Alternative Insight – January 2016

The New Year; (More) New Guidance

New industry guidelines increase pressure on managers to provide investors with more information about their funds, especially fees and expenses. But how much will really change?

New Professional Standards Handbook

InvestEurope, the trade association formerly known as the EVCA, late last year published the latest edition of its Professional Standards Handbook. The Handbook covers the whole life-cycle of a private equity fund, and aims to set authoritative standards for how a GP should run its business and deal with investors and portfolio companies alike.

The 2015 edition has the same basic outline as previous editions:

  • At its heart sits the Code of Conduct, which sets out six fundamental operating principles – things like “act in fairness” and “disclose conflicts of interest”.
  • There is detailed guidance (in user-friendly Q&A form) on how to apply the Code in a wide range of practical situations, and special guidelines covering the work of placement agents.
  • The Handbook continues to incorporate the widely-used IPEV Valuation Guidelines, but there are updated Investor Reporting Guidelines (IRG) that supersede the IPEV Reporting Guidelines that were incorporated into the 2014 Handbook.

Why now?

The updated Handbook arrives at a time of mounting pressure on GPs to improve investor reporting, particularly on fees, expenses, carried interest and other forms of compensation:

  • The U.S. Securities and Exchange Commission (SEC) made hay in 2015 with a series of enforcement actions against PE managers over various questionable fee and expense arrangements and says that it will continue to focus on fees and expenses in 2016.
  • Some big public pension funds have said they’re making GP transparency a key plank of their fund evaluation process.
  • The Institutional Limited Partner Association (ILPA), an influential investor grouping, is preparing to issue a comprehensive new template for GPs’ fee, compensation and expense reporting.

So what’s changed in the Handbook?

Against this stormy backdrop, the Handbook talks up themes of greater transparency and accountability:

  • It certainly looks different – the layout is visually clearer and more readable.
  • It now includes example reports on fund performance, portfolio companies, capital account statements, cash flows, and calculation of net IRR and fund multiples. The IRG doesn’t want these examples to become standardized reporting templates, and says GPs are free to design and adapt reports to their funds’ particular circumstances.
  • It encourages additional reporting on non-financial areas – a recurring theme is an increased focus on environmental, social and governance (“ESG”) factors, with a call for GPs to consider and disclose ESG issues that could have a material impact on investments or the risk profile of investments.
  • The IRG distinguishes between two categories of disclosable information: “requirements” (information which funds must disclose if they want to say that they are in compliance with the Handbook) and “additional possible disclosures” (information which Invest Europe recommends should be disclosed, but is still optional). The new categories map almost exactly onto the 2014 Handbook’s categories of “essential disclosures” and “additional disclosures”. Compared to the 2014 Handbook, the content of “requirements” has grown, and there are more detailed and more itemized disclosures in the IRG generally.

So far, so good. But a lot of the detailed guidance is, in substantive terms, not hugely dissimilar to what came before. And one fundamental issue remains: it is not mandatory for InvestEurope’s members to implement the Handbook’s detailed guidance. Only the Handbook’s Code of Conduct is compulsory – but it is a corpus of values and principles that will not in and of itself resolve LPs’ ongoing concerns about getting more and better information out of their GPs.

Reporting fees, expenses and carried interest

Invest Europe says that the IRG has been “substantially updated” to “emphasise the importance of clear and detailed disclosure of fees”. Most of the detailed guidance here would appear consistent with the 2014 Handbook, although it has been reorganized and rewritten in a more accessible way. Section 3.5 of the IRG (allied with section 3.2.6 of the main Q&A guidance) extends the previous edition’s guidance to capture a wider variety of direct and indirect fees.

GPs that opt to comply with the Handbook should:

  • provide investors with a detailed breakdown of the nature and source of all fees paid directly or indirectly by portfolio companies to the GP and/or any related persons, and to what extent such fees will be offset against the management fee or otherwise credited to the fund;
  • disclose all of the fund’s operating expenses, providing a breakdown by category (e.g. audit, legal, fund formation, abort costs);
  • clearly differentiate between costs borne by the fund and those for the GP’s account; and
  • disclose whether the hurdle rate has been exceeded, how much carried interest has been accrued earned on realisations, what amounts of carry have been distributed, accrued and/or escrowed from period to period, the total carried interest payable on unrealised investments assuming they are realised at the current fair value, and the value of potential carried interest clawbacks.

Conclusion

Under pressure from regulators and institutional investors, the 2015 Handbook suggests an industry keen to get ahead of the curve, or at least wanting to show that it is attentive to investor concerns about disclosure.

With a roster of 650 full members and 500 affiliate members, InvestEurope is certainly well placed to influence best practice across European private equity, so LPs may view it as a lost opportunity that member compliance with the entire Handbook hasn’t been made mandatory.

In the short run, it will be interesting to see whether GPs gravitate toward the Handbook’s principles-based approach or ILPA’s standardized templates. In the long run, the wave of new guidelines and recommendations from both regulators and investors is likely to improve disclosure practices, which should also make it easier to directly compare charges across funds.

 

Alternative Insight is produced by MJ Hudson’s private funds lawyers. We provide expert legal advice to fund managers, other financial sponsors, investors and advisers on the formation, structuring, investment into and regulation of private funds, managed accounts and similar vehicles. Our practice covers the full spectrum of alternative assets, including private equity, venture capital, hedge funds, private debt, real estate and infrastructure. Clients praise our entrepreneurial approach, commercial outlook and dedication to helping them achieve their objectives, regardless of the obstacles.