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Coronavirus Disruption: Regulatory and Litigation Risks for Private Fund Managers

The impact of the global coronavirus (COVID-19) outbreak has been rapidly evolving, causing disruption in global commerce across a wide range of industries. Private fund managers are not immune to the disruption. According to PitchBook’s latest analysis, private equity and venture ­­capital still have record amounts of dry powder ($2.4 trillion) to weather the storm and step in to provide liquidity to businesses. However, operations, fundraising, deal sourcing, and performance will likely be negatively affected, at least in the near-term, by the economic deterioration caused by COVID-19.

The sharp decline in the economy will cause ripple effects throughout the ecosystem. A few consequences to prepare for:

Challenges Stemming from Liquidity Concerns

The sharp decline in the economy will cause ripple effects throughout the ecosystem. A few consequences to prepare for:

  • As liquidity becomes a concern, fundraising for new funds may be challenged, particularly as large institutional investors see their alternatives allocation become overweighted in comparison to the rest of their investment portfolio. GPs may try to expedite fundraising on an accelerated timeline, trying to lock down commitments before a potential recession hits. Other GPs may delay fundraising, hoping that the impact of COVID-19 lessens sooner than later.

  • GPs may also make capital calls earlier than anticipated because of concern over LPs’ liquidity. However, if capital calls are made with no investment intent in mind, even if allowed under the relevant LPA, the sponsor will be trading liquidity for fund performance as LPs’ IRRs would be negatively impacted.

  • LPs may consider pulling back from verbal investment commitments to new funds for various reasons. For example, certain investors, like pension plans, may project fewer plan contributions and/or investment distributions than usual and therefore have less capital to allocate to investments.

  • Some portfolio companies may be under significant financial pressure, especially where their business models have been negatively impacted by governmental orders to close non-essential business – travel, leisure, retail, hospitality, gaming, sports and many others have all been disrupted.

Uncertainty Leading to Commercial Disputes

  • One phrase that we are hearing more frequently is “force majeure.” Force majeure provisions excuse performance due to events beyond the parties’ control.  Whether the coronavirus can trigger a “force majeure” excuse at this point in time is an open question though, historically, economic hardship by itself is an insufficient reason to excuse performance.

  • “Material adverse effect” or MAE clauses may excuse performance for under certain circumstances. These clauses are often heavily negotiated and vary significantly deal-by-deal, and therefore must be evaluated on a case-by-case basis.

Business Continuity Planning

The SEC’s exam staff has started reaching out to fund managers asking what their Business Continuity Plans look like. Managers must consider whether they are prepared to have all personnel work remotely for an extended period of time and assess whether there are business operations that cannot be performed remotely or have not performed as previously anticipated.

Out of an abundance of caution, GPs should consider putting power of attorney rights in place for key people at the fund.

Regulatory Issues for Fund Sponsors

The SEC can be expected to examine how fund managers respond to the crisis and whether their responses were consistent with their fiduciary duties.   Any deficiencies that may have been overlooked and potentially hidden by the strong economy are likely to be scrutinized.

  • Economic impacts may adversely affect the performance of a fund’s investments. Managers should consider adding risk factors related to recent developments.

  • The SEC will likely look at whether a fund manager made false or misleading statements to its limited partners, investors or clients regarding the severity of the impact of the crisis on its funds.

  • Valuation of privately-held investments will be a key area of focus, particularly the process surrounding potential write downs and related presentations or reporting to investors.

  • The SEC will also likely examine whether, in responding to the crisis, a fund manager took measures to benefit itself or certain investment vehicles at the expense other limited partners.

The current crisis brings to mind the Warren Buffett quote that “only when the tide goes out do you discover who’s swimming naked.” We are already seeing distress that was not even on the horizon a few weeks ago.   The tide is going out and managers’ actions, including matters that may be entirely unrelated to the coronavirus, may be scrutinized in an economic downturn.

© 2020 Proskauer Rose LLP.

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About this Author

Michael R. Hackett, Litigation Attorney, Proskauer Law Firm
Associate

Michael R. Hackett is an associate in the Litigation Department and a member of the Asset Management Litigation practice. His practice focuses on disputes and regulation involving private funds, including private equity, venture capital, hedge, real estate and private credit funds, as well as other limited partnerships, where he regularly advises funds, fund sponsors, investment advisers and institutional and individual investors.

Mike’s experience representing private fund clients runs the gamut, from control contests within advisers, to...

617-526-9723
Joshua Newville, Proskauer Rose, regulatory enforcement attorney, industry compliance legal counsel, securities exchange commission lawyer
Partner

Joshua M. Newville is a partner in the Litigation Department in New York. His practice focuses on commercial litigation and regulatory investigations. Mr. Newville advises companies and individuals in securities litigation and compliance matters. He also focuses on internal investigations and enforcement matters. Prior to joining Proskauer, Josh was senior counsel in the U.S. Securities and Exchange Commission’s Division of Enforcement, where he investigated and prosecuted violations of the federal securities laws. Josh served in the Enforcement Division’s Asset Management Unit, a specialized unit focusing on investment advisers and the asset management industry.  His prior experience with the SEC provides a unique perspective to help private investment funds and their advisers manage risk and handle regulatory issues.

212-969-3336
Samuel Waldon, Proskauer Law Firm, Washington DC, Corporate Law and Litigation Attorney
Partner

Sam Waldon is a partner in the Litigation Department and a member of the Securities Litigation, White Collar Defense & Investigations and Asset Management Litigation Groups.

Sam’s practice focuses on securities litigation, enforcement and regulatory matters. He represents corporations and financial institutions, and their officers, directors and employees, in investigations, exams, internal investigations and litigation. Sam has in-depth experience in a broad range of Securities and Exchange Commission (SEC) enforcement matters, including...

202-416-6858