Research Trends and Conclusions: Private Funds 2011
Emma Notfors -
Who’s Who Legal interviewed hundreds of lawyers active in this practice area during the research for this publication and the vast majority were in agreement over the continuing harsh climate for the funds industry.
There has been a dramatic slowdown in fundraising over the past three years and the size of the funds has decreased. It has become increasingly difficult to reach a first closing and investors remain more likely to place investments with established fund managers who have proven track records. Add to these factors the Dodd-Frank Act, the Volcker Rule and the European Alternative Investment Fund Managers Directive and the often misinformed attitude of the general press to private funds and what results is an extremely turgid witches’ brew of a market in which investors are, to say the least, reluctant to risk their capital.
This is not to say there are no signs of growth or optimism. Sovereign wealth funds and emerging markets appear to be potential new sources of investment and new fund structures to attract shy investors. Examples of this include the exchange fund, hybrids of hedge and equity or UCITs funds and shariah-compliant structures. Indeed, those lawyers who claimed to have seen an increase in capital raising assignments often pointed to more specialised strategies as the successful ones. These specialised strategies can often be those considered as ‘safe’ by investors – infrastructure funds, for example, are an enduring favourite of pension funds, while conversely, buyout funds and real estate funds have arguably been the hardest hit.
Regulation
The issue that was mentioned in almost every one of our interviews was, predictably, regulation (for a more in-depth analysis, articles by Thomas H Bell and Jason Glover and by Iain McMurdo follow this piece). Fund managers have become the whipping-boys of the press and a convenient scapegoat for governments wanting to be seen to act decisively against entities that are perceived by some to be among the culprits of the global financial crisis. Many have argued that the AIFM Directive was heavily shaped by pressure from the governments of countries which do not themselves possess significant funds industries, and further, that the various drafts of the Directive betrayed a level of ignorance about private and hedge funds (perhaps reflective of those pressuring for harsh new regulations rather than those tasked with meeting these demands). Regulations across the Atlantic, while predicted by some to have a more muted effect than the AIFMD, are nonetheless likely to result in a change in the cultural landscape for investors and the funds industry.
The repercussions of these regulatory measures have somewhat different ramifications for lawyers than for their fund manager clients. Due diligence and regulatory compliance have become even more significant and this of course means an increase in work for lawyers. Many practitioners mentioned to us that they, or senior members of their teams, have been spending a significant proportion of their time (60 per cent was one figure) lobbying regulatory bodies in a bid to better inform and exert a positive influence on regulators.
A number of our sources admitted that the increase in scrutiny by regulators means that more attention is being paid now when drawing up contracts and legal documents to make sure that they have the desired effect and that their language is precise enough to deal with any eventuality. This is in contrast to a practice common a few years ago when this aspect of private funds work was described variously as often akin to form-filling. Several of our sources noted that documentation was receiving increased attention – in particular redemption and lock-up provisions – as it had fallen a little short during the white heat of the financial crisis. In many cases, funds work has become more sophisticated and many of our interviewees were keen to emphasise the strength of their funds team on the regulatory side. This could translate into the hiring of former staff of regulatory bodies, or simply involving senior partners with wide-ranging experience in what is otherwise considered to be more routine work such as the drawing up of documents. Both law firms and clients have been doing a great deal of housekeeping in the downturn.
Areas of Activity
Regulatory changes do not only mean an increase in compliance-related work for lawyers – transactional work is likely to increase as well. Certain provisions of the Volcker Rule will severely restrict the ability of banks to invest in funds or to sponsor them and, given that financial institutions must be able to demonstrate the viability of their investments, the slow fundraising of recent times means that many are considering which parts of their investment arms to shut down or spin out. Other investment funds are being started up as teams leave firms whose retention techniques have ceased to be effective. The carried interest that had served as an incentive to stay put during the bull market (as a leaver forfeits the interest they have earned) became devalued with the downturn and many teams are considering spinning out and setting up as new investment fund managers. For lawyers, this means not only transactional work but also the opportunity of gaining fund formation work from start-ups.
Despite the continuing difficult conditions for fundraising, law firms seem to remain optimistic about the future success of funds. Investors continue to favour experienced fund managers but buoyant times are predicted ahead. One of our sources claimed to have noticed that law firms who were not previously players in this practice area were attempting to establish a presence in anticipation of higher volumes of work in the future. Other firms are pitching themselves as go-to firms for start-ups. For example, Simmons & Simmons held a seminar in recent months when it spotted a gap in the market in educational opportunities for would-be fund managers. This seminar was oversubscribed and the law firm is now one of the training partners of the BVCA. In general, firms are diversifying in terms of the range of funds that they serve. A firm that had been known for its strength in major buyout funds has changed its strategy to include infrastructure funds, renewable energy and cleantech, mezzanine funds and distressed assets. This has allowed its funds team to maintain level revenue streams.
Lawyers and law firms have had to diversify geographically as well as in terms of the type of fund they service. Many have highlighted the trend among law firms to move or hire partners in locations such as Luxembourg, Ireland, Brazil, Hong Kong, Singapore and the UAE and this is reflected in the higher number of listed experts in those jurisdictions (see chart 1). These centres have the attraction of having retained relatively high liquidity in comparison with Europe and the US or their regulatory environment may seem more attractive. Sovereign wealth, distressed debt, infrastructure, RMB and shariah–compliant funds are all potential areas of work.
This trend is certainly borne out in our research – since the last edition of this publication, we have included five more practitioners in Hong Kong, three more each in Singapore, Luxembourg and the United Arab Emirates and four more in Ireland. One of the most significant moves within the private funds legal market in recent years is that of Jason Glover from Clifford Chance to Simpson Thacher, giving the firm a strong presence in both of the major fund centres, with the potential to attract a number of prominent EU-domiciled private equity funds.
Private equity is an industry that is dominated by strong personalities – LPs base much of their confidence on the track record and reputation of the GP. Several prominent GPs who have been part of the industry for a long time and are nearing retirement are facing what one source termed ‘succession issues’ – finding a GP who will inspire enough confidence in LPs that they do not baulk at the transition. Even legal teams are facing similar situations – in London alone there are a couple of practices which have been led for years by ‘figurehead’ partners who have built up strong relationships with fund managers but who are now nearing retirement. We can expect to see successors taking over in the next few years and it is likely that, in the lawyers’ cases at least, they will come from these pages.
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It has been said that there is an alternative investment strategy designed to raise money for most conceivable market conditions. One lawyer joked that “if there’s a market for lemons, we’ll be working on a lemonade fund”. It is this adaptability that makes private funds an attractive asset class. However, the ability of fund managers to invest in new businesses, infrastructure, clean technology and so on is likely to be hampered by new regulation. The pressure of these regulations is increased by risk-averse investors and the amount of perseverance necessary to raise and close funds. For lawyers, this means an increase in due diligence and compliance work as well as the galvanisation of contracts and documents. Law firms are looking to strengthen their presence in jurisdictions that appear attractive to fund managers and, just as fund managers are trying to find new strategies to gain investors, law firms are seeking strategies to attract fund managers.