Podcast: COVID-19: End of Life Fund Issues
In this Ropes & Gray podcast, asset management partner Jason Kolman and counsel Steve Zaorski discuss certain challenges facing funds reaching the end of their terms, which have intensified in light of COVID-19-related disruptions.
Jason Kolman: Hello, and thank you for joining us today on this Ropes & Gray podcast. I’m Jason Kolman, a partner in the asset management group of the Boston office. Joining me today is my colleague, Steve Zaorski, a counsel in our asset management group in the New York office. Today, we are going to talk about end of fund life issues. In recent months, a number of funds that were raised during the Great Recession of 2007-2008 are starting to reach the end of their terms. As luck would have it, some of these funds are running into issues with disposing of their assets during the current recession and the volatile economic climate brought on by COVID-19. But the good news is that there are a number of options to take in connection with the end of the life of a fund. Steve, can you talk about that in more detail?
Steve Zaorski: Yes. Thanks, Jason. That’s right – while every fund is different, the governing documents often permit the sponsor to extend the term of the fund by one or two years, with the first or both extensions being in the discretion of the sponsor. Alternatively, it is not uncommon for the term extensions to require Limited Partner advisory committee consent or the vote of the limited partner base. In the latter scenarios, the sponsor needs to obtain consent – we often see the partners negotiate down the management fees in exchange for the term extensions. Sponsors sometimes resist this because they are still actively managing the portfolio during this period, plus fees at this stage (which are often based on invested capital) should naturally decline over time. However, as we’ll discuss shortly, reducing fees does help to mitigate potential “zombie fund” scenarios that have attracted recent regulatory scrutiny. In deciding whether to seek an extension, it is obviously important for the sponsor to have developed a clear plan for moving the remaining investments towards realization. By having a clear plan to show LPs, it usually will increase the likelihood that they will go along with your extension. In light of the unique and severe disruptions caused by COVID-19, sponsors may have a particularly strong story to tell about why the winding-up process is taking longer than anticipated. Jason, I will let you provide more details about the post-dissolution period of a fund.
Jason Kolman: Thanks, Steve. Yes, the good news is that, for sponsors with positions still in their portfolios at the end of the fund term, there are many options. In particular, it’s important to note that there is generally significant flexibility to manage the post-term wind-down process in a manner that the sponsor believes is prudent and in the fund’s best interests. Two common jurisdictions for private funds, Delaware and the Cayman Islands, don’t mandate a set duration for the winding-up period, which means that the sponsor should not be pressured to engage in a “fire sale” of the remaining assets. This is particularly relevant in the current climate, with COVID-19 creating market disruptions that may make asset sales inadvisable at the present time. Of course, there may be contractual provisions in the fund documents that impose an outside date for the completion of the winding-up or are otherwise implicated. For instance, LP clawbacks often run for a certain number of years following the commencement of the dissolution period of the fund, so sponsors may not be able to rely on the clawback if the winding-up process drags on for a long time. There are also certain regulatory risks associated with letting the process drag on that Steve will briefly touch on.
Steve Zaorski: Yes, that’s right. Thanks, Jason. Notwithstanding that Delaware and Cayman Islands law do not impose a set period of time to complete the winding-up, sponsors need to be cautious that the process does not implicate the so-called “zombie fund” concerns which have attracted regulatory scrutiny in recent years from the Securities and Exchange Commission. The SEC is concerned that sponsors are taking too long to wind-up their remaining positions and are effectively keeping funds around primarily to generate fees for the sponsor. As discussed earlier, reducing or waiving management fees is commonly requested by LPs as a commercial matter as part of the term extension process, but a sponsor should consider further reducing and/or waiving its fees if the winding-up process drags along as a way to mitigate the potential regulatory risk. Jason, now what are some other options that you have seen clients recently explore as their funds approach the end of their lives?
Jason Kolman: One option we sometimes see clients consider is a cross trade of positions to another of the sponsor’s funds. While appealing due to the convenience, this approach obviously involves significant conflicts. In particular, the sponsor may be viewed as improperly “dumping” positions on the other fund to facilitate the first fund’s liquidation, or conversely giving the other fund access to distressed assets at fire sale prices. Investments at this stage are also often illiquid and difficult to value, which creates significant uncertainty as to how to determine an appropriate price. These conflicts can potentially be mitigated by presenting cross trades to the LP advisory committee or LPs for approval, which is often required under the fund documents in any event. Another option that has become more popular in recent years is engaging in a single asset recapitalization or a continuation fund for managing out the remaining assets. This option is appealing because it provides liquidity for LPs who want to get out, while also providing a short duration fund typically with reset economics for the sponsor. However, these types of transactions are generally complex, costly and time consuming due to the number of stakeholders involved. Similar to the cross-trade option, these transactions also often require LP advisory committee consent or LP consent, either as a means of mitigating conflicts or in connection with any required amendment to the fund documents. Ropes & Gray has produced a few other podcasts on recaps and continuation funds that we would recommend that you check out, if you are interested. Steve, what are some terms that sponsors should be focusing on in their fund documents to help mitigate these issues?
Steve Zaorski: For clients bringing new funds to the market, we have often seen them taking a fresh look at the fund term and extension mechanics, to confirm they make sense and provide a sufficient runway in case the winding-up process takes longer than expected. Some clients have also refocused on the post-term fee provisions, given that LPAs sometimes cut off or sharply reduce fees once the term ends, or are otherwise ambiguous on the topic (so sponsors may not get compensated for managing the wind-down process). Finally, we have seen sponsors focusing on disclosure issues relating to prolonged wind-downs, including making clear to investors that the fund term is not a true “end date,” that they may not receive any proceeds from the fund for years after that point, and that fees will continue to be charged during the wind-down.
Jason Kolman: Thank you very much to our listeners. For more information on the topics that we have discussed or other topics of interest, please visit our website at www.ropesgray.com or contact a member of your Ropes & Gray client team. You can also subscribe or listen to this series wherever you regularly listen to podcasts, including on Apple, Google and Spotify. Thank you again for listening.