The experience of managers during the Global Financial Crisis of 2008/2009 (GFC) made it very clear that proactivity, communication and transparency is paramount in order to maintain investor relationships and investor confidence during a period of market disruption and uncertainty. This lesson is even more applicable in the context of the current Covid pandemic than it was during the GFC. The preferred frequency and form of such communications should be discussed with the investors, however given that circumstances are changing rapidly, such communication should be frequent enough to keep the investor informed and up to date as to the ongoing impact of COVID-19 on the fund’s portfolio. Communication should be detailed and specific to the risks and challenges being encountered. Investors do not want their inboxes flooded with irrelevant data and waffle.
In this regard, managers should assess the impact of the market disruption on their funds’ portfolio companies, take pro-active steps to develop and implement contingency plans to ensure the financial stability and business continuity of its portfolio companies, and determine the priority and allocation of its limited time and resources as between such portfolio companies.
Investors are generally willing to engage with managers and to assist managers in implementing plans to ensure value preservation of the portfolio companies, including increasing flexibility around recycling of commitments and creating larger cash reserves (and correspondingly, having reduced, delayed or deferred distributions during this period). Some investors have already developed programmes in terms of which they intend to make a portion of their undrawn commitments available for drawdowns to provide short-term working capital relief to portfolio companies whose business operations have been materially adversely impacted by the COVID-19 pandemic. As an alternative to such cash funding, the programme may also permit an extension of portfolio companies’ existing credit lines to the extent required (subject to the programme limit) backed by a guarantee from the fund. In addition to the above options, managers are also encouraged to stay abreast of and ensure that its portfolio companies take advantage of, government bailout policies and initiatives.
Investors expect managers to ensure that robust business continuity plans are in place to maintain continuity of their own critical processes and the services they provide, including reporting obligations. Managers should also review service provider and counterparty business continuity arrangements to assess any impacts this may have on their own processes (e.g. administrators). To the extent that there will be any issues with meeting any of its obligations, these should be communicated to investors and managers should be proactive in requesting flexibility where this is practical.
In addition to engaging with investors in respect of the needs of the fund and its portfolio companies, managers should also engage with investors in respect of any assistance or flexibility that they may require during this period. For example, certain investors may request that the manager increase the period for drawdown notices to give the investor additional time to address their own liquidity issues and to avoid defaults. Managers can also engage with existing investors to consider additional commitments to pick up any potential defaulting investor allocation, but in doing so should be ever mindful not to treat certain investors more favourably than others.
In determining and implementing their response to the COVID-19 outbreak, managers should review the mechanisms available under the terms of the relevant fund documentation. The considerations and actions discussed below may require amendments to fund terms and documentation, as such managers should always consult the existing fund documentation to ensure that any such amendments and/or actions are implemented in compliance with the terms of the existing fund documentation, including any consent requirements.
The impact of the COVID-19 pandemic on funds will vary at different stages in the fund life-cycle. Funds which are currently raising capital and those which are at, or nearing, the end of their life-cycles will be most affected. The key impacts are outlined below in respect of each stage.
1.1 Funds currently raising capital
Engaging with and raising commitments from new prospective investors will be more difficult in the current circumstances due to travel restrictions and lockdowns and managers will therefore be more likely to receive commitments from investors who have an existing relationship or who are already familiar with them.
Managers may nevertheless engage with new prospective investors via alternative marketing and business development mechanisms. To accommodate potential delays in this process, managers should consider extending the period during which they seek investor commitments before holding their first close and, to the extent that the fund has already completed its first close, obtain investor consent for an extension of the final closing date (it should however be noted that this may bring complicated equalisation issues into play).
It would also be prudent for managers to review and ensure that risk disclosure statements in their fund documents, including offer documents and private placement memoranda, are accurate in the context of the current situation and updating such statements to the extent necessary.
1.2 Funds in the investment and holding periods
Managers of funds in the investment period should consider whether an extension of the investment period (i.e. the period during which investor commitments can be drawn down) is required, and if so, the effect of such extension on management fees (this may need to be agreed upfront with investors).
Managers would also do well to review their fund terms as to whether:
1.2.1 it allows for deals that are in progress to be completed after the end of the investment period;
1.2.2 it contains follow-on investment provisions which permits the manager to make capital calls after the end of the investment period to preserve and enhance the value of the existing portfolio;
1.2.3 the investment guidelines and strategies can accommodate opportunistic investments which may arise as a result of the current financial market displacement and equity valuations;
1.2.4 the business plan reflects the current and probable future market disruption;
1.2.5 the risk strategy is sufficiently robust to address any new or increased risks; and
1.2.6 short term illness such as COVID-19 triggers a key person event, although this is unlikely as it is typically provided that only an extended period of absence would trigger a key person event.
As discussed above, following engagement with investors, managers may also wish to increase the notice period for drawdowns in order to give investors additional time address their own liquidity issues and to avoid defaults.
1.3 Funds nearing the end of life
A manager of a fund nearing the end of its term may wish to extend the life of the fund or raise new capital in order to preserve value of its portfolio and avoid a fire sale in the currently unfavourable market. Bridging the valuation gap is discussed in more detail here. In addition to recycling and increasing cash reserves (discussed above), some options available to managers of funds nearing the end of its term are:
1.3.1 Fund extension in terms of the fund documentation (which typically allows for one to two-year extensions) or by unanimous investor consent, depending on the fund terms;
1.3.2 Secondary transactions whereby the portfolio companies are transferred into a continuation fund to be established by the manager, and the investors will have the option to roll over into the continuation fund or cash out of the existing fund at prevailing NAV (or even a discount to NAV);
1.3.3 Cross trades in terms of which the portfolio companies are transferred from a prior fund to a successor fund, or between a fund nearing the end of its life and a newly launched fund. Cross-trades are distinct from secondary transactions in that it does not necessarily require the establishment of new fund specifically for the purpose of acquiring the portfolio companies, it may involve an existing fund managed by the manager, and it does not necessarily require that the existing investors be given the option to roll-over into the acquiring fund. Managers should be particularly careful to consider any conflicts of interest provisions and related party rules applicable and should rely on independent valuation of the fair value of the assets being sold and purchased;
1.3.4 Offering co-investment opportunities to investors or establishing an annex fund in which interests are offered to investors on a pro-rata basis, for the purpose of providing follow-on funding to portfolio companies. This may not necessarily provide any additional time for realisation of investments, but it will allow for additional drawdown capacity for follow-on investment in portfolio companies; and
1.3.5 Strip sales in terms of which a fixed percentage of the fund’s portfolio is transferred to a new acquisition vehicle to which commitments for follow-on funding is made by an entirely new investor (secondary buyer). A strip sale is treated as a disposal by the fund, and the fund’s remaining interest in existing portfolio companies which have been stripped will be progressively diluted to the extent that the new acquisition vehicle is further funded by the secondary buyer.
In implementing any of the above options, managers will need to ensure they follow the correct procedures as set out in the fund documentation, including seeking investor consents to the extent required.
Managers of funds at all stages in their life cycle should ensure they have robust business continuity plans in place and should review the fund documentation to ensure that it allows for board meetings, investment committee meetings, advisory board meetings, investor meetings, annual partnership meetings, and any other relevant meetings to take place virtually or by telephone. Where relevant, managers will also need to consider whether there are a sufficient number of directors or key persons remaining in the jurisdictions where funds or fund managers are established to maintain tax residency, as well as the legal effectiveness of electronic execution of documents in respect of the relevant jurisdiction.
Notwithstanding the disruption the COVID-19 outbreak has caused, managers are still required to comply with their regulatory obligations, save where regulators have stated otherwise. It is therefore important for managers to ensure that they keep up to date with and be alert to variations to existing regulatory requirements or the introduction of new regulatory requirements.
In this regard, it is worth noting the recent FAIS Notice 17 of 2020, issued by the Financial Sector Conduct Authority on 31 March 2020, which provides an exemption from and extension of the period to comply with certain fit and proper requirements, including continuous professional development requirements and regulatory examination requirements. A summary of this notice is available here.
Although the COVID-19 outbreak has caused a massive disruption in the public markets and is doing the same to private markets, there are options available to managers which seek to mitigate the negative effects of this crisis on the funds they manage. Whichever options are considered, communication and transparency between the manager and the investors will be the key to maintaining investor relationships and investor confidence during this crisis.
The humanitarian crisis caused by COVID-19 also presents an opportunity for managers to enhance their commitment to environmental, social and governance related investing and to evaluate their response through a lens of social citizenship.
We recently discussed the topic of this note in a webinar hosted by the Southern Africa Venture Capital and Private Equity Association (SAVCA), a recording of which is available here.