Research Trends and Conclusions: Private Funds 2010
Emma Notfors -
The market has been behaving atypically recently and many of the lawyers we have interviewed are relishing the challenging and interesting workload as the focus of private funds practices shifts to accomodate new trends.
As activity in the industry has slowed, lawyers are working on opportunistic funds and solving problems for existing clients instead of the concentration on buyout funds, venture capital and frequent fund creation that represented the bulk of the work before the downturn. Clients are mostly worried about keeping their funds afloat and lawyers are frequently working on fund restructuring and advising on problems such as defaulting investors. “There is a potential to sue investors who renege on commitments,” according to Jason Glover of Clifford Chance LLP in London. The firm’s funds practice “has spent increasing amounts of time with litigation colleagues.” Lawyers we spoke to have noted more tension in management teams as a result of bad times. Slower activity in raising private equity funds has also “opened the door to much greater investor demands from funds actually being raised, particularly the right to exercise ‘no-fault’ termination rights,” in the words of Phyllis Schwartz of Schulte Roth & Zabel LLP in New York. The incidence of funds-related litigation has increased, and our sources have underlined the importance of excellent negotiation skills.
Alterations experienced in the funds industry are translating into more evolved legal practices. “The funds industry – particularly the hedge funds industry – has not really been through a crisis before and the last year has been a huge learning curve for investment managers and lawyers,” reports Richard May of Walkers. “Many of our existing clients are now looking to set up funds with new types of fee structures and longer lock-up periods geared towards attracting the longer term investors.” This is evidence of the trend of managers seeking new strategies as a solution to the illiquidity of the market.
Changes are not only being made to the models of prospective funds; existing funds also need to be improved. “Work has tended to be fund-by-fund problem-solving,” says Geoffrey Kittredge of Debevoise & Plimpton LLP in London. “We have seen firms approaching the ends of their investment periods anticipating a need for additional capital to make follow-on investments, or seeking to extend those investment periods for opportunistic reasons. It is certainly a quirky time for younger associates to cut their teeth – there are more offbeat challenges and there is a lot of room for finding solutions to novel issues.” Because funds work has diversified, it is arguable that the current climate is more favourable to experienced lawyers. Indeed, in the words of one practitioner, “There is less work, but what there is, is more demanding, so the last couple of years have separated the wheat from the chaff.” The best practitioners are brought to the forefront by the more challenging conditions.
This is already happening to some degree – one development noticed by our sources is a flight to quality. “Managers are increasingly looking at the experience and the quality of the law firms that they hire – if a law firm can add colour and practical business advice from the past, then that is a desirable quality,” says one of our sources. Many of our interviewees noted that clients are expressing a preference for a heavier involvement of senior partners. Long experience of the funds industry is a rare quality, particularly in jurisdictions outside the major financial centres. In many jurisdictions, the sector came of age in the mid-1990s so lawyers often have no more than 15 years’ experience.
An untarnished reputation is essential to securing work. Because of how tight-knit and relatively small the funds industry is, positive word-of-mouth can lead to new clients and work. One of our sources related how, after having successfully handled a restructuring for one member of an informal circle of fund managers, most of the rest of the group retained him as well. Clients are scrutinising lawyers’ track records so a good reputation is more important than ever.
PRACTICE MODELS AND LOCATIONS
Fund managers are diversifying structures in an attempt to remain attractive to investors and the lines between different types of funds are becoming blurred. Hedge fund managers in particular are interested in diversifying their structures and are showing interest in hybrid structures that draw upon the private equity model. “There are much more complicated funds structures taking on aspects of both hedge funds and private funds,” according to Timothy Spangler of Kaye Scholer LLP in New York. “Work then becomes about bridging the gap between these two different models.” This trend is particularly prevalent in the United States and in East Asia.
Although new types of funds are emerging, the bulk of the workload has been determined by problem-solving and opportunistic funds, such as distressed investments and secondaries. This sector of the industry is booming, and secondaries were mentioned by almost all of the lawyers we spoke to as an area in which they were expecting significant growth. Other possible areas of growth include emerging markets funds, infrastructure funds and green funds. This is not to say that innovation comes at the cost of simplicity – “Investors have been burned by over-complicated investments so they are looking to stuff they can actually understand,” according to Andrew Ostrognai of Debevoise & Plimpton LLP in Hong Kong.
Although investors in general have become reluctant to commit capital to new products, the Middle East and East Asia remain areas of activity. Sovereign wealth funds are among the only active investors, and as many of these are based in Asia and the Middle East. Some law firms are looking to gain a foothold in these markets. SJ Berwin recently opened an office in Dubai, and placed leading private equity partner Benjamin Aller there. Similarly, Kirkland & Ellis LLP recently bolstered its Hong Kong office with Justin Dolling, part of a triumvirate of ex-SJ Berwin partners hired in 2008. “A lot of investors are looking at Asia, and China in particular, as the land of promise,” says Dolling. “Any law firm that holds itself up as a global leader is looking to Asia.” Firms that want to build on previous successes in this area are also turning to the East. Ashurst LLP’s investment funds practice, which recently recruited a partner in Paris to head its funds formation practice there, with an emphasis on pan-European funds, has moved a partner to Dubai. According to London-based practice leader Jeremy Sheldon, “In order to maintain momentum, we need to have more of a presence in the Far East. We would be missing a bit of a trick without China, so the opening of our Hong Kong office earlier this year complementing our existing offices in Singapore and Tokyo can only be a good thing.” Although the funds industry has become somewhat diminished in terms of the amount of capital being circulated, it continues to expand geographically, and firms with a global footprint will have an advantage.
Inevitably, opinions differ on which practice model is best suited to the current economic climate and the changes it is causing. The lack of big-ticket funds launching and the relative prevalence of middle-market funds’ closures mean that law firms whose business is targeted at this section of the industry may benefit. Because mid-market funds have tended not to depend quite so heavily upon leveraging, these have remained more active than their larger counterparts. Also, medium-sized funds are arguably more flexible and were able to react relatively quickly to the change in market conditions. Law firms will no doubt see the relatively high level of mid-sized fund activity reflected in the amount of work they do. They are already contending with larger firms competing for market share in the sector.
On the other hand, it can be argued that larger firms are more easily able to accommodate funds that require specialised expertise or multidisciplinary knowledge. According to Schulte Roth & Zabel’s Udi Grofman, “These changes bring out the best of multi-practice firms. Partners from all different practice areas are needed to help, so multi-practice firms have an edge over competitors.” Several lawyers during the course of our research claimed that the leading funds practices are accustomed to dealing with idiosyncratic funds work. For example, Michael Harrell, of Debevoise & Plimpton LLP in New York, says, “At the high end of the practice, private funds are quite tailored and heavily negotiated. Firms with a broad-based funds practice have an advantage because as the favoured geographies and strategies shift around, they will stay busy one way or another.” As in many other practice areas, law firms are also securing work through competitive pricing. However, this is unlikely to faze practices that are already established participants in the funds areas, as premium clients are still willing to pay for expert, tailored advice.
REGULATORY CHANGES AND COMPLIANCE
Both the European Parliament and the United States Congress are currently drawing up regulations to discourage the risky financial behaviour that is considered by some to have caused the current financial crisis. These regulations have been prominent in the media recently and have inevitably become a bone of contention between the funds industry and its prospective regulators. Funds lawyers on both sides of the Atlantic have been providing advice to clients wanting to prepare for the repercussions of the new directives. Many are also involved in lobbying or advising governments.
A possible effect of these regulatory changes will be that the jurisdiction in which a fund is based may have an increased importance. According to François Pfister, of Oostvogels Pfister Feyten in Luxembourg, the regulatory environment that pertains to a fund is becoming as important as the tax aspect, as far as off shore funds are concerned. He says that “‘on-shoreisation’ is a trend that means that Luxembourg is being increasingly considered as a jurisdiction in which to base funds. As a jurisdiction, it is regulated in a pragmatic and flexible way and has a good balance between offshore and tough onshore-style regulation.” Statements from a number of governments have made it clear that there is likely to be more pressure imposed on tax haven structures, making these less appealing.
What seems clear is that any new regulations will require fund managers to spend more time on compliance, which in turn means more work for their lawyers. Indeed, lawyers are already busy ‘bolstering the compliance’ of funds in preparation for potential new regulatory regimes. Some industry insiders feel that the compliance costs might be high enough to drive smaller funds out of business and increase the barriers to entry in the industry. Many lawyers expect that new regulatory conditions and the attendant costs will also lead to the consolidation of funds on both sides of the Atlantic. Leor Landa at Davis Polk & Wardwell LLP in New York believes that whatever the regulatory changes and their market impact, they “will lead to increased demand for legal work in the private funds area across a variety of practice areas. Larger law firms with diverse and strong practices, such as fund formation, regulation and compliance, tax, derivatives, commercial law, bankruptcy and litigation, should be well-positioned as they have the experience, breadth of practice areas, depth of personnel and infrastructure to accommodate those needs.” Landa goes on to specify that it is not just the overall size or expertise of a law firm that is relevant, but also the client’s ability to access those resources effectively: “Law firms with a lockstep pay structure incentivise lawyers within the firm to work together to bring the appropriate expertise to bear in client matters, rather than encouraging competition between partners. Our expectation is that law firms that use lockstep are likely to be favoured by larger funds that have diverse needs and require sophisticated representation across a variety of practice areas, as the compensation system ensures that clients will have direct access to all the expertise they require.”
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It is some time since the onset of the recession and credit remains scarce. Activity in the private funds industry has decreased and future investors are still waiting for the market to recover. Several funds have ceased investment activities, while others are taking longer to market and mature. On the other hand, the amount of fund restructuring is high, meaning that the decrease in activity for lawyers is somewhat tempered.
Many smaller funds remain active and managers are finding new strategies and sources of capital. While there is much talk of consolidation of smaller funds and spinouts of fund managers from parent companies looking to streamline their operations, the industry will benefit from the regulations, innovation and improvements that are necessary for its survival. If the funds industry does consolidate as much as some people predict, it is likely that the legal practice area will shrink correspondingly, making it even more important than ever that lawyers show their mettle.