There is a scene in the movie "Apollo 13" in which, after astronaut Jack Swigert, played by Kevin Bacon, performs a routine check on his ship’s oxygen tanks, an explosion occurs and all hell breaks loose on the ship. Warning lights and buzzers are going off on all sides, and chaos reigns back at mission control on earth.
Thanks to COVID-19, we’re all on board "Apollo 13" right now. Tom Hanks has tweeted out that he has a problem, and the warning lights and buzzers are going off all throughout the public markets. As of this writing, the Dow Jones, the S&P 500 and the NASDAQ are down by roughly one-third from their all-time highs in the span of just over a month, and the results from public markets across the globe are similarly bad. Closures of sporting events, schools, bars and restaurants and social distancing and self-quarantines are undermining economic activity, and the preliminary effects on the U.S. and global Gross Domestic Product (GDP) won’t even be known until the next round of government statistical reports.
But at the end of that same scene in "Apollo 13," Chief Flight Director Gene Kranz tells engineers at mission control to calm down, work the problem and not make things worse by guessing. That’s exactly what the investment management industry is currently doing as it takes stock of and plans its responses to the COVID-19 impact on existing portfolio companies and other investments and future fundraising.
PE- and VC-Backed Portfolio Companies and Real Estate Projects
This first order of business for sponsors of investment funds is protecting their existing portfolio companies and other investments by making sure that they have access to capital to weather the storm, meet their financial obligations and stay in compliance with covenants in any loan agreements.
Any portfolio companies and real estate projects who do not currently have revolving lines of credit should investigate them at their earliest opportunity, and those who do should reach out to their lenders to discuss their options. Anecdotally, we have been hearing that some lenders are one step ahead of their borrowers and are proactively reaching out to assess their borrowers’ capital needs. This may be a function of the Federal Reserve having recently cut the federal funds rate on overnight borrowings to almost zero. Some lenders have been willing to get creative with options like interest-only loans for the near-term, and borrowers in need of capital should explore the full range of options that their lenders can put together for them.
But investment fund sponsors are likely going to have to put more chips on the table, too. Lenders may expect investment funds to guarantee a portfolio company’s repayment obligations and/or to make a follow-on investment into a portfolio company or real estate project to bring it back into covenant compliance.
When issuing guarantees, investment fund sponsors need to be mindful of their contractual obligations, if any, in their fund agreements to avoid permitting the investment fund to recognize unrelated business taxable income (UBTI) and/or income effectively connected with a trade or business in the United States (ECI). Although there may be somewhat less risk that issuing guarantees will constitute a trade or business activity than originating loans would, it is still a risk that frequent guarantee activity will be deemed to be a trade or business. Moreover, because this activity occurs at the fund level, it cannot easily be solved using above-the-fund or below-the-fund blockers. As a result, guarantee fees can constitute UBTI and ECI in the hands of limited partners.
When calling capital to make follow-on investments, investment fund sponsors may quickly find themselves drawing more heavily on their capital call facilities than they would otherwise have expected and, therefore, having to call capital from their limited partners on a more frequent basis. Sponsors should be mindful of the possibility that, given the growth in capital call credit facilities, some limited partners may have gotten used to less frequent capital calls. The facilities may not be expecting a sudden increase in capital call activity, particularly when they may also be stretched thin financially and operationally. Indeed, in the case of institutional investors, many of their employees and personnel who will need to arrange wires to satisfy capital calls are likely to be dispersed and working remotely. So sponsors should consider communicating with their limited partners more frequently and letting them know in advance when a capital call is coming. Limited partners will appreciate the extra information and the opportunity to plan so that they can satisfy their capital calls and spare everyone the pain of defaults.
Investment fund sponsors should generally try to avoid calling capital solely for the sake of having reserves on hand just in case they need the capital to support an investment later. That is the financial equivalent of hoarding toilet paper and isn’t going to help. It also comes with the obvious downside for the sponsor that any preferred return in the sponsor’s fund agreement will run on any capital held inside the investment fund. This will burden the sponsor’s carried interest in the investment fund’s distribution waterfall. As a result, the sponsor should consider the expensive option of sitting on capital inside the investment fund if and only if its capital call facility is largely drawn and the sponsor has serious concerns about the creditworthiness of its limited partners. Even then, a sponsor should be mindful of any applicable requirement in its fund agreement that states that it must distribute money to limited partners within a definite period of time. Along these same lines, fund agreements typically give sponsors the power to set aside proceeds from dispositions as reserves for anticipated liabilities. For example, an investment fund’s obligation to pay the sponsor’s management fees, and commitments, which sponsors may feel more inclined to do under the circumstances. However, in most fund agreements, the preferred return will continue to run on such amounts here also.
Private Equity, Real Estate and Venture Capital Funds
As sponsors of closed-end funds lift their gazes from their current investments to future fundraising, the horizon is anything but clear. Institutional investors trying to decide how best to deploy their capital in times of uncertainty may see large swings in the public markets causing portfolios to appear over-allocated to alternative investments, a result commonly referred to as the denominator effect. In that situation, one might typically expect some institutional investors to sell some portion of their holdings in private investment funds in order to rebalance their portfolios by allocating more capital to the public markets at a time when the asset class appears relatively cheap compared to alternative investments.
But whether and to what extent institutional investors will make this strategic choice is not so clear cut because professional allocators of capital recognize the lag between large market dislocations and their impact on valuations in private investment funds. An investment fund’s underlying portfolio companies and real estate projects may not be publicly traded, but they are just as exposed to the underlying recessionary risks that are causing dislocations in the public markets as publicly traded companies are, and an eventual recovery in public markets should eventually bring portfolio allocations back into line. Moreover, institutional investors may be too risk-averse to make large bets on the public markets’ eventual recovery in the short-term while the uncertainty is still too great.
Under such circumstances, institutional investors are as likely as anyone else to be looking for more clarity before making major moves. Therefore, sponsors looking to fundraise are likely to be stuck playing a waiting game during the short term, and that means stretching their existing investment funds as far as they will go. Sponsors should be reviewing their fund agreements’ recycling provisions to determine how much capital they can still call from limited partners in their existing funds. Using a recycling provision to recall distributions to make one more platform or add-on investment could help a sponsor push fundraising for the next fund out just far enough to give institutional investors time to adjust to new conditions and move forward.
Pledge Funds and Independent Sponsors
We’re about to test out the theory that pledge fund sponsors and independent, or fundless, sponsors have a better or easier approach than sponsors of traditional investment funds with blind pools of committed capital.
The argument in favor of a non-committed fund or a deal-by-deal approach has always been that it’s difficult to get an investor to commit capital to a manager on a blind basis without a strong track record and that investors like the decreased uncertainty that comes with evaluating investments on a deal-by-deal basis. In uncertain times, investing on a deal-by-deal basis may have relatively more appeal, but that may not be saying much if institutional investors are keeping their powder dry for the time being.
One disadvantage that pledge fund and independent sponsors face is that without a blind pool of committed capital, they don’t have the same large pool of capital to charge management fees on to cover their own expenses. Pledge fund sponsors generally charge management fees to their investors for the obligation to show them potential investments, but these management fees are typically lower than those charged by sponsors of blind pools of committed capital. Independent sponsors are generally more reliant on monitoring fees that they charge their portfolio companies, who may be dealing with their own liquidity issues and looking for accommodations.
Time will tell who has it better, or worse, but sponsors of traditional investment funds can console themselves with the knowledge that, unlike pledge fund sponsors and independent sponsors, they still have their existing investment funds as a source of management fees. They should try to reserve space for their existing investment funds at their capital call facilities in case limited partners become less creditworthy, while simultaneously planning their next moves. For example, a sponsor of a traditional investment fund could explore the possibility of, subject to their allocation policies and restrictions on forming new investment funds, adding an additional investment strategy to its platform that follows a deal-by-deal approach. Whereas pledge fund sponsors and independent sponsors are not likely to be able to diversify in the other direction.
Sponsors of hedge funds face different concerns than closed-end funds because they are constantly fundraising but are also subject to the constant prospect of withdrawals. In times of great volatility, limited partners may seek to withdraw their capital in the hopes of redeploying it in safer investments like treasury bonds, leading to a dreaded run on the bank. Sponsors should be reviewing their fund-level gate provisions to determine whether, under what circumstances, and to what extent, they can limit their limited partners’ ability to withdraw capital.
Importantly, because hedge funds are generally more affected by events in the public markets, given the nature of their assets, hedge fund sponsors should also review their suspension provisions and consider whether completely suspending withdrawal rights is necessary under the circumstances and permissible under their fund agreements. For example, it is not uncommon for a hedge fund agreement to provide that the sponsor may suspend withdrawal rights if the sponsor determines that conditions would make it prejudicial to non-withdrawing limited partners or the hedge fund as a whole to permit a limited partner to withdraw.
These are admittedly challenging times, but Taft’s investment funds, M&A and debt finance lawyers stand ready to assist you and your portfolio investments with all of the temporary issues that COVID-19 creates for your capital-raising and liquidity needs.