Private equity deals involve several parties and numerous complex processes, some of which are timely. Good governance should be considered during the whole life of the venture capital and private equity firm. To ensure fairness and transparency, governance principles should be followed starting from the fundraising process through to the investment of assets and continuing through divestment and dissolution.
To simplify understanding, it helps to break down investment practices for private equity into three parts — aligning the interests of the manager and investors, governance and transparency.
Aligning the Interests of the Manager and the Investors
There are multiple interests in a private equity fund and it’s essential that everyone’s best interests are protected and served well. This is one of the basic principles of governance. Fund managers must dedicate the proper time to setting up funds and follow all the regulations as described in the Management Regulations.
Another matter is the term of the fund. Good governance requires limiting the time for attracting investors. Managers should set a goal to devote sufficient time to managing the fund and ensure that they put substantial time into it as early as possible in the process. Because it may be difficult to manage the investment and divestment within a specified period, it’s prudent to establish the investment or divestment periods to extend the life of the fund.
The manager gets a management fee for its work on the fund, which is charged to the fund itself. As such, the investors incur the fee. As a matter of transparency, the manager fee should be spelled out in the Management Regulations and it should correspond to the commitment that the manager assumes. The fee helps to ensure that there is a balance between the manager and investors.
The fund manager may have different economic rights related to the fund than other investors because they’re linked to the level of capital gains generated for them. Managers make some investment, which may be minimal. The manager makes an agreement with the investors on how they will share in the fund’s returns. This is the manager’s main incentive, so regulation is important to help align the interests of the managers and those of the investors.
Something that can cause conflicts of interest between the manager and the investors is when the manager decides to retain the distributions received by the fund from the investments it makes or recovers directly from the investors if funds were already distributed to them. This situation may set up conflicts of interest between the manager and the investors.
Managers can get income from other sources, such as from other firms or from people who are related to the manager. This situation can be an additional source of income, so it’s important that it be properly regulated in the Management Regulations.
The setup stage and the process of attracting investors can be costly, so these costs should also be regulated in the Management Regulations so that investors can assess related factors in profitability. This also applies to the fund’s ongoing costs related to management and operation. This is an area in which managers should be transparent and establish clear limits on various fund-related expenses.
At certain times, it’s possible for the manager or their partners, directors or employees to co-invest with the fund or to make parallel investments in underlying companies outside the fund. These situations can create a conflict of interest between the manager and the investors. Investors may also be looking to make parallel investments in underlying companies outside the fund. The manager must be transparent when providing investors with opportunities to co-invest with the fund. Reports from managers to investors are another way that managers can create transparency and create trust.
Governance and Investment Practices for Private Equity
The Supervisory Committee consists of the fund’s major investors. They stand as an advisory body to promote and resolve governance issues related to the fund, including conflicts of interest.
In the event that there is cause, investors should be able to remove the manager. In this case, the manager may be entitled to compensation for being removed, depending on the cause.
The Key Men (or Key Executives) are the investment team, and they’re expected to devote a significant amount of their time to the fund. Changes in the Key Men are considered relevant changes in the fund and the Management Regulations outline how to address this issue. In particular, this comes into play at the time of a Key Executive Event, such as the case when a certain number of Key Men resign.
The investment policy should be properly defined and outlined in the Management Regulations. The manager may opt to obtain additional financing in the interest of efficiency, to optimize the fund’s operational efficiency or to increase its ability to invest additional funds. The managers should explain their reasons for it and establish limits in using it.
It’s vital to define the terms and governance of the fund because of the long-term nature of the investment. At the same time, there should be some amount of flexibility to adapt the fund to changes in circumstances. Too many changes are unsettling to investors, and regulations create a safety net.
The manager typically makes investment and divestment decisions via the recommendations by an investment committee. This committee may consist of the board of directors or another specific body.
Finally, ESG is an important issue in the financial world. The managers should consider the impact of ESG when managing underlying companies.
Transparency and Private Equity Governance
The managers should be completely transparent around the level of fees and expenses that are being charged to the fund on a regular basis.
The manager and the potential investor may negotiate on the investment conditions that were agreed upon with investors. Some investors may request specific conditions, rights or benefits. Agreements are permissible, but they must comply with specific regulations and investors must be treated equally.
In fact, good governance should be a thread that weaves its way through every part of the process. Private equity firms need digital tools to support their efforts in good governance. The tools that comprise Governance Cloud by Diligent Corporation make up the modern approach to investment practices in private equity.