I GENERAL INTRODUCTION
The last couple of years have witnessed a period of fundraising not seen since the leviathan leveraged buyout funds that preceded the global financial crisis. Billions of dollars in capital commitments have been gathered and need to be put to work. Investor confidence is high and there is an almost universal enthusiasm to maintain or increase allocations to the asset class. While most of the names remain familiar, and though there has certainly been a concentration of capital in the hands of the institutional fund managers, what is different from the previous cycle is that there are now more specialist funds in the marketplace.
The social and political context could not be more fascinating. Unpredictable leaders and even more unpredictable voters have undermined the certainties of the past. Technology has altered the way in which we live, work and interact with the world; all of which means that there are opportunities for the nimble and for those who embrace the fast-developing global socio-political uncertainties.
In this context of fresh dry powder, the older generation of funds are coming to the end of their contractual terms and are faced with the challenge of extracting liquidity from their historic portfolios. For these funds, the uncertainties are less welcome. One of the many unique factors about an investment in a private equity fund is that such funds are closed-ended and so, by definition, have an end point. Happily, there are sophisticated investors with recently filled war chests who are seeking to exploit the availability of secondary investments in funds and their assets. That presents a rather complex set of challenges with which we anticipate the industry will be heavily occupied in the days ahead.
Pressure on fees, or at the very least on the ability to be innovative about fees, remains the area in which investors feel that their interests with fund managers could be better aligned. For fund managers, and for law firms that consider themselves genuinely to be in partnership with their fund manager clients, this should be an encouragement to be innovative: to embrace the benefits of technology in order to improve internal efficiency so that services can be provided more profitably at lower costs. Take-up among fund managers and their counsel alike has been remarkably languid, but it seems inevitable that the days of traditional approaches to fee generation are numbered.
We consider below the key trends for both old and new funds.
i Restructuring end-of-term funds
Each year we run a rule over the funds that we help to raise. The relatively unique vantage point enjoyed by us as offshore counsel allows us to see the huge cross-section of funds that run the entire spectrum in terms of size, strategy and jurisdictional focus. One notable conclusion that emerges from our analysis is the degree to which the documentation for funds at the time of their launch is remarkably homogenous.
Whatever those similarities at the time of formation, however, by the time that a fund has reached the end of its life, the nature of its investors, their particular imperatives and concerns, the relationship between the investors and the fund manager, and the state of the fund's investment portfolio are entirely distinct. All this means that lawyers advising their clients on how best to approach the end-of-life scenario need to have a number of tools at their disposal. In an industry so heavily influenced by arguments as to what is on-market or industry-standard, the need for creative thinking and the ability to consider and implement innovative structures mean that the year ahead promises to be refreshing for lawyers.
The most interesting funds to consider are those that are near the end of their contractual term but that retain significant assets that, either because of the state of the global markets or because of factors unique to the particular assets, do not lend themselves readily to disposal. Inevitably, there will be investors looking for end-of-term liquidity and there will be those who prefer to exploit the prospect of the long-term generation of value. Assets may need significant additional investment before their value can be fully realised. In addition, fund managers may be in a position where the effect of the fund's contractual terms on their ability to generate fees for completing the work required simply means that interests are no longer aligned. Balancing those competing interests can be a supreme test for fund managers; however, managed properly, a fund restructuring can achieve that balance by providing liquidity for those who seek it without forcing a fire-sale exit from the assets themselves.
Not all funds lend themselves to restructuring transactions. The investor group may be too disparate in terms of interest, or the assets simply not suitable. Often, a simple extension of the fund's term will do the trick, affording the manager the extra time needed to tie up loose ends. Or it may simply be that allowing the fund to click over into winding-up mode is perfectly sensible: Cayman law does not impose timetables for winding up and the process may take as little or as much time as makes sense given all the circumstances. Fund managers may find the generation of fees is adversely affected, but where assets do not require particularly active management, that is of no great consequence. However, where there is a significant pool of assets, and in particular assets that will require active management and investment to achieve their value potential, then a restructuring offers the best solution for managers and investors alike.
Of course, in all this, the usual imperatives apply: for legal counsel, an understanding of the client's commercial context, the need to preserve and entrench long-term relationships with investors, and careful analysis of the likely effect of any proposed course of action. For fund managers, more than ever, communication in relation to a restructuring is critical; it is imperative to explain in detail the reasons for and objectives of the transaction, and to provide transparency as to the manager's motives and incentives. Fiduciary issues will be thrown into stark contrast. Cayman law does afford contracting parties the ability to manage those issues to an extent, but effective agreement between contracting parties relies on disclosure of the relevant conflicts. Provided that disclosure is full and fair, the risk that disgruntled investors may seek redress will be capable of management.
ii New fund trends
For new funds, a world of often baffling uncertainty abounds, and managers, replete from a successful few years' fundraising, are now tasked with deploying their capital to take advantage of volatility as it arises. When we compare the most recent round of fundraising with that of the previous generation, one of the clearest differences has been the institutionalisation of the industry. Again using the offshore counsel's perspective, we are able to view this trend by examining its effect on a broad range of funds.
Apart from large leveraged buyout funds, we have witnessed effective fundraising for a number of smaller, more specialised funds. Historically, these funds would often have been formed by new fund managers seeking to exploit a unique selling point. However, barriers to entry for new fund managers are now prohibitive. The regulatory compliance burden, the imposition of European-style waterfalls as standard, the narrowing of mandates by institutional investors and the broader context of volatility have meant that these smaller funds, many of which are brand new in terms of teams and very focused in terms of strategy, are being raised under the umbrella of the large institutional fund managers.
Fund strategies show something similar, from a different perspective. Comparing recent years, we see what we would expect in terms of traditional large funds generating very predicable returns over the short to medium term for institutional investors. Of particular interest has been the growth in distressed debt and work-out structures and, more recently, the debt-origination and direct lending funds and the much-discussed displacement of ordinary banks as providers of credit continues. In part, these funds fill the holes left by traditional lenders. However, more positively, they look to leverage unique industry knowledge and more flexible balance sheets.
Some of the challenges presented by new strategies are well illustrated by the relationship between these credit and lending funds and the energy funds sector. There are significant transactions between the two and this has generated a sort of microclimate within the funds industry, where exposure to the global energy markets and geopolitical uncertainty have been amplified as a consequence. What is encouraging for an industry that has had a consequential double exposure to changes in the price of oil is that energy valuations have been better than expected and the long-term prognosis is more optimistic.
Something that has gained momentum recently is the interest in access fund structures that afford investors of more modest means to invest in private equity assets where historically the ticket price would have been too high: a consequence of the success of closed-ended asset managers as compared to open-ended hedge funds has meant that the demand on the part of individuals and other investors on the retail end of the spectrum has increased. For an industry seeking new capital in addition to the traditional sources from pension funds, endowments and sovereigns, an access structure or being able to tap into mutual fund capital or 401k platforms presents opportunities.
At the other end of the spectrum, challenges associated with the cost of regular rounds of fundraising, the benefits of being able to pursue strategies without being concerned about end-of-life fire sales and pressure from very long-horizon investors such as pension funds and endowments to manage capital over longer periods, have all meant that some interest in very long-dated (and even evergreen) funds has seen a revival. The prosaic economics of compensation mean that only the large institutional funds are really able to sustain these sorts of models.
iii Regulatory trends
The pre-eminent position of the Cayman Islands as the jurisdiction of choice for offshore private equity fundraising is long-established. Cayman offers a flexible statutory regime within a common law system renowned for its sensible approach to commercial disputes. Nowhere is this better illustrated than in the response to changes in the global investment and regulatory context. Regulatory transparency and a robust anti-money laundering regime provide peace of mind to investors and regulators alike, but these are now a given for credible jurisdictions. The implementation of legislation to enforce intergovernmental agreements relating to the US Foreign Account Tax Compliance Act and Common Reporting Standard reporting has been well documented and these provisions have simply become an inevitable part of the investment funds landscape.
The Cayman Islands have continued to refine our approach to anti-money laundering, and the updates to practice and procedure in this regard published recently by the Cayman Islands Monetary Authority preserve Cayman's position as the avant garde in terms of a practical, risk-based approach to preserving the integrity of the capital raised and deployed by investment entities.
iv Fund structuring
Remaining relevant and innovative in response to market reality, as well as being credible, is critical to the world's most prominent financial institutions and international investors, which is why most see Cayman as the favoured tax-neutral jurisdiction for private equity funds. Key to this market is the existence of architecture that allows fund sponsors to structure and manage entities with many investors, a variety of strategies, and multiple layers of efficient and effective debt and equity in a multinational environment.
In this context, Cayman legislation and regulation continue to be responsive to trends and challenges in current market practice. An active partnership between the government and the private sector ensures the development of legislation, and recent amendments to the law have streamlined procedures for raising and managing Cayman-based funds, going some way to addressing long-standing concerns about the delineation of the lines of general partners' fiduciary duties.
In particular, Cayman is the first significant common law jurisdiction to offer a limited liability company (LLC) product. LLCs occupy an interesting jurisprudential territory somewhere between a company and a partnership, exhibiting properties of both in a way that affords a skilled and experienced draftsman significant flexibility. The Cayman LLC is based very closely on the traditional Delaware model, although it leans more towards English common law when delineating fiduciary responsibilities, affording a degree of clarity and contractual certainty that many practitioners have welcomed.
In response to the anticipated trend for fund restructuring discussed above, Cayman will shortly be amending its Exempted Limited Partnership Law to provide partners with the tools they need to restructure funds in innovative ways. In particular, the introduction of statutory processes to merge and amalgamate funds, and to propose schemes of arrangement, and exploit Cayman's position of being an English jurisdiction in an American context, will draw the best from both legal systems.
1 Rolf Lindsay is a partner at Walkers.