Podcast: Credit Funds: A Framework for Addressing and Mitigating Conflicts of Interest
Today’s asset managers are increasingly multi-platform, regularly managing private equity funds, hedge funds and credit funds all under the same roof. Invariably, it might make business sense for some of these funds to engage in transactions with or alongside one another which give rise to potential conflicts of interest. This podcast will discuss three key considerations in addressing these conflicts: (1) developing a framework for conflict mitigation in a fund’s governing agreement, namely the Limited Partnership Agreement, (2) navigating the Investment Advisers Act, and (3) implementing internal written and unwritten policies and procedures.
Geoff Goldberg: Hello and thank you for joining us for this Ropes & Gray podcast. My name is Geoff Goldberg and I’m a client relationship executive at Ropes & Gray. I’m joined today by Amanda Persaud, a partner in our private investment funds practice who advises prominent sponsors on the formation, fund raising and operation of their global private investment funds.
Today’s podcast is the second in a series focused on issues related to credit funds. We’ll be discussing conflict of interest situations that arise when funds managed by the same sponsor engage in transactions with one another or alongside one another, as well as best practices for mitigating and addressing these conflicts.
Amanda, today’s asset managers are multi-platform; they have private equity funds, hedge funds, and credit funds of various stripes all under the same roof. Invariably, it might make economic sense for these funds to engage in transactions that have the potential to create conflicts of interest. Could you help us understand the precise nature of the conflict and what types of transactions are we talking about?
Amanda Persaud: The conflict most often arising is when a manager is the decision maker on both sides of a transaction and the manager itself is an interested party in the transaction. For instance, the manager is earning fees or carried interest or other forms of compensation in the transaction, and therefore could be viewed as lacking impartiality in the decision-making process. Some examples of transactions include: one fund selling an asset to another fund where the two funds are under common control and management. Another example: one fund owns debt in the capital structure of a company and an affiliated fund owns a different type of debt or securities in the same company. Final example: a manager allocating an investment opportunity across multiple funds that it manages.
Geoff Goldberg: So Amanda, even though each situation would be different, the underlying conflict issues seem to be essentially the same. Is there a way for fund managers to systematize how they address and mitigate these conflicts?
Amanda Persaud: Absolutely. In our experience, there are three key considerations that come to bear in every conflict situation. First, the governing agreement of a fund, namely the fund Limited Partnership Agreement, and side letters. Two: applicable regulations—and in this case, today we will focus on the Advisers Act. (Our prior podcast covered ERISA, and future podcasts will cover other relevant regulation.) And last but not least, the written and unwritten policies of the organization that go hand in glove with the first two considerations.
Geoff Goldberg: Okay, so let’s address the first of those considerations. How can the manager use the LPA to help address this risk?
Amanda Persaud: It’s important to view each new fund that is raised as an opportunity to create better rules of the road in the partnership agreement for mitigating conflicts. So why is the partnership agreement the key to getting this right? Well, if your investors agree on a framework, you’ve made it much easier for the investment professionals to actually go about getting deals done without increasing risk profile to the business. Let’s take one of the example I mentioned earlier. Say a sponsor has two affiliated funds that have overlapping investment objectives, namely they both invest in capital structures of companies, one broadly investing in credit opportunities and the other investing in debt, say with a view to control. By drafting your LPAs at the time an investor is subscribing for interest in the fund, to include not just good disclosure of the overlap but to include a framework for how the manager as an interested party can bring objectivity to the decision-making process, this goes a far way in establishing that the manager’s duties have been effectively discharged both under the contract and under the Advisers Act. A successful framework would focus on balancing the manager’s discretion with a clear process that demonstrates successful application of these duties.
Geoff Goldberg: Could you provide an example of how a successful framework could be implemented in the LPA? What would it include?
Amanda Persaud: This framework could be memorialized in a number of ways. For instance, the partnership agreement could establish rules as to when affiliated funds are permitted to participate in the same investment and on what terms. It could give the general partner flexibility to bring certain types of conflict transaction to a Limited Partner Advisory Committee (LPAC for short) or an independent representative. On the other hand, the partnership agreement could simply handle other types of conflict transactions through explicit disclosures in the partnership agreement and offering memorandum. Determining which approaches to embrace is often informed by how frequently a manger expects affiliated funds to transact with one another or alongside one another. While having a Limited Partner Advisory Committee to turn to in one-off situations is incredibly helpful, it might not be the right approach if these transactions arise often. Perhaps being more circumspect in the partnership agreement, in addition to having an LPAC, is a better approach from a transaction execution perspective. It’s worth bearing in mind that the Limited Partner Advisory Committee is one of the tools, not just the only tool, in the partnership agreement.
Geoff Goldberg: And the partnership agreement also doesn’t exist in a vacuum—you have a regulatory environment. How can you use the LPA to manage your obligations under the Investment Advisers Act?
Amanda Persaud: Think of the Limited Partnership Agreement as the starting point for addressing conflicts. Sometimes the process in the LPA is sufficient to satisfy the Advisers Act requirement. This is because certain types of conflict transactions might have been expressly contemplated in the agreement at the time investors subscribed for interest. Other times the LPA is less sophisticated and must be supplemented by internal policies in order to effectively mitigate the conflict.
Let’s take the example of a cross trade and a principal transaction under the Advisers Act. Both of these transactions require client consent and disclosure. In the case of cross trades, such as a season and sell transaction, building in robust disclosure of the anticipated transaction at the time investors subscribe for interests in the fund may very well alleviate the need to seek additional consents in the future. Contrast this with a principal transaction—for instance, a transaction where a manager for its personal account is buying from a fund that it manages. Consent in this case cannot be satisfied solely through robust disclosure in the partnership agreement. Given the heightened nature of the conflict, the manager will need to undertake additional steps to obtain consent of the fund. That being said, however, the partnership agreement can and should serve to streamline the consent process by spelling out who is actually providing the consent. For instance, is it the LPAC? Or are we talking about the limited partners in the fund? Or would it be more prudent and desirable to have an independent representative provide the consent? In certain situations, LPACs can be incredibly useful for the timely execution of transactions, and therefore managers would seek their consent. However, there may be other circumstances where consent would be prudent to be provided by a different body.
Geoff Goldberg: So that leads us right into to the final consideration: the real world. How do you apply internal controls, written or not, to keep you in compliance with your LPA and regulatory requirements on a daily basis?
Amanda Persaud: In our experience, good policies and procedures recognize precisely how the Advisers Act comes to bear in transactions that a sponsor is regularly engaging in. When done correctly, these policies will build off of a conflict mitigation framework that is expressly agreed to with investors and memorialized in a partnership agreement. And it’s this framework that makes it possible to satisfy Advisers Act obligations in a consistent, efficient and timely manner. So as you go about designing policies for your business, a few things to keep in mind: Number one: clearly identify conflicts that are relevant to your specific business. Two, view the Limited Partnership Agreement as a tool for effectively managing and mitigating these conflicts. As stated before, by creating good processes and rules in the LPA, well, this can spare many headaches in the future and delays. Three, develop a flexible framework, both within the institution and in the form of your policies and procedures as well as in your governing documents, and a framework that is adaptable to changing needs of the business. And last but not least, craft policies with input from all constituents in the organization, not just compliance and operational professionals but also the deal professionals. In this way, the policies that are put in place will make sense for the business while at the same time mitigating the risks introduced to the business.
Geoff Goldberg: Thank you, Amanda. That’s all the time we have. Thank you for listening. For more information, please visit our website at www.ropesgray.com. Stay tuned throughout the coming months for more news and analysis concerning credit funds issues.