor during, for example, fundraising, a number of factors in relation to the operation of the GP will be carefully scrutinised. The due diligence process will normally look at the GP’s:

• corporate governance processes, culture and values;
• policies and procedures (including in the field of responsible investment);
• investment, divestment and portfolio company decision-making processes;
• reporting processes, including in the field of responsible investment;
• compliance and risk management processes;
• business continuity plans;
• conflicts of interest management and resolution procedures (likely to include conflicts between employees and the GP, third parties and the GP, the GP and the LPs and between the LPs themselves).

Recommendation

It is important that a core team, typically including representatives from across the GP’s operational areas, regularly reviews the requests being made by LPs for information on processes, policies and controls and that the information being supplied is kept current and is provided in a consistent manner. Ideally this information should be held in an electronic format that can be easily collated depending upon the request and to the extent possible is compatible with the LP’s own systems.

A record should be kept of when and what information has been supplied to each LP. This group should review and agree to new requests or requests for information that has not been supplied in the past. Where possible and practicable, the GP should benchmark the type and level of information it is supplying against its peers as transparency and a willingness to provide such information can be one of the factors an LP will use when deciding which GP(s) will receive a capital allocation.

Explanation

The industry is continuously evolving. ESG considerations are becoming more prominent and increasingly integrated into all aspects of the GP’s activities. At the same time, the formal regulatory environment is evolving, not only with the AIFMD, FATCA and similar initiatives, but also with developments impacting corporate governance and responsibilities in general. Whether directly applicable to the GP or not, the emerging standards impact the expectations of LPs for all of their GP relationships.

Recommendation

The GP’s corporate governance processes and procedures should be reviewed by the GP on a regular basis to ensure policies are reflective of current standards, laws and regulations, are up-to-date and are being implemented and followed.

Explanation

Management is responsible for ensuring that throughout the GP organisation employees recognise and respond to the need for integrity and ethical behaviour in the GP’s own organisation and throughout the portfolio. A high standard of corporate governance sets the framework to meet this goal effectively.

Recommendation

Management should identify, select and adopt an appropriate governance and control framework taking into account the size and complexity of the business and should communicate the key features of that framework, applying it consistently and effectively. In doing so, the GP needs to be fully aware of relevant regulatory requirements (including those established by the AIFMD, where that applies to the GP) which will dictate certain aspects of the control environment.

Explanation

Control activities are those protective measures in business and financial processes which help prevent errors and omissions from occurring or which detect when errors or omissions have occurred.

In a well-governed organisation, all members of the management team are aware of the importance of control activities and acknowledge their responsibilities for control activities in their particular area, ensuring the importance of these is communicated to members of their team. Control activity is not just the remit of one particular function within the organisation, e.g. compliance and risk or finance, and it is important for all members of the management team to acknowledge this and place the necessary internal emphasis on its importance.

Recommendation

Management should ideally conduct a review of control activities on a regular basis covering both the design and operation of those activities and ensure that the conclusions and any necessary remedial actions are discussed and followed up at an appropriately senior level of the GP’s governance structure.

Explanation

Risk measures from a GP point of view

As equity investors operating in an environment surrounded by uncertainties, GPs are faced with a set of risks that may hinder the completion of their objectives. At each key phase of the investment, GPs are responsible for implementing processes designed to identify and assess the primary risks. In assessing the return potential of an investment, consideration should be given to the associated risks. To achieve an attractive risk-return ratio, three essential features should be considered:

• assessment of business risks during Due Diligence phases by including in the scope of investigation country risk, financial risk, management organisation, business ethics, interest rate risk, ESG risk factors, monitor with appropriate KPIs those identified risks and put an appropriate action plan with the portfolio company management to manage those identified risks;
• assessment of financial risks stemming from debt leverage at acquisition and during the life of the investment vs cash-flow generation by the portfolio company;
• involvement of the executive officers and employees, at their respective levels of responsibility and authority to establish a strong risk management culture.

GPs are expected to prevent and mitigate significant risks through organizational and operational measures within their own organization and facilitate this for their portfolio companies. These may include: improvement objectives, training, awareness raising, risk mapping, action plans, questionnaires, supply chain audits, whistleblowing mechanisms, operational procedures, development and integration of ESG policy and internal audit.

Recommendation

Management should make sure appropriate risk measurements and procedures are in place to assess the key risks that could evolve during the lifetime of each investment. Once risks have been identified management should make sure executive officers and employees are appropriately involved.

In addition, applicable laws (including the AIFMD) make specific provisions concerning GP and portfolio risk management.

Explanation

A GP can expect extensive due diligence on its risk management and processes to be conducted by the LPs. The following points could be assessed:

• Has the GP established a risk management function?

• How is risk management organised at the GP?

• Does the GP have an ESG policy?

• Is the GP’s team structure sustainable and is there a key man risk clause in the LPA?

• Does the LPA contain a limit on concentration risk?

• Are political, regulatory, country, tax risks considered in the LPA?

• Have all conflicts of interest been considered and identified and properly addressed in the LPA?

Furthermore, a Limited Partner should assess and measure its own private equity portfolio risks, which include:

• Investment risks (e.g. expected return scenarios, FX, alignment, risk/return profile, etc.)

• Funding and liquidity risk

• Market risk

• Capital risk

Risk measurement guidance on these topics is provided in the EVCA Risk Measurement Guidelines as published by Invest Europe in January 2013.

Recommendation

Management should be open to facilitate the assessments by LPs in an open and constructive manner in the due diligence process and throughout the monitoring of the investments by LPs.

Explanation

Risk assessment includes determining an appropriate risk appetite, identifying specific legal, commercial and reputational risks, assessing the effectiveness of mitigating actions and controls over specific risks and comparing residual risk to the overall appetite for risk that has been agreed, and adjusting the mitigating actions and controls as necessary. As the business environment is frequently evolving, effective procedures for risk assessment will necessitate a regular and rolling review of strategic and operational matters.

Many areas of risk touch on specific and often technical issues. A GP may need support from external specialists when dealing with specific risk areas such as legal risk, market/public relations risk, treasury risk, tax risk, financial crime risk, labour relations risk, regulatory risk or information technology risk.

Explanation

Preferably and where practically possible a GP should establish a fully or substantially independent risk management role within their firm. The risk manager should act as a second line of defense, making sure all risks are measured and assessed to the highest standards, complete and in all parts of the process. Where possible it is preferred that the risk manager provides his/her independent opinion on the risks assessed in all decision-making processes concerning the GP’s investments. The risk manager should be as independent as possible, to make sure he/she is not influenced in his/her judgement or is feeling dependent upon other parts of the GP organisation to give his/her opinion.

Recommendation

The assessment of risk should be a regular ongoing process that identifies, measures, monitors and mitigates risks, and which should combine risk management judgment by the GP with quantitative measures to support such judgments.

The assessment should involve the senior management of the firm and encompass risks at the fund level as well as those of the GP’s own business.

Any processes or procedures introduced to an organisation should normally be subjected to an analysis comparing cost, benefit and any potential regulatory implications.

The introduction of any new risk assessment infrastructure or procedures by an organisation should acknowledge that much of what happens in existing business processes is likely to include the proactive assessment and mitigation of risk and that therefore the introduction of procedures is partly a matter of making explicit what is already in place. This is particularly true in the case of private equity firms that are likely to have well-developed risk assessment and mitigation approaches and processes already embedded in their investment decision-making process.

A GP should seek external support from specialists as required when dealing with specific risk areas beyond its internal competences.

Explanation

Employees and others engaged by the GP are a vital resource. If this resource is not adequate or is not maintained and appropriately managed, the GP may not be able to implement the fund’s investment policy.

Recommendation

The GP must, at all times, have a staff of adequate size and appropriate skills and competence to ensure that it is able to fulfil its obligations, including to all funds under management. These staff should be appropriately allocated.

The GP should implement human resources management processes to administer appropriate functions (such as payment of taxation and social security contributions) and to implement any training and development policies together with policies and procedures that ensure compliance with employment law.

The GP should implement and maintain arrangements requiring its employees to act with integrity and to conduct themselves in an appropriate and professional manner.

The GP should ensure that it implements appropriate succession planning arrangements to ensure that the quality and experience of its key personnel is maintained over time.

The GP should ensure that it has sufficient skill and experience to manage and maintain LP and other key stakeholder relationships.

Diversity is becoming an increasingly important consideration including amongst regulators and GPs should stay prepared and carefully consider the issue of diversity in developing their human resources policies.

Explanation

An incentivised and motivated team is vital to the success of the GP. By adopting appropriate policies to maintain a stable and motivated team, the GP is likely to improve its performance and returns to LPs.

The AIFMD and/or other regulatory provisions applicable to the GP may have an impact on the structure of remuneration within the GP and the GP should ensure that it fully complies with any such rules. For example, the AIFMD requires managers to ensure that their remuneration policies and practices are consistent with and promote sound and effective risk management and do not encourage risk-taking which is inconsistent with the risk profiles, rules or instruments of incorporation of the funds they manage.

The LP community is also increasingly benchmarking remuneration practices against the requirements and principles set out in the AIFMD, similar regulations or standards.

Recommendation

The GP should ensure suitable remuneration for its staff. An important factor in the development and structuring of a remuneration scheme will be to ensure that it creates an alignment of interests between the staff, the GP and the LPs in the fund, including appropriate attitudes to risk and risk management. The GP should ensure that its remuneration policy and practices are consistent with its responsible investment objectives. The GP should ensure that carried interest and similar arrangements are structured in a balanced manner to motivate, retain and incentivise the team and its key members throughout the life of the fund. The GP should also ensure that there are provisions that set out the extent to which individuals are permitted to participate in carried interest arrangements upon leaving the GP.

Explanation

According to the local regulatory environment of the GP (including, where applicable, the AIFMD) or any of the entities through which it is authorised or carries on its management activities, minimum levels of capital adequacy and/or liquidity may have been prescribed. The AIFMD for example provides that both capital and cash or readily realisable securities must be higher than specific thresholds related to fixed overheads and assets under management as well as requiring the AIFM to maintain professional liability risk cover through appropriate insurance or additional own funds.

It is important that the GP plans its own financial resources to ensure that they remain sufficient to allow the GP to operate effectively and to implement the investment policies of the funds under management, over their entire life. Particularly as management fees typically decline later in a fund’s life, adequate planning over the life of the fund is needed.

Prior to their making a commitment some LPs may request due diligence information on GPs’ financial resources. 

Recommendation

The GP should maintain adequate financial resources to allow it to continue to operate during the life of all funds under management.

The GP should implement internal financial reporting procedures to ensure that it effectively monitors its financial position on an ongoing basis.

In addition, GPs should be prepared to respond to requests for information on its financial resources.

Explanation

In the event of the GP becoming insolvent or being the subject of legal proceedings, it is essential that assets it holds or controls on behalf of funds are protected and cannot be used to discharge the liabilities of the GP.

Any GP which is fully authorised by the AIFMD will require a depositary to carry out three core duties: cash management, safekeeping of assets and general oversight of the AIF. In very broad terms, the role of the AIFMD depositary is to safeguard the fund’s assets by verifying that no assets (cash or otherwise) are transferred in or out of the fund without appropriate documentation for the transaction.

Recommendation

The GP must make appropriate arrangements to ensure that fund assets (including cash) are segregated from its own assets at all times.

When the GP achieves this by lodging assets with an external custodian, the GP should ensure that such assets are appropriately protected by the custodian and that there is a suitable written agreement with the custodian.

AIFMD-affected GPs should ensure their internal procedures fulfil the various requirements including, subject to certain conditions, the appointment of a depositary.

Explanation

While the efficient operation of the GP will be supported by adhering to general principles of good governance and effective business management, there are certain matters that are specific to the industry that the GP should address.

Recommendation

The GP should implement procedures to address the following matters (which are in no particular order):

• personal dealing in investments by GP staff and connected persons and if necessary, with other parties with whom the GP is dealing;
• decision-making on investments in target companies and disposals of portfolio companies on behalf of the funds;
• storage (and as required, confidential destruction) of documents and record-keeping;
• outsourcing of material functions (particularly where they may impact on the management of funds);
• anti-corruption rules, the prevention of money laundering and other forms of financial crime;
• anti-trust law requirements, in particular bid-rigging;
• business continuity in the case of a business interruption;
• insurance requirements to protect both the GP and the funds it manages, for example Directors & Officers insurance for executives appointed as directors or non-executive directors on portfolio company boards and professional indemnity insurance, if applicable;
• the protection of the fund and the GP in the event of key employee departures;
• any other required regulatory procedures as outlined in, for example, FATCA and AIFMD.

Explanation

LPs place a high degree of trust in a GP, committing their capital and in effect “locking it up” over the medium to long term.

The best assurance and control mechanisms for an LP are the regular flows of information, communication and face-to-face meetings with GP’s senior management. Formal procedural steps should however also be put in place that provide a reasonable level of assurance that the terms of the agreements and any particular laws are being adhered to.

Recommendation 

A GP should make provision for internal review procedures which allow the board of the GP to gain a high level of comfort that the terms of the agreement with any LP or customer and any applicable legal requirements are being followed.

These procedures should be overseen by a member of staff of sufficient seniority and independence and with sufficient resources to ensure that they are undertaken effectively.

Explanation

GPs vary in their size and experience, but no GP is likely to have all the internal resources necessary to deal with every possible matter for which it is or becomes responsible.

The establishment of a fund and its operation frequently involve specialist considerations in many jurisdictions.

Recommendation 

A GP should obtain appropriate specialist and technical advice in order to carry out its duties. Legal, tax and accountancy advice will almost always be necessary and sometimes other specialist consultants (e.g. environmental, scientific, social and technological) may be required.

Explanation

Effective management by the GP depends on the ability of individuals to make well-informed decisions. The accuracy, timeliness and relevance of information on which to base decisions is therefore of paramount importance.

Businesses generate large amounts of information: about customers and markets; historic, current and future financial and non-financial performance; profitability, efficiency and effectiveness; and about risk and the management of risk. One of the key roles of the GP’s executives is the assimilation of the data and management information being generated at a portfolio company level. Analysis and assessment of this information is critical to gaining a clear insight into the portfolio company and as a result ensuring the most effective management of the portfolio company at a strategic, tactical and operational level.

Recommendation

Management should ensure that the organisation’s information is:

• accurately compiled;
• clear and unambiguous;
• kept secure and confidential;
• available in a timely and appropriate format and manner.

Explanation

Business is largely dependent on up-to-date computer and software technologies for the recording, storing, processing and reporting of information. The suitability, efficiency and security of information systems are vital to the ability of the business to function effectively.

Recommendation

Management should regularly assess the suitability, security and reliability of the business information systems used by the GP. It should also consider those same factors in relation to the systems used by third parties to whom functions are outsourced.

Explanation

Management needs to communicate both internally within the GP and externally with LPs, advisers and other stakeholders.

For example, management will inform GP employees about strategy and expected performance and will give LPs and, as relevant, other stakeholders trading updates and other information.

Recommendation 

Internal and external communications should be:

• based on accurate information and honest interpretation;
• clear, unambiguous and suitable for the target audience;
• delivered in a timely manner.

Members should contribute such data about themselves and their portfolio companies as may be requested by Invest Europe from time to time and which are to be used on an aggregated and anonymous basis.

It is good practice to nominate a member of management to take overall responsibility for the GP’s public relations strategy.

Explanation

A greater understanding among the general public of the private equity industry, its working methods and what it brings to the real economy enhances the industry’s ability to match investment capital with investment opportunities. The better the industry communicates, the greater will be the understanding of its activities.

The rapid growth of the industry over the past decade implies that an increasing number of people are today employed by companies that are wholly owned or controlled by the industry. An even wider group is increasingly impacted as stakeholders in portfolio companies. This creates the need for a greater level of transparency and disclosure of information by individual GPs and the industry to a wider stakeholder group.

When a GP is undertaking an investment in a portfolio company or implementing a new strategy or change programme for the business, the need for communication with the portfolio company’s stakeholders is even greater. It is an integral and important part of the value creation process as the GP seeks to create buy-in and align interests to enable it to advance its strategic and business goals.

Recommendation

GPs should have an appropriate communication strategy, reflective of their operations and scale. A website is the starting point to provide information regarding themselves and their investments in a timely fashion.

The GP’s website could include information on:

• description of the firm and key elements of its organisation;
• senior management or senior investment professionals;
• size and investment strategy of the different funds;
• investments made with the following information about each portfolio company:
  • date of investment
  • date of divestment
  • type of industry
  • link to the portfolio company’s website
• policies regarding responsible investment;
• press releases issued by the GP;
• public relations contact details.

The GP should also pay attention to local transparency requirements and disclosure requirements of LPs in considering the information made available.

Explanation

With the growth of the private equity industry comes increased public attention. Politicians and regulators call for increased transparency. They also propose regulatory initiatives that require all industry participants, both GPs and LPs, to operate on a documented basis of shared information. The industry’s ability to respond is enhanced by its access to a reliable and respected set of data collated by a non-commercial provider. Many data providers operate in the field but have varying resources to allocate to data collection and all rely on voluntary, intermittent submissions, mainly from GPs.

Due to Invest Europe’s structure as a co-operation between GPs and LPs, the Invest Europe Research department is uniquely positioned to collect, analyse and disseminate data on all relevant components of the private equity industry throughout Europe. However, in order to make the most of this position, the Research department relies on submissions from all member groups. All collected data will only be reported in the aggregate to ensure full confidentiality and no commercial purpose is pursued. The scope of data collected includes: activity data on fundraising (including category and geography of LPs), investments and divestments; performance data to inform fund-level and portfolio company-level aggregate benchmarks on the industry; and economic impact data relating to employment and performance of portfolio companies.

Recommendation

LPs and GPs should structure their contractual arrangements so as to allow for the submission of information to the Invest Europe Research department and should generally encourage industry participants to contribute to establishing Invest Europe Research as an information provider that is trusted by industry participants, academia and regulators.