Checks and balances in protecting the family office position during fund or direct investment

Speaker A: This is family Office intel at Dentons. The place where we discuss developments currently shaping the industry and actionable ideas for advisors, executives and families. We share uncommon knowledge from insiders for the modern family office. I'm Edward Marshall, global head of family office here at the firm. The following is a conversation with Chinese Jonathan Kanter. Jonathan's a partner in our office in the uk focuses uh, on real assets and he's a uh corporate partner in that group. Over two decades of experience working on corporate transactions, uh both uh domestic and cross border and international all across the board and uh, some, some strong experience in the real estate space as well. So Jonathan thanks for uh, coming on.

Speaker B: Yeah, great to, great to speak to you today.

Speaker A: Excellent Jonathan. So tell us a little bit about your practice, how you got uh, into uh the type of work that you're doing today.

Speaker B: Yeah so the practice that, that I work with here in London um ah focuses on um investors who are investing into private fund vehicles. Um and those investors can be of all types. They can be anything from sovereign wealth funds to um, pension funds but include high net worth individuals and family offices. And the work that I do is focused around um, protecting um an investor's position when they're investing into um, some sort of pooled investment vehicle like a fund. Um and so it's, it's really sort of looking at those fund documents and making sure that they're fit for purpose and include the terms that investors want to see in them so that they know their um, investment is going to be managed properly.

Speaker A: So the term portion uh, is an area that I know many private investors are looking at and family offices are looking at of what's market, what should they be asking for, what should they be looking for when they are uh, making investment or considering an investment. How have you seen that play out with the family offices and private clients that you work with?

Speaker B: Well yeah, I mean the thing to remember first of all is there are many different types of funds that are available to invest in and the work that we do spans all of those. It really doesn't matter whether the fund is based in a particular jurisdiction, whether it's a Luxembourg fund or ah, um, a Cayman fund, um, a M Jersey fund, Delaware fund. The location doesn't matter and the sector uh, um, doesn't matter either. Um m. So what we're seeing um, across the deals that we've been working on here um, are really sort of up to date. Um intel on um, what's happening in the market. And, and this goes for both closed ended funds and open ended funds, those that have a fixed term life and those that are um, open for um M redemptions um throughout. With closed ended funds what we're seeing a lot of is um a sort of flexibility to extend at the end of the fixed term. So typically there would be a 10 to 12 year period of the fund um which could be extended by um up to 2 years um either um at the behest of the manager or better at the um m approval of the limited partners. And you know that's a really important point at the moment um for all investors because uh m no one quite really knows what the future is going to hold and so they want to make their fund as flexible as possible and have as much control as they can um over the decisions that it takes particularly at the end of their life.

Speaker A: So the control mechanisms and other governance areas. Where have you seen some potential room for improvement for private clients and family offices when they're looking at making either fund investments or direct investments on there?

Speaker B: Yeah, I mean ah, that's one of the hot issues that we see all the time with these funds. The amount of, of um governance um that there is. And it's important that there's a balance here. So obviously one of the key features of these funds is the limited liability of the investor. Um and a lot of the time the way that they're structured necessitates that the control and management of the fund is ceded to the manager. The limited partners don't get involved in the management and that way maintain their limited liability. But at the same time you want to be sure that there's a significant degree of oversight into what the manager can and can't do. Um and also for those very key strategic decisions that there is the ability for the investor body of which the family office would play a part um to make those decisions and they're able to do that um, without losing their limited liability. So what we do when we're reviewing documents is make sure that there's a strict protocol in place as to the things that the manager, the general partner can do on its own and in particular the way in which there are checks and balances on the way um, in which it uses its control rights. And often that'll be through the way of the limited um partner Advisory committee or sometimes called the Investment Advisory Committee. And this committee consists of a small pool of, of investors but it should be a diverse group of investors so not necessarily the biggest and the most powerful because um, everyone knows the benefit of having a diverse pool of views being represented. And that limited partner advisory committee would have, um, a high degree of oversight over what the manager is doing, how they're dealing with conflicts of interests, um, how they, how they manage the whole processes that the investment in the fund has been based on. And what we're seeing is a high degree of interest by our investments to ensure that there are strict policies in place for that advisory committee, um, so that it's got real teeth, um, to sort of look over what the manager does and make sure that it does it in the right way.

Speaker A: When you're looking at these funds or other types of direct investments, you start with a blank sheet of paper on the due diligence side. What does that look like? Um, when you have to build it up from there and produce a due diligence process, what does that look like? What do the mechanics look like on your end? Broad strokes.

Speaker B: Yeah. So when we, when we're doing due diligence for our, for uh, our clients in this, we're really looking at the key elements for an investor of that type. And those would really be the following. It'd be looking at what fees are they going to be paying as an investor? You know, are those fees what we would see in the market as being normal? You know, do the fee levels reduce at the end of an investment period? Is it based on committed capital? Then we'd look at how investors get their money back. How are the dividend, how are the distributions dealt with within the waterfall? Um, is there a catch up on the carried interest that's being paid to the manager? Is the fund being calculated, the fund returns being calculated on, on the basis of a deal by deal, um, formula, or is it based on a whole of fund formula? And we would look at those particular terms. So first of all, um, you've got the distributions, secondly you've got the fees. And we would report to a client on whether those are, uh, what we would consider to be market standard. We'd also look at things like removal of a manager. You know, you're not happy with the way in which the performance of a fund is going, or maybe there's been some sort of a cause event. How easy is it to take back control of the fund? After all, it is the investor's money that's being put to use here. Um, how easy is it to remove a manager who's performing not as well as you would like him to perform. We'd also, um, we'd also go on to look at, uh, things like key persons, you know, who Are the people who are going to be doing the day to day on the fund and how are they um, how are they incentivized to perform and what happens if for example um, one or two of them move on to another job? You know, does the whole fund need to have a reset? So what we would do is we would, we would look at these, these key elements and we would compare them to the market position, um and then report to the client and if necessary we would engage with fund counsel to um, amend the terms that have been presented to us. Now what's really interesting in all of this is finding out what's marketing. So we act for lots of institutional investors from around the world and so we get insight into um, into a lot of um, a lot of fun documentation. So um, we get our own intelligence from that to see what um, what the market is doing. But there are also various um bodies that um assist both managers and investors like family offices in um engaging um what's normal and what should be um an accepted position. One of those is the um Institutional Limited Partners association known as ilpa um and they produce reports on um what should be the industry standards looking to maximise efficiency both for investors like family offices and for. And for managers. And they're advocating um the position to make sure that um the managers um aren't taking advantage um of their advantageous position as being the stewards of um investors money.

Speaker A: So in that vein of being good uh stewards uh and being careful of what you're looking at, what are those two or three things that you see are most common pitfalls that families should be looking at when they're, when they're trying to make an investment in a fund?

Speaker B: Yeah, I mean there are. If I were to pick up the top points, um, it would be first of all making sure that um the managers um got an alignment of interest with, with the family office. Um so what do, what do we mean by an alignment of interest? You're all pushing in the, in the right direction. The manager um needs to have skin in the game in these funds. Um it needs to have a substantial meaningful equity interest. Um and that interest needs to be committed by cash. So for example, it can't just say um, I'm going to forego some management fees um in lieu of um actually putting money in its pocket and investing it in the fund. And it's also important that the manager is incentivized by um not being able to cherry pick um the deals that it invests in and making sure that that alignment is maintained throughout the life of the fund. So it's, it's not enough for the manager to say well you know we're going to be investing um, a couple of million at the outset. If it can then divest of that um after, after six months. You know, investors want to know that the manager is aligned with the interests of the investors all the way through.

Speaker A: People both have skin in the game on both sides.

Speaker B: Skin in the game on both sides. But, but it's got to be meaningful and it's got to be maintained as well. It can't just, you can't just um, allow them to put the money in and then, and then sell on um, after a short period. And similarly you don't want a change of control of the manager. You know, you, you want to be sure that the, want to make sure that the manager is the um, is controlled by the people that you um, that controlled it when you made the investment. So that's really important. And then you're really looking at ah, things like transparency. So one of the things that's been very important is um, the reporting element of general partners, of managers to their investors. There should be clear lines of communication um, between investors and managers, regular reporting and that's um, been even more important over the last two years um, throughout the pandemic where um, you know, the sort of the ability to look across the table from your manager and get reports has been diminished um and you know more reports need to come out um, in different manners and it's really incumbent on the manager to take the lead here and to always be available to report to investors in the manner that they need reporting. Now what we're finding with our clients is enhanced reporting being needed in areas like ESG because investors, whether they're big or small, need to report uh, themselves on the ESG performance of the investments that they've made. And they can only do that if they've got the um, they get the data from, from the various funds that they've put their money in um to um, to to then um, analyze and then pass on. So you know the, the big things that, that I would say that family offices need to look out for, uh, really making sure that the interests of the, of the family office and the manager are aligned in um, sort of bringing a successful uh, investment um, with um, an acceptable level of returns, having transparency on what the fund is doing, how the fund is performing, how the fund is putting the money to work. And then as we talked about through various decision making processes Making sure that there's a robust system of corporate governance in place so that the manager um um doesn't go beyond um the scope of what it's allowed to do under the, under the various fund documentation.

Speaker A: When you're looking at these funds and other investments that families are looking at and without revealing confidences uh can you give us an example of when something didn't go according to plan either because diligence wasn't followed or the process that you talked about of evaluation wasn't followed? Because I think sometimes learning from a bad example can be just as helpful as a best practice.

Speaker B: Yeah, so there are a couple of examples. I mean one of them um, you know um during the pandemic what we found with some of the um open ended real estate funds here was that they were not able to um they were not able to redeem interest. So this is where an investor has invested but gives a notice to the fund um and would effectively over a period of time receive its money back and exit the investment. Um now in a real estate fund that relies on being able to do evaluation of the assets of the fund to determine the price at uh which um uh the UM m interest would be redeemed. And because of the inability to value real estate assets at the height of the pandemic due to lockdowns um Funds were unable to make valuations and therefore said to their investors um notwithstanding anything else um in the the gates are coming down and no redemptions are allowed. And we had instances of of of of clients who you know would like literally shocked by that. You know they thought not having done sufficient due diligence. An open ended fund basically means if I ask for my money back then I get my money back. You know. They weren't aware of the various UM M provisions that allowed the managers to um m sort of suspend that process and they weren't aware of the various procedures that were needed to then um unlock that suspension. And they were therefore left in limbo for quite a long period of time before being able to um to remedy um the position and um and exit the fund. So that was an example of of not having liquidity. If they'd have you know we could have looked at the um looked at the documentation beforehand and make. Make clear to people exactly what their letting themselves in for and um the circumstances in which that type of redemption is able to um is able to be suspended by the manager and when the manager um has to um m reopen the gates and allow people to um M exit so that was one example of sort of things going wrong. People thought they were in a position and then they weren't in the position quite um. How they thought. Um. Another one is around Most Favored Nations. This is um. Um a An element of um fund investment that's um Fairly common that um. You're able to receive the more favourable terms that a comparable investor would have obtained from the fund. Um normally either contained in the fund documents or negotiated into a side letter. Uh but in a particular fund um that we were asked to look at after the event, um. The um. The right was only given to investors who had invested more than a certain quantum as opposed to applying to everyone. So um, if you are a ah relatively small um investor notwithstanding that um. Um you're still putting in you know well over sort of eight figures um in terms of equity commitments you wouldn't be entitled to Most Favored Nations. So again the client thought they were in one position. An analysis of the documents showed that they were in a different position. We could have sort of highlighted all of that to them um if we negotiated uh a better position for them if we'd have looked um at it at the outset. As it was, they're sort of stuck. Once you've. Once you've signed on the dotted line you're sort of stuck with the terms um that you've signed up to and it's you know it's very, very difficult to get any concessions after the event. So that's why it's so important I would say when you're making these investments into funds that you know exactly what your um. What. What you're doing and what you're letting yourselves in for. Because um. There's a. There's a great deal of scope for the. The management um Side of the. Of of the. Of the deal to um. To. To put in clauses that will benefit them um as much as. As much as they can.

Speaker A: Well as you're seeing you know the rest of 22 play out and as we're looking at 20, 23, where do you see some of those issues uh popping up? Are there new ones uh that. That investors should be thinking about? Are there the realities of economic and geopolitical things that are going on in the world uh, that investors uh should take into consideration as they're evaluating these types of funds?

Speaker B: Yeah, well there are a couple of things that we're seeing coming to the fore right now. The first one not surprisingly is. Is sanctions um and sort of the tests that get um undertaken at the start of the investment process. Um funds have always been um subject to enhanced um sort of kyc um anti money laundering provisions uh that's really sort of gone on to the next level now um with the um with the enhanced sanctions regime that's that's in operation and I think investors should be alive to the fact that there will be an even greater um amount m of due diligence ongoing by the fund prior to an investment being made by uh a family office or other investor. And also that throughout the life of the fund there'll be regular sort of checks being made that the position um of being sanction free is, is being maintained. So that's sort of one, one sort of element of the funds investment world that's being impacted. I think that another area that we're seeing um or that I can see being really um sort of changing over the next, over the next few years is the role of the um of the Investor Advisory Committee um and particularly how they get involved in GP led secondary transactions. So this is um, this is in essence where in a closed ended fund it's come to the end of the term and is in a position where um it's going to have to sell all of its assets because it needs to do under the documents um some sort of a liquidation um so sell the assets and distribute all the proceeds um to its shareholders. But of course it might very well be the complete wrong time to do that. It might be the bottom of the market um you know and and you know that would be a disaster for everyone. You know the sort of um getting the worst possible um returns um at that point the fund manager might say you know let's start a new fund and roll our um existing portfolio into that new fund. But they would only able to do that if they get the consent of the um Limited Partner Advisory Committee. And so that then puts a whole load of um of responsibility um onto M, the limited Partner Advisory Committee um and it's also quite a time consuming process to run through what can be quite complicated documents um um M for the new fund that needs to be formed. So what you would have is um a situation where what you thought was going to be a relatively um straightforward role of of sort of policing the. The manager um and dealing with a few fairly minor conflicts of interest questions and suddenly um as a member of this advisory committee you're you're sort of thrown this um sort of curveball of having to deal with a significant um transaction. Regular calls over like a. No these things normally take you know easily six um to eight weeks to manage themselves, um, through, um. And what we're seeing is, um, some of the bigger investors sort of stepping back and saying, you know what, we actually don't want to be on this, this advisory committee, um, just because we haven't got the bandwidth, um, or the uh. Or the inclination really to, To. To do it. So I think there's going to be a bit of pressure on the manager, uh, to. To find uh, people who are going to be willing to take on that slightly enhanced role.

Speaker A: So Jonathan, last question for you. Looking back at your career, the work that you've done, uh, in this space and in corporate and beyond, what's a lesson learned that you could share something you wish you had known back then but you know very well today?

Speaker B: Yeah, I mean, that's a good question. Um, well, I think that the. I think that what I would say is that um, having been involved in this particular sector, sort of investment funds for, as you say, um, you know, over. Over nearly 20 years or so, um, everything just evolves so, so quickly. Um, so what I would say is don't, don't treat what was the position, um, you know, even, Even last year as being the. Being the position this year. We've, we're in a world now where the private equity market, um, is um. Is. Is booming. There are record distributions, um, There are m. Complex structures that are getting even more complex. So um, it's. It's in. It's. I would just say you've got to, You've got to be able to move quickly in, in this um, in this sector, um, and understand exactly what it is that um, if you're an investor, what you're being sold, um, and, and. And how it, how it all works because um, the complexities are ah, um, really there and people are thinking up more and more complex, um, structures all of the time. And so it's not enough just to say, well I'm gonna, I like this particular sector, it's gonna make me money, um, and make an investment. It's really important to understand, um, the, the nitty gritty of, of what you're investing in, who you're giving your money to. Um. So you know, the thing that I would, I would suggest is, you know, be prepared, um, and just sort of understand what you're um. What you're investing in right at the outset.

Speaker A: Well, thank you, uh, Jonathan. Appreciate it.

Speaker B: Uh, yep. Really good to speak to you.

Speaker A: Likewise. Likewise. And thanks for all of you for listening in today. If you'd like to get in touch with Jonathan or you have questions, do send us an email to family office dentons.com if you enjoy today's conversation are so inclined. Please subscribe to the channel, review us on Apple Podcasts, follow us on Spotify, or keep in touch with us wherever you prefer to listen to. Uh, podcasts and as always, sharing this episode is very much appreciated and probably the best way you can show your support. To sign up for our newsletters and learn more about our solutions in the Reese and research in the Family Office space, check, uh, out our website that is dentons.com forward/family office. Well, that's it. Bye everyone.