Planning and making investments

Explanation

The due diligence process undertaken by the GP prior to making an investment in a portfolio company is vital. The information acquired during the process, together with the GP’s own knowledge and expertise, will form the basis of any investment decision.

The due diligence process will investigate a wide range of aspects of the target company’s business including commercial, market, financial, tax, legal, regulatory, pensions, insurance, information technology, intellectual property, environmental, social and governance aspects and management capability. The objective will be to gain a detailed understanding of the prospects for the target company, evaluating the risks and issues it is facing or may have to face in the future that may play a part in the GP’s investment decision and the ultimate success of the portfolio company over the projected investment period. From this, an assessment will be made of the potential for value creation and ultimately exit opportunities from the investment for the fund.

In certain circumstances, a GP may face time constraints on the execution of an investment. These can arise from the specific bidding environment of the transaction or the condition of the portfolio company in the case of a turnaround or distressed investment. Planning and prioritisation will be needed in these circumstances to ensure the GP has an adequate understanding of the opportunity to make its decision.

Recommendation

In the absence of exceptional circumstances, a GP should seek sufficient information to allow it to properly evaluate the investment opportunity being proposed and to establish the value of the target company. The information sought should (within the confines of what is practicable in the circumstances) address all appropriate issues which may include the financial position of the target company, the experience and ability of its management team, the sector(s) and geography(ies) in which the target company operates, the potential to exploit any technology or research being developed by the target company, possible scientific proof of any important concept, protection of important intellectual property rights, pension liabilities, relevant ESG factors, litigation risks and insurance coverage).

The due diligence process should also include testing the assumptions upon which business plans are based and objectively evaluating the risks that may arise from investing and the potential return on investment.

Other appropriate checks, as required by LPs, regulators and other stakeholders should be carried out. This should include taking steps to be satisfied that the transaction does not facilitate money laundering, and to ensure that the investment complies with anti-corruption or anti-bribery regulations and relevant sanctions regimes.

Explanation

A GP should be mindful of the risks posed and opportunities presented to its portfolio companies by ESG factors. The success of an investment may be impacted not only by its financial performance but also by other performance criteria. A GP needs also to be mindful of its own LPs’ approaches to ESG and to seek to comply with their requirements, which may include expectations in relation to reporting on responsible investment factors in the investment and ownership processes and in some cases exclusion from investing in certain sectors.

Examples of some of the practical arrangements for achieving integration of responsible investment include:

• using ESG information requests/questionnaires for the portfolio company, an example of this is the ESG DDQ for Private Equity Investors and their Portfolio Companies as published by Invest Europe in 2016;
• using a standardised ESG investment framework to help identify relevant ESG factors and formally addressing ESG factors in the investment process;
• including ESG site visits during the due diligence and ownership phase;
• including a dedicated ESG section in investment proposals.

Recommendation

GPs should integrate consideration of responsible investment risks and opportunities into their due diligence and investment approval processes and keep their investment documents and processes under periodic review.

Any staff training needs on responsible investment matters should be identified, addressed and kept under regular review. Evaluation of responsible investment matters should not be limited to legal compliance, but could also include any additional standards and practices that could materially impact an investment from an ESG perspective; potential future regulation and marketplace factors such as existing or emerging voluntary standards; consumer expectations and client requirements; and broader issues that could have a reputational impact. It is also important that ESG risks and opportunities are considered across portfolio companies’ value chains.

Where the GP has identified ESG risks and opportunities that are deemed potentially material to the success of the investment or are particular focus areas of LPs, the GP should ensure that practices are developed to mitigate associated risks and pursue opportunities. These practices should also be included in post-investment action plans. The implementation and effectiveness of these practices should be monitored as appropriate, and therefore the GP should consider how it will obtain relevant ESG data from the portfolio companies. Noting that the ESG context could evolve, the GP should undertake to regularly update its responsible investment risk/ opportunity analysis and revise, remove or add governance and monitoring frameworks as appropriate.

A GP that has created governance structures and due diligence processes for responsible investment factors should report to LPs on its findings on a suitably regular basis. The GP may also choose to send unsolicited reports on responsible investment factors and performance to all LPs, or report following a significant ESG incident.

Explanation

Any decision by a GP to make an investment involves an appraisal of the opportunity and an evaluation of the risks versus the rewards of the opportunity. The information on which this decision will be based will usually have been gathered and critically appraised within the team of executives working on the transaction during the due diligence phase. The quantity of such information, however, will normally be so great that it will need to be summarised before it is presented to the Investment Committee or other decision-making body of the GP that ultimately decides whether or not to make an investment.

Undertaking a successful due diligence exercise that confirms the validity of the underlying assumptions of a business plan will not generally be sufficient in itself. What is also required is the experience of the senior executives of a GP to add value to the due diligence exercise by critically evaluating the information collected by applying their depth of business and investment experience.

The investment proposal is an important document; not only does it provide a written record of the information considered in making an investment decision, but it will typically contain the core investment thesis that will continue to provide the yardstick by which the success of an investment will be judged during its regular review by the GP.

Recommendation

The results of the due diligence exercise and the GP’s senior executives’ recommendations should be distilled into a comprehensive written investment proposal, which accurately reflects the potential of the target company, addressing a range of both financial and non-financial factors. Amongst these factors are the ability of the GP to execute and manage the investment and possible exit routes. As part of this process, consideration should be given as to whether the proposed investment fits the investment criteria and complies with the investment restrictions in the fund documents.

Investment decisions should be made by suitably senior and experienced personnel of the GP; normally these individuals will form an Investment Committee. If there are any significant changes to an investment proposal, further review, evaluation and additional approvals may be required.

It is good practice to use the underlying reports from which the investment proposal is drawn to form an important set of source documents for strategic review and assessment of the performance of the portfolio company.

Explanation

Investments by funds can be structured in many ways. In some cases, the fund may be a passive minority investor in a portfolio company, while in others the fund may obtain substantial or indeed full control over the portfolio company. In determining how the investments should be structured, consideration should be given to e.g., the jurisdiction in which the investment is to be made, the terms of the investment, the investment strategy and risk limits of the fund and whether the investment is to be the acquisition of a minority or majority interest.

The GP may also need to carefully consider its position and strategy when investing alongside other parties (e.g. as part of a syndicate) and whether it owes any duties or obligations to others as a result.

It is possible for the structure of an investment to impose liabilities and responsibilities on the fund and any such liabilities will typically be thoroughly investigated with the help of the fund’s lawyers.

Recommendation

The GP should structure and negotiate each investment made by the fund in such a way so as to ensure that it meets both the obligations to and the interests of the fund. This will often involve the engagement of specialised, local professional services firms to help with and to advise on legal, tax and regulatory matters.

When structuring any investment the GP should take steps to consider the tax, regulatory (such as US ERISA) and other consequences (including reputational) for the fund and its LPs of making the investment.

Explanation

In some jurisdictions, it is common practice in the industry for different classes of investors to acquire different types of security according to their relative position in the transaction, the nature and level of the risk they are taking on and the relative value they are bringing to the investment.

The returns for each type of security, whether equity or debt, will typically vary depending on certain outcomes. It is therefore possible that conflicts may arise between holders of different classes of securities.

Recommendation

Whether as a shareholder in the portfolio company, or through provisions agreed in the Investment Agreement, the fund has ownership responsibilities and should exercise those responsibilities proactively and in a way that continually supports the value of the fund’s investment.

The negotiation of shareholder rights should be conducted openly and with clarity among all investors in the portfolio company.

Due consideration should be given in advance to potential areas of conflict and where conflict does arise, the resolution of that conflict should be conducted fairly and, to the extent possible, in such a way that the outcome does not impact the value of the portfolio company.

Explanation

There are a number of different ways in which the GP can ensure that the fund can influence a portfolio company. Which of these will be appropriate will depend on a number of factors (including the size of the fund’s investment and the level of influence that the GP considers to be appropriate). If the fund holds a majority shareholding in the portfolio company, it will have the ability, as a matter of company law, to determine the outcome of matters that are reserved to shareholders. The GP may also seek to specify certain additional rights in the portfolio company’s constitutional documents and agree contractual rights in the Investment/Shareholders Agreement it enters into with the shareholders of the portfolio company, such as (i) requiring certain strategic and significant operational matters to be subject to prior investor/shareholder consent; and (ii) the ability to make board appointments.

Investor consents

In some jurisdictions, it is common in the Investment Agreement between the fund and the portfolio company for certain actions of the portfolio company to be subject to the prior consent of the GP on behalf of the fund in its capacity as shareholder. These are commonly called “investor consents”.

Where the GP has appointed individuals to the portfolio company’s decision-making body, their consent may also be required before certain action can be undertaken by the portfolio company, although they will often be under a duty to act in the best interests of the portfolio company, rather than the fund.

The availability and level of investor consents that are deemed appropriate will vary depending on the size and nature of the fund’s investment.

Board appointments

The GP will typically also consider making:

• appointments to the board or other decision-making bodies of the portfolio company (see sub-section “Board structure” in chapter “Management of an investment”);

• appointments of persons to internal committees of the portfolio company (e.g. advisory committees or the remuneration or audit committees, where relevant).

It is important to note that individuals appointed to sit on the board of the portfolio company by the GP may have responsibilities both towards the GP who has arranged their appointment and to the portfolio company and all its shareholders as a director (as well as to the company’s creditors in certain circumstances). Typically, such individuals, as directors of the portfolio company, will be required to act in the best interests of the portfolio company. The portfolio company’s interests may conflict with those of the fund and in such circumstances the director must act in accordance with the relevant legal rules applying to directors with conflicts of interest (which may be determined in part by the company’s by-laws or articles of association) and in accordance with the duties owed to the portfolio company.

Recommendation

In relation to investor consents, the GP should consider requiring the portfolio company to obtain investor consents for governance, corporate, financial and accounting, business and other key matters. The list of matters will vary depending on the relevant jurisdiction, the size of investment, the type of organisation and the shareholding held, but the following should be considered:

• significant developments in the business (e.g. capital expenditure, new issues of capital, acquisitions or disposals of significant divisions, businesses or assets including real estate, changes to the portfolio company’s constitution);

• major outsourcing contracts;

• changes in the capital structure and borrowing arrangements;

• changes in leases or other material contracts;

• material litigation claims;

• changes of control, acquisition or disposal of shares by other shareholders;

• adoption of the portfolio company’s audited accounts;

• making any dividends or distributions;

• adoption of a new business plan;

• changes to the portfolio company’s key management or their remuneration;

• adoption of or changes to the communication policy;

• developments in the financial or other performance criteria of the portfolio company which will materially change the nature of the business in which the fund has invested;

• winding up or dissolving the portfolio company;

• any transactions between portfolio company and shareholder, portfolio company management or other related parties;

• any ESG issue that could materially impact the investment or the risk profile of the investment.

Investor consents, while needing to be comprehensive in scope, must not be so wide-ranging as to restrict the management team’s ability to run the portfolio company or take up excessive amounts of the GP’s time. The list is not exhaustive; rather it gives an indication of some typical matters which are subject to investor consent.

When considering the advantages to the fund of taking any control rights, the GP should also consider possible liabilities or restrictions imposed by law on those exercising certain types of control.

Explanation

At the time of investment by a fund, the investment decision is normally taken in support of a specific strategy, business plan and management team. Frequently, through the negotiation process leading up to investment by the fund, the GP will have had significant input in determining the target’s future corporate strategy. Over a period of time, this business strategy may need to be refined and amended.

Recommendation

The degree of activism of the GP will vary according to the nature and structure of the investment made, the size of its ownership stake and the jurisdiction in which the portfolio company is located. The GP should therefore ensure its level of involvement is suitable relative to the circumstances of a particular portfolio company and the fund’s ownership strategy/policy.

Consistent with these considerations, the GP should be an active participant through its board representation or, where permitted by the relevant company law in a particular jurisdiction, through the exercise of shareholder voting or contractual rights in the setting of the portfolio company’s strategy. The responsibility for execution of strategy sits with the board and management team of the portfolio company. The GP should ensure that it remains informed of the progress being made towards achievement of the strategy. Where appropriate, the GP, once again through its board representation or through the exercise of shareholder voting or contractual rights, where so permitted, should be available to advise and assist where the strategy needs to be refined and amended.

Further, the GP should ensure that the portfolio company understands the importance of having the right mechanisms and processes in place for responsible, efficient and appropriate decision-making and effective corporate governance.

Explanation

Where an investment has been syndicated or there are co-investors, a GP may not be able to control an investment and may have to co-operate with other shareholders in order to achieve defined goals and build a consensus as to appropriate actions to be taken.

Recommendation

The GP should act in the interests of the fund and any other clients investing in the relevant portfolio company and identify and manage any conflicts of interest that may arise between them. Wherever possible, the GP should only accept an obligation in favour of another investor if it would be in the fund’s interests to have some agreement or understanding with the investor.

Explanation

It would be useful for the fund documents negotiated with investors prior to their investment to deal with a GP co-investment and parallel investment. In many cases, LPs will welcome additional alignment of interest created by such arrangements.

However, even if the fund documents permit the GP, its associates or its executives to co-invest or make parallel investments alongside the fund, there is potential to create a conflict of interest for the GP.

Recommendation

Subject to what is provided in the fund documents, details of co-investment arrangements should be disclosed to the fund’s LPs. To avoid the potential of prejudice to the fund’s interest, it is recommended that such documents only permit co-investment or parallel investment by the GP, its associates or its executives where investment and divestment is exercised on a pro-rata basis with the fund, in the same securities, at the same time and on the same investment terms. If this recommendation is not followed, it is particularly important that the operation of the co-investment arrangements is subject to the GP and fund’s conflict of interest procedures and should be disclosed to LPs and documented.

Explanation 

In some circumstances, LP co-investors in the fund or other third parties with whom the GP has some relationship may wish to invest directly into a company that the GP is considering investing in on behalf of the fund. When a co-investment is more successful than the fund as a whole, the fund’s LPs may argue that a greater proportion of the investment should have been allocated to the fund.

On the other hand, such syndications may allow funds to invest in a target company otherwise beyond their reach, while still complying with any diversification restrictions in the fund documents.

Recommendation

The GP should first determine the fund’s appetite for each investment and only after that should co-investment and/or parallel investments be considered (apart from in the case of pre-arranged and disclosed co-investment arrangements or where the LP co-investor lends special expertise or other value to the transaction).

Where co-investment opportunities are anticipated during the life of the fund, detailed and clear contractual terms with regard to co-investments and direct investments are essential in the fund’s documents and details of co-investment arrangements, both for the fund and individual deals, should be disclosed to the fund’s LPs.

When a conflict of interest arises, it should be resolved in accordance with the GP’s conflict of interest resolution procedures. LPs may place themselves in conflict of interest situations where they engage in co-investments. The conflict may be more problematic where the LP also sits on the LPAC. The criteria for invitations for LPs to co-invest present another potential source of conflicts of interest. The parameters of any co-investment process should be clearly set out to all LPs in advance.

Explanation

It is important to ensure that before an investment is made the key shareholders agree a common strategy for realising the investment.

It will not always be possible to achieve this strategy, for example if the investment fails to perform and/or purchasers decline to come forward, but it is desirable to agree an exit strategy in advance.

Recommendation

In initially considering the investment, exit considerations should form part of the discussions and provisions negotiated to cover both likely and less likely situations. These considerations should be reflected in the overall investment recommendations.

The divestment or exit process should be discussed with co-investors, other syndicate members and the management team of the portfolio company before the initial investment. The GP should seek to ensure that, on investment, it negotiates suitable mechanisms to ensure that any deadlock regarding divestment of an investment can be resolved in a manner appropriate for the fund.