In evaluating a prospective investment in a collective investment vehicle, an investor should consider how such vehicle’s offering terms align not only with such investor’s commercial and risk profile, but also how such terms align with the terms offered in the broader international funds industry. This article provides an overview of current developments and market trends in the international funds industry that we have identified in connection with advising our clients on their investment activities.
Increase in Alternatives to Fund Investments
As investors continue to identify and focus on key themes and issues in the alternative investment space, we have seen investors seek to mitigate such issues by identifying alternatives to investing in funds. Key issues include: (1) increasing regulation; (2) variability in fees charged; (3) ability to achieve performance result; and (4) access to investment opportunities. Generally, investors seek individualised alternatives to investing in funds where they can exert greater control over the arrangement. Typical alternatives include:
- Direct Investments: Where an investor invests alongside the fund manager and directly in the underlying investment in lieu of participating indirectly through a fund (or in addition to such investor’s participation in such investment through a fund). Typically, these direct investments are structured as co-investments or joint ventures.
- Separately Managed Accounts: Where an investor opens a brokerage account and grants discretionary or non-discretionary trading authority over that account to a third-party manager.
- Secondary Investments: Where an investor has the opportunity to purchase interests in funds from the market at large, usually at discounted prices.
Methods to Overcome Limited Access and Oversubscription
Investors have found increasing competition in gaining access to funds sponsored by premier fund managers, as such funds tend to be oversubscribed, have insufficient capacity and/or provide investors with minimal leverage to negotiate favourable investment terms. In light of these challenges, we have seen investors seek alternatives to these opportunities, which may include:
- Investing with funds sponsored by new managers, which will likely involve greater diligence on the managers and evaluating their qualifications, but may result in the investor being able to negotiate more favourable terms; and
- Pursuing a fund-of-funds strategy by engaging a fund-of-funds manager, who will have access to fund managers and capacity to build a diversified portfolio of fund investments for the investor.
Term and Period Extensions
In advising our clients in connection with their ongoing fund investments, we have noticed an increase in fund managers seeking to extend certain key time periods and/or to amend certain key commercial terms. A fund’s governing agreement sets forth the various periods and terms within which the manager has, for example, the ability to draw capital or make investments. These deadlines create pressures on managers to utilise the fund’s capital in accordance with the governing agreement before the respective deadlines are reached. Where managers come up against such deadlines (in particular, a trend we see with respect to funds raised during the 2008 financial crisis), they may seek extensions to such period, which will require investor consent at the thresholds specified in the governing agreement. Where a fund’s period or term is extended in accordance with its governing agreement, investors generally remain committed to the fund and subject to its terms regardless of whether such investor approved of such extension. Where a manager approaches an investor to seek its consent for such purposes, the investor should consider the outcome where it does not give its consent but the change is otherwise approved.
Investors have found increasing flexibility in negotiating fees with managers depending on their respective track records. Where a manager has a strong track record, investors are more likely to agree to customary fee structures in line with the traditional 2-20 model. In other circumstances, however, there is a general trend away from this model. Many investors are now able to negotiate management fees of 1.75% or less and performance fees of less than 20%. However, in order to achieve lower fees, investors may be required to agree to other terms less favourable to the investor such as lock-up on investment, or increased subscription amount.
A separate question investors will need to evaluate is whether fees and expenses are part of an investor’s commitment to the fund (i.e., “inside” the commitment) or in addition to an investor’s commitment (i.e., “outside” the commitment). Where fees are outside the commitment, an investor will be required to contribute capital to the fund in excess of its capital commitment.
Limitations on Liquidity
Generally, there has been a return to the liquidity limitations that existed in funds prior to the 2008 financial crisis. Notably, we have seen investors focusing less on liquidity as a key issue as the markets have recovered. Managers may seek to limit the ability of investors to achieve liquidity by (i) providing the manager the ability to suspend withdrawals where the manager deems such withdrawals to be unfavourable to the fund, (ii) providing for “gates” (i.e., limitations on the amounts allowed to be withdrawn during a specific period) and “holdbacks” (i.e., a hold-back of a percentage of withdrawal proceeds) and (iii) allocating portions of a fund’s assets to assets deemed to be illiquid and lacking a readily accessible market value (i.e., “side pocket” investments).
Increased Reporting and Disclosure Obligations
With the heightened regulatory scrutiny on funds and their managers and increasing pressures to respond to information requests from regulators, a fund’s governing agreement now includes expanded reporting and disclosure obligations on the part of investors. Generally, such obligations relate to a manager’s compliance with the U.S. Foreign Account Tax Compliance Act (“FATCA”) and increasing focus on anti-bribery and anti-corruption compliance (in addition to more traditional anti-money laundering compliance obligations).
In order to comply with such reporting and disclosure obligations, managers have broad powers to request the information from investors necessary for them to comply with such obligations. Among other considerations, investors should seek to have any information they provide to managers subject to usual and customary confidentiality and disclosure limitations. Investors should also be aware of the remedies available to managers should investors fail to comply, which may include mandatory withdrawals and forfeiture of investments.