The challenge of credit

Private equity firms face some complex legal and compliance issues if they want to expand into credit funds, write Jason Brown, Jessica O’Mary and Catherine Skulan of Ropes & Gray

Over the last 18 months, numerous private equity firms have followed the well-trodden path of some larger sponsors by expanding to include credit funds. While adding a credit fund product diversifies a sponsor’s asset base and income stream, there are some legal and compliance issues to address when running credit and PE funds together.

Non-public information

Confidential or material non-public information, or MNPI, acquired in one part of a firm may limit investment or divestment by other parts of the firm.

Most sponsors with private equity and credit arms institute some form of a wall to address MNPI issues. They are not a one-size-fits-all solution and need tailoring so they can evolve with a firm’s changing business goals and organization. Walls also require separate investment personnel and additional infrastructure, resources and procedures.

That can make strict walls unfeasible when launching a credit fund, particularly if the platform relies on synergies of investment personnel with its affiliates. Walls can also isolate investment teams and prevent other appropriate synergies from developing. For example, a wall may restrict the credit side from leveraging core private equity work, such as company diligence.

In operating without walls, sponsors may try to mitigate MNPI issues by limiting receipt of confidential information – for example, by declining to serve on creditors’ committees, avoiding reorganization discussions with debtors or electing not to receive non-public information concerning the borrower. However, managing a portfolio with incomplete information is far from ideal, and MNPI can seep through. So despite the synergies of operating without walls, many credit teams are forced to institute some sort of partition to avoid becoming overburdened by the restrictions on trading on MNPI as the credit platform expands.

Regardless of the approach taken, most sponsors are forced to introduce some kind of MNPI procedure. These may include monitoring the receipt of non-public data, maintaining a restricted securities list (or a watch list), establishing protocols for transmitting information within the business and training personnel to identify and respond correctly to MNPI issues.

Capital and allocation conflicts

Material conflicts can arise when a sponsor’s private equity and credit funds invest in different levels of the same portfolio company’s capital structure. The JH Partners enforcement action in November 2015 and other ongoing SEC inquiries exemplify the regulatory focus on this issue.

Sponsors should clearly disclose to investors how this conflict may arise. Common examples are: non-arm’s length terms of debt; debt being used to support the equity position; information sharing limiting the sponsor’s ability to take actions; and differing priorities in investment decision-making, including in distressed situations.

Sponsors should also disclose their policies and procedures for conflict resolution and mitigation. Prohibiting the financing of portfolio companies in which the firm’s private equity arm has made an investment avoids the problem, but this approach is uncommon. Rather, managers generally prefer the flexibility of investing in the debt of affiliated portfolio companies and so must take more nuanced approaches to address these conflicts.

For example, on conflicts concerning debt terms, a fund may be comfortable acting as lead arranger for other lenders extending debt to a company controlled by an affiliated PE fund if third-party lenders are extending credit on the same terms, therefore validating the price.

However, most sponsors avoid being lead arranger for other lenders, given the possible perception that the credit fund has access through its PE fund affiliate to information about the portfolio company that is not made available to the other lenders, or that the credit fund is facilitating the PE fund’s acquisition of the target, supporting the PE fund’s equity position, or that the PE fund is “giving” business to the credit fund.

Rather, sponsors tend to be a minority lender in this situation – commonly 25 percent or less. Some managers may also require another lender to purchase the debt on the same terms or, less commonly, require limited partner advisory committee (LPAC) consent to the terms.

Importantly, by implementing a wall separating business teams, sponsors can expand their conflict resolution options to include the use of conflicts committees, separation of teams and decision-making and/or restrictions on information flow between separate teams.

Conflict can arise if the credit fund is called to vote as a creditor in a distressed or other voting situation. Approaches suggested below are just some ways to address this issue. Sponsors must adequately disclose that they may rely on a given policy, although it is commonplace to maintain flexibility to use multiple procedures:

Voting proportionately to other creditors in a workout. Some investors may resist this approach, questioning why the manager should receive fees and then effectively withdraw its expertise on the matter.

Separating teams and decision-making for each arm. Although very common among managers with separate teams and/or walls, this is less likely to be feasible when investment teams are integrated and there is no wall, as well as when teams do not have separate compensation interests.

Requiring LPAC approval of the vote. Some investors are less willing than others to accept responsibility for these decisions. In addition, even if the LP committee is willing to accept responsibility for such matters, LPACs may not act timely and generally require expert guidance.

Requiring an overarching conflicts committee to arbitrate PE and credit arm interests. This would commonly be implemented through formal separation of the private equity and credit teams and the establishment of appropriate procedures to ensure the neutrality of the committee. Compensation of committee members may compromise decision-making in investors’ eyes.

Calling on an unaffiliated third party to make the decision. Although still relatively uncommon as a primary solution, managers are increasingly interested in engaging independent third parties. The cost and willingness or ability of third parties to approve complex transactions hampers this approach.

Given the risk and return profile of typical private equity and credit fund investments, allocation issues are less likely to arise between these funds than other asset class combinations. However, many PE funds have broadened mandates that include debt, particularly higher returning or synergistic debt. Given the life of PE funds, sponsors should consider the likelihood of a future credit platform and potential allocation issues.

A sponsor should clearly disclose the potential for allocation conflicts among vehicles and accounts with strategies that overlap, even in part, with the strategy of its other funds. For example, it is crucial to disclose the parameters of any contractual priority that an existing fund has with respect to opportunities that may fall within the credit fund’s investment strategy. Likewise, the credit fund documents should clearly describe the sponsor’s obligation to offer to the credit fund and any carve outs thereto, calibrating investor expectations and demands around allocation with the sponsor’s business goals and flexibility needs.

As a fiduciary, sponsors must make allocation decisions on a fair and equitable basis in the absence of clear disclosure to the contrary. Importantly, allocation decisions should be as consistent as possible, made in advance and adequately documented. Allocation issues are mitigated by a wall, but in that case, disclosure should clearly indicate that opportunities sourced on one side of the wall will not be offered to funds operated on the other side.

Clearly developed policies and procedures to address allocation conflicts are crucial. They may include a clear understanding of who will identify potential issues and make the decision, together with an outline of possible factors on which the decision will be based.

Sponsors that manage both credit and PE funds must deal with multiple legal and compliance issues, including those described above. A sponsor’s approach to these issues will impact the structure and strategy of its businesses, as well as the regulatory risk profile of the firm. With advanced and thoughtful planning, many of the risks associated with these conflicts can be mitigated.