Steering clear of conflicts of interest can be the difference between life and death for private equity investments, writes PM Devaiah
It may be trite to say that trust is the force that drives the private equity business. Conflicts of interest arise when someone is unable to carry out a legitimate activity without fear or favour, and without prejudice or malice. The possibility of a clash between a person’s self-interest and professional interests can lead to unfair outcomes.
Regulators across the globe are proactively identifying conflicts and using prescriptions in the form of codes and regulations spanning general laws, special securities laws and other governance requirements.
Indian regulators have been proactive too, putting in place several laws and regulations. For instance, section 184 of the Companies Act, 2013, mandates that all directors must disclose their interests and prescribes serious consequences for failing to do so. In addition, the act (unlike its predecessor, the Companies Act, 1956), codifies the duties of directors, covering various conflicts of interest, so as to mandate a positive obligation to be followed by all directors while performing their duties.
Similarly, the Securities and Exchange Board of India (SEBI) regulations, including the SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2018, require a disclosure of conflicts of interest of directors in the offer document. The Insolvency and Bankruptcy Code, 2016, for instance, prescribes stringent norms regarding conflicts for insolvency professionals. In addition, The Code of Criminal Procedure, 1973, one of the oldest laws dealing with this issue, prevents judges and magistrates from taking up cases where they have conflicts of interest.
While this is an indicative list of laws and regulations, the intent is clear – conflicts must be avoided as they can undermine the trust and robustness of the business environment.
Since the entire spectrum of activities in the business of private equity – fundraising, deployment, management and exit – are complex and engaging, the potential for conflicts of interest is very high.
Typically, the most susceptible to conflicts are directors on the board of a private equity-funded portfolio company. Nominee directors should know their duties when confronted with a conflict of interest situation, where the interests of the company and the interests of the nominating shareholders are different.
When in doubt, such nominees should not shy away from seeking specialist legal or other technical advice on how to vote on a proposal before the board, or even recuse themselves after having recorded the reasons in writing. If directors fail in their fiduciary duties they risk serious consequences.
In practice, nominee directors often neglect their duties to the company and see themselves as the guardians of their nominating shareholders’ interests. And often, the interests of the company and that of the investors can be at loggerheads.
Terms and conditions of borrowing, encumbrance on the equity of the company, timing and pricing of a public offering, mergers and acquisitions, diversification into new businesses, cultural disconnects are all potential hotbeds for disputes between a company and its investors. The investor nominee has the task of balancing these conflicting interests, while upholding the best interests of the company.
There are many predictable conflicts in the private equity industry. A good example is in club or consortium deals, where multiple funds with different investment ideas, or funds at different stages of their investment cycle, pool their resources to invest in a company. The conflicts from such congregation of investors get deeper if the club or consortium deal were to be constructed as a platform deal or a management buyout, leveraged or otherwise, which involves a deeper and longer engagement. In such situations, there need to be well-documented limited partner agreements that are backed by transparent and well-drafted internal compliance manuals for day-to-day operational matters.
Similar situations arise when a fund makes investments into competing companies, or if two funds managed by the same manager invest in competing companies. The transparency with which a general partner deals with the conflicting interests of the portfolio companies is the sole test for governance standards.
Questionable practices in normal operational matters include allocating management bandwidth to only one of the competing portfolio companies, or supporting the IPO of one portfolio company while denying the other company’s needs.
Under the lens
The technical committee of the International Organization of Securities Commissions (IOSCO), in its 2009 report, encapsulates instances of conflict of interest in the private equity industry across different stages and throughout the life cycle of a private equity investment. They are:
Fundraising stage conflicts
- Investment advisers. General partners apportioning fundraising costs to the funds on an undisclosed basis. Third-party service providers providing investment advice to either limited partners or general partners without disclosing pre-existing conflicts.
- Size of fund and internal rate of return. General partners aspiring for a large fund, which can earn significant management fees, irrespective of its ability to effectively deploy the capital within the investment period, and the potential of the market. This could impact return for the capital.
Investment stage conflicts
- Placement fees. General partners receiving transaction fees from portfolio companies can have a negative impact on the fund and could be detrimental to limited partners. This is more so if the fee is not disclosed or the transaction is not transparent.
- Overlapping funds. General partners that manage multiple overlapping funds, particularly private equity funds operating alongside debt funds. The problem is compounded when funds managed by the same general partners take equity and debt exposure in the same portfolio company.
- Rescue funding. Follow-on or rescue fund allocation into a portfolio company that had previously raised capital from a fund managed by the same general partner.
- Follow-on funds. General partners embarking on fundraising or soft marketing for a new fund even before investments made from the preceding fund have reached the mandatory threshold limits and allocation of investment opportunities among overlapping funds. Typical mandatory threshold limits range between 75% to 90% of the committed capital of a preceding fund.
- Co-investment. Giving limited partners or general partners the right to co-invest in a deal on preferential or same terms.
Management stage conflicts
- General fees. General partners receiving fees, such as consultancy fees or directors’ fees, from portfolio companies without the informed consent of limited partners.
- Dealings with affiliates. Commercial dealings with affiliate companies that are not awarded in a competitive process or done at an arm’s length basis, which result in the general partner receiving fees.
- Fiduciary duties. A series of conflicts can arise because of the dual position occupied by the nominee of an investor on the board of the investee company. Conflicts normally arise when the interests of the investor and the portfolio company are different.
- Time allocation. Conflicts arise when there is lack of transparency in the manner in which general partners allocate managerial resources between the funds.
Exit stage conflicts
- Divestment. Conflicts arise on account of issues with regards to the timing of divestment in a portfolio company by multiple funds that are managed by the same general partner. This may arise because the funds had invested in the portfolio at different points in time.
- Return expectations. Pricing conflicts arise when trying to meet the return expectations of the investors, which could be at odds with the interests of the portfolio company that is in dire need of capital for growth, expansion or even operations.
- Fund life. General partners requiring unreasonable and needless extensions to the fund life, which results in increased management fee obligations for limited partners.
- Secondary sale. Secondary sale of fund units and related issues that arise, which could be to the detriment of the limited partners’ interests.
The principles of private equity investment demand outright avoidance of conflicts. Mitigating mechanisms are merely preventive and a process to achieve the principles.
The mitigation of conflicts can be institutional or ad hoc. The typical forum for institutional mitigation of conflicts in any private equity structure could be a committee or supervisory board that facilitates consultation and deliberations. Mitigation of conflicts of interest in an ad hoc manner happens through informal discussions and collaborations between investors.
Ensuring adequate disclosures, transparency from start to finish with inter se agreements between general partners and limited partners, clarity in the manner in which the business will be conducted, particularly when confronted with a conflict, will go a long way towards avoiding and resolving conflicts. The use of disclosures that are complete, fair and honest has been the preferred and the most workable approach in resolving conflicts of interest in the private equity business.
PM Devaiah is a partner and group general counsel with Everstone Capital Advisors. The views expressed here are personal.