Background
Last summer the European Venture Capital Association ("EVCA") presented a preliminary version of its Handbook for Professional Standards (the "Handbook") which, for the first time, combined EVCA's Code of Conduct, Governing Principles and Corporate Governance Guidelines.
The Handbook aims to assist private equity and venture capital industry participants to establish and manage their relationships through open and fair interaction. In practice, the Handbook serves as a useful industry wide reference tool in relation to practical management issues that arise between managers ("GPs"), investors ("LPs") and portfolio companies.
The principles contained in the Code of Conduct form the foundation on which the Handbook is based. The principles require industry participants to act with integrity, keep promises, disclose conflicts of interest, act in fairness and maintain confidentiality.
In January 2012, EVCA published a revised draft of the Handbook for consultation. As with last summer's version and in order to assist GPs in complying with the Code of Conduct, the Handbook provides a series of questions and answers in section 3 ("Guidance on the Application of the Code of Conduct: Questions & Answers"). These provide recommendations on different aspects of a fund's life from fundraising issues to exit. In the context of fund formation and the relationship between GPs and LPs, the main updates to the last version include new recommendations on the following:
- Fund formation and fundraising;
- GP communication and transparency;
- Conflicts of interest;
- LP Advisory Committee;
- Keyman provisions; and
- Secondary transactions.
The Code of Conduct will be familiar to existing GPs. However, it is particularly useful for newer GPs entering the market as it provides a helpful overview of the interaction between GPs and LPs. That said, whilst it is useful, as the Handbook also says, "one size" does not fit all and each GP will need to consider the Handbook in the context of its fund.
The remainder of this briefing note provides a high level overview of the additional recommendations included in this version of the Handbook which are relevant in the fund formation context.
Fund formation and fundraising
The impact of the proposed Alternative Investment Fund Managers Directive (the "Directive") needs to be considered at the formation stage of a fund. The Directive, when implemented, will impact how funds are operated and marketed to LPs. It is recommended that the fundraising team have regard at an early stage to the jurisdiction in which the fund is formed and its regulatory landscape in the context of the Directive.
It is also recommended that the fundraising team select LPs in such a way as to minimise the risk of default on a draw down. Whilst this is not always possible to determine given the uncertain economic climate, the Handbook explains that this may be achieved by building a balanced LP base to avoid the risk of concentration by type and geographical location.
Private equity fundraising is time consuming and complex. The recommendations explain that this needs to be borne in mind early in the fundraising process to ensure that parties are well prepared. It is recommended that the fundraising team devote a balanced portion of time to fundraising and fund management. This may be better achieved with the early support of various service providers such as accountants, lawyers and placement agents.
GP communication and transparency
Generally, GPs should promote parity of treatment amongst LPs. However, the Handbook acknowledges that there are circumstances that may excuse or require the GP to act outside this principle. GPs may be required to provide different information to LPs by reason of differing tax or industry regulations and commercial obligations and they are encouraged to comply with such requests where practicable (subject to confidentiality and legal obligations).
A trust-based relationship between GPs and LPs is achieved by ongoing communications. It is recommended that annual and periodic meetings take place for GPs and LPs to meet in person, although any geographical boundaries may be overcome by hosting meetings via webcasts and conference calls.
It is recommended that LPs have the opportunity, in advance of a meeting, to provide input as to what the GP is expected to report on. Generally, LPs would expect an overview of the market developments and updates of their team and processes.
Management of conflicts of interest
Previously GPs were encouraged to treat conflicts of interest in a fair manner and to ensure that conflicting interests were diligently identified and disclosed. The revised version of the Handbook retains this requirement, with added clarity and advice for identifying and disclosing conflicting interests. To this end, the Handbook refers to the following values:
- Where relevant, a GP should always consult with the LP Advisory Committee;
- When the GP consults with LPs on potential conflicts of interest, LPs should immediately disclose all conflicts they may have to the GP and other LPs of the fund/funds; and
- Disclosure should be open to promote better understanding and informed consideration of the LPs' positions.
LP Advisory Committee ("LPAC")
The LPAC plays an important role in facilitating interaction between the GP and the LPs. While recognising that LPs may not become involved in the management of a fund (to preserve their limited liability status) the nature of the role of the LPAC has played an increased role in recent years. The Handbook sets out certain recommendations regarding the role, composition and meetings of the LPAC including:
Role
- The LPAC role should be advisory and not decision making;
- The LPAC should not be a barrier to the GP communicating directly with the LPs when the situation requires it; and
- The role of the LPAC should be described in the constitutional documents of the fund, with a clear understanding that the LPAC does not owe a fiduciary duty to the rest of the LPs in the fund.
Composition
- There should be a separate LPAC for each fund raised by the GP;
- The composition of the LPAC becomes a relevant factor in forming an interactive relationship with the GP which is broad and balanced in its perspectives;
- The number of members on the LPAC should be appropriate for the size of the fund but not so large as to make effective discussion difficult; and
- To ensure full contribution by all, members of the LPAC should each have an appropriate level of fund investing experience.
Meetings
- The governance of the LPAC should include proper document management both ahead of and during meetings. This should involve circulation of the agenda and supporting papers in good time in advance of meetings;
- Procedures should be agreed and followed to ensure that all LPs receive knowledge of any meetings and the minutes of those meetings within a reasonable time following each meeting;
- Meetings themselves should be conducted in accordance with established procedures, including the declaration by members of any conflicts at the start of the meeting and the taking of formal minutes;
- LPAC meetings should be convened annually and permit periodic meetings initiated by the GP, or at the instance of the LPs without GP involvement; and
- The names of the LPs in the LPAC should be made known to all LPs in the fund.
Keyman provisions
LPs should have regard to the composition of the investment skill in the management team, and consider the procedure to follow when a change occurs to the quality of the team. The Handbook recommends that the identity of the keymen and the procedures to follow if a keyman is absent or ceases to devote sufficient time to the business of the fund should be included in the fund's constitutional documents. LPs and GPs should also consider the procedures for prompt resolution of such situations and for selecting a replacement keyman.
Secondaries
In the context of the Handbook, secondaries cover the following transactions:
- Where a LP wishes to transfer its interest in a fund to an existing or new LP through a privately negotiated contract of secondary sale; or
- Where the GP wishes to transfer the fund's interest in one or more of the fund's portfolio companies to a fund managed by another manager (an investment realisation).
In both contexts, it is recommended that the transfer of interests be performed pursuant to professional advice confirming that existing rights are protected and obligations are properly transferred. The LPs and GPs should consider any confidentiality constraints and pre-emption rights in negotiating secondary transfers.
The final Handbook
The consultation period for the Handbook closes on 30 March 2012. After the consultation period EVCA will seek approval of the final EVCA Handbook by its Board of Directors. The final version will include the International Private Equity and Venture Capital (IPEV) Valuation Guidelines, as well as the new Reporting Guidelines, which have been transferred to the IPEV Valuation Board, for further development in an international context. They will shortly be published for consultation before becoming an integral part of the Handbook.
How does this impact me?
GPs should consider the contents to the Handbook at the preliminary stages of forming a new fund, in particular the recommendations in section 3, as it will assist in the marketing process if the fund's constitutional documents are consistent with the Handbook. Equally, LPs should consider the contents to ensure that GPs they are investing in have considered the Handbook.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.