GOVERNANCE ISSUES IN PRIVATE FUND STRUCTURES
Institutional investors in private fund structures are generally passive, aiming to make steady gains over a fairly long holding period. For example, investors might choose to invest in the development of care home facilities for the elderly, based on the long-term demographic trends associated with an aging population.
The process of finding those opportunities, developing the sites, starting to operate the assets and then selling them will likely take ten years or so. Institutional investors like pension funds are happy with that, because they have long-term liabilities to their pension holders which the long-term nature of the investment strategy matches.
This is where it gets interesting: the investment manager of the fund will normally have the power to make investment decisions on behalf of the fund, and is paid for their expertise (normally through a share of the profits made). The investors invest in the fund precisely because of the investment manager's skills and experience, so they don't have to be involved in day-to-day decision making.
“There’s a delicate balance to be found between allowing the manager scope to manage the fund, and the need for appropriate supervision and oversight.”
That said, in the same way that the shareholders of a company have ultimate oversight over the activities of the company's board of directors, the investors in a fund will want to ensure that there are appropriate governance mechanics in place to ensure that the investment manager does not go off the rails. There’s a delicate balance to be found between allowing the manager scope to manage the fund, and the need for appropriate supervision and oversight.
There are a number of structural and contractual bases on which the interests of the investment manager and the investors are normally aligned. These include:
- The fact that the main financial incentive for the management team is a potential share of the fund’s profits means that it is in both their and investors' interests to maximise the fund’s return.
- Investors will normally expect the management team to make a reasonable investment of their own capital into the fund alongside the third party money, so that they have the same investment risk.
- Managers are normally restricted by contract from raising other funds with similar investment strategies until they have substantially deployed a fund's capital, so that they are focussed on one fund at a time and avoid issues around allocation of opportunities among their clients.
- Funds have closely defined investment policies, with limits on concentration of investments by size, in particular jurisdictions or by sector: investor consents are normally required if the manager wants to exceed those limits.
- Deals that would involve a conflict of interest for the investment manager (for example if it were to seek to buy an asset for the fund from a related party) normally require investor consents.
Each investor or type of investor may also have its own specific concerns or sensitivities in relation to governance that also need to be factored into the fund documentation. That may involve particular policy restrictions on investments, for example for investors who are bound to invest in accordance with religious or social policy principles. A key part of our job is to advise investment manager clients of the likely demands of different investor groups and structure their offerings accordingly, so as to be attractive to a wide range of potential sources of capital.