Research

Many private fund terms are intrinsic to the funds themselves and are therefore unaffected by whether a fund invests in developed or emerging markets. Outside of these “inward looking” fund terms, there are certain differences between developed and emerging markets funds. However, it is surprising how few there are given the significant differences between the investment environments in many emerging markets compared to developed markets. A number of areas where differences could be expected, but are absent, are highlighted.

Key private fund terms are relatively similar across asset classes …

For private fund formation lawyers, the dominance of the eight to ten year closed-ended fund, usually in the form of limited partnerships with a four to five year investment period and a value building/divestment period of roughly equal length, has led to a relatively common set of fund terms across the core asset classes of private equity, real estate, infrastructure and private debt (collectively referred to as “private equity” in this article).

Much of the energy of fund sponsors, investors and their respective counsel has been focused on key economic and governance-based terms such as:

• whether the fund’s management fee is excessive compared to market norms for funds of similar size;
• the percentage level of the fund’s preferred return;
• the rate of the sponsor’s “catch up” of the preferred return, in other words the share of distributions paid to the sponsor until it has received 20% of distributions over and above a simple return of drawn capital to investors;
• the amount of the sponsor’s “skin in the game” in the form of fund manager’s commitment or co-investment;
• sharing of transaction fees (though following widespread acceptance of the ILPA Guidelines’ recommendation that 100% of transaction fees accrue to the benefit of the fund, this is less contentious than it has been);
• key person clauses;
• termination of the fund manager, both with and without cause, particularly voting thresholds, the nature of cause events, compensation of the fund manager if terminated without cause and how much accrued carried interest a terminated fund manager should retain;
• allocation of co-investments;
• valuations and reporting; and
• composition and remit of a fund’s Limited Partners’ Advisory Committee.

… and across markets

However, in most of these cases there is no significant difference between emerging markets funds and other funds. This is not surprising given that most of the above fund terms relate to the internal characteristics of the fund rather than the markets in which the fund invests.

The exceptions are perhaps management fees, where it could be argued that the relatively high cost bases of many emerging markets sponsors should lead to acceptance by investors of a slightly higher “market standard” management fee at most fund size levels; and sponsors’ commitments to their own funds, where it could be argued that, because many emerging markets funds are in relatively early vintages (third time funds and below), and therefore sponsors have not received significant amounts of carried interest from earlier funds, investors’ expectations of sponsors’ commitments should be relatively low. These issues are however not unique to emerging markets funds, they are merely issues that occur particularly frequently in relation to emerging markets fund sponsors.

So what are the differences between emerging and developed markets fund terms?

Investing in emerging markets comes with a number of challenges that are not present in developed markets, in particular:

• greater uncertainty about the political, economic, legal and regulatory environments;
• a difficulty in acquiring control of portfolio companies in many emerging markets with attendant consequences for implementing the sponsor’s desired strategy at the portfolio company and for ensuring a timely and effective exit;
• longer holding periods may be needed in some emerging markets to develop an asset to the point where it is suitable for sale to a broad range of institutional buyers; and
• a lack of a viable IPO exit route and/or refinancing options in some markets.

Emerging markets funds also feature sponsor and investor communities with different characteristics to their developed markets counterparts, for example:

• a relative shortage of experienced fund sponsors with outstanding track records; and
• the prevalence of development finance institutions (DFIs) in their investor bases, particularly as anchor investors in first and second time funds.

These factors have undoubtedly created differences between some terms of emerging and developed markets funds. These include:

LP giveback: Sophisticated purchasers of private equity assets will seek warranties from vendor funds (or from holding companies owned by vendor funds) that certain post-completion liabilities will not arise or will be no larger than as accounted for in the purchase price. A common example is a warranty that the purchaser or the relevant portfolio company will not have to pay any taxes (or a certain amount of taxes only) as a result of the sale of the asset. Such a warranty may be backed by an indemnity from the vendor fund, should taxes turn out to be greater than the warranted amount.

A sophisticated purchaser would also seek to establish in its due diligence the ability of the vendor fund to honor this indemnity, in one or more of three ways:

1. by escrowing sufficient of the exit proceeds to cover the indemnity;
2. by obtaining third party insurance against a claim on the indemnity by the purchaser; and
3. by relying on the LP giveback power in the fund’s limited partnership agreement – the power of the fund manager to require investors to return monies distributed to them in order, amongst other things, to meet indemnity claims against the fund.

Options 1 and 2 both negatively impact the exit return, potentially meaningfully. Furthermore, because of additional legal uncertainty in emerging markets, particularly in relation to tax laws, it may be impossible or prohibitively expensive to take out warranty insurance. In some cases this has led to the abandonment of proposed exits where the vendor fund and the purchaser could not agree on apportionment of the risk of higher than expected taxes resulting from the exit.

The drawbacks of Options 1 and 2 put additional pressure on Option 3 – the LP giveback power in the fund’s LPA. In other words, purchasers are looking to establish both the existence of the LP giveback power and its limits, in particular the limits on the amount that can be called back by the sponsor (commonly 20-30% of a distribution) and the time limit on calling it back (commonly two to three years after distribution, with givebacks after the end of the fund life also time limited in many funds). Purchasers compare these limits to the likely size of the indemnified liability and the longevity of the associated warranty. Caps on amounts which can be recalled are generally adequate but time limits are frequently too short to reassure purchasers that an LP giveback power will be helpful in the event of a warranty short.

It is therefore arguably in the interests of both sponsors and investors in emerging markets funds to allow longer time limits for LP givebacks. Although it may go against investors’ instincts to do this, in my experience it increases the likelihood of exits without escrow or costly insurance.

Sanctions – excuse and withdrawal: Most of the countries and individuals appearing on US (OFAC) and EU sanctions lists are located in the emerging markets. Investors in emerging markets funds are increasingly aware of this and are seeking to build into their side letters the right to excuse themselves from investments, or in some cases withdraw from funds entirely, if a fund’s investments involve financial interaction with sanctioned countries or individuals. If anything, it is surprising that more investors are not seeking this protection, particularly given the prevalence of governmental entities, public pensions and university endowments in private funds’ investor bases.

Significance of ESG: One characteristic of some emerging markets funds that relates more to their investor base than their investment program is their significant focus on the environmental and social impact of their investments, and on good governance in their investments. In relation to fund terms, this is manifest in the detailed ESG codes that can be found in the constitutional documents of many emerging markets funds. This can largely be explained by the prevalence of DFIs as anchor investors. Large commitments from these investors, without which many emerging markets sponsors would not have a viable first fund, come with strings attached. One such string is often the adoption by the fund of an ESG code which is similar to the DFI’s own code.

There are important areas where you might expect differences, but there are none

More surprising however is the number of areas where you would expect to see significant differences given the differing investment characteristics outlined above, but where there seems to be little or no divergence between emerging and developed markets funds terms. The most fundamental of these are:

Fund life and extension rights: An important characteristic of investing in many emerging markets – in particular India and many Africa countries – is the longer holding periods that may be required in order to create a business which is large enough or sufficiently professionalized to sell to the kind of buyer sought by a private equity fund – a global or regional strategic investor or a secondary sale to another private equity fund. Coupled with the temporary or permanent absence of a robust IPO market in some of these countries and the absence or relatively recent arrival of a refinancing market, this can lead to holding periods which are significantly longer than the four to six years required to make a timely exit within the term of a ten year fund.

However, I have seen relatively little discussion of whether ten years is the correct term for private equity, infrastructure and real estate funds investing in these countries or about whether it should be easier or more difficult for the sponsor to obtain extensions of the initial fund term. I have also seen no special degree of attention paid at the time of fund formation to what should be done with any fund assets that remain at the end of the fund’s scheduled number of term extensions. This is particularly surprising given that: (1) the proportion of emerging funds of which I am aware that are still holding assets at the end of their second or third extensions is not insignificant, and savvy emerging markets investors must also be aware of this; (2) in my experience the number of investors requiring undertakings from fund sponsors not to distribute assets in specie is increasing; and (3) if emerging markets assets ever are distributed in specie, I would expect the number of investors with the necessary skills and market knowledge to realize them for value to be lower than for developed market funds.

Control of political and economic uncertainty: Rightly or wrongly (and many would say wrongly given the causes of the global and Eurozone financial crises of recent years), emerging markets have a reputation for greater levels of political and economic uncertainty than developed markets. Over the last few decades, we have seen:

• political and/or economic crises in Russia in the 1990s, Asia in the 2000s, different parts of North Africa and the Middle East for most of the last two decades, if not longer, and in Russia again today;
• currency crises in parts of Africa, Asia and Latin America, and again in Russia today;
• relatively frequent inward and outward flow of large amounts of capital from some emerging markets (often for reasons that have little to do with these markets themselves); and
• some large emerging markets (such as India in recent years) going through periods where they are seen as relatively unattractive investment destinations and others such as China remaining relatively opaque to international investors.

It is therefore surprising that emerging markets sponsors and investors have not focused harder on how to deal with major market disruptions in the fund terms they negotiate.

Relative shortage of experienced sponsors: A related characteristic of emerging markets funds is a comparative shortage of experienced sponsors who boast a strong track record over multiple fund vintages. In large part this may be explained by the comparative youth of emerging markets private funds, particularly outside of East Asia and Brazil. It is also slightly surprising that emerging markets sponsors and investors have not sought to address this in fund terms.

Rarity of control investments: Finally, it is surprising that sponsors and investors in funds which invest in countries where control investments are uncommon have not, in my experience, sought to deal in the fund terms with the consequences of this absence of control.

The future

Perhaps in future some of these issues will be picked up by sponsors and investors and a genuinely different set of terms will develop for emerging markets funds, at least in some geographies and for some strategies. If so, I would expect this to come about initially in first time funds or in funds with less established track records, as more tends to be up for discussion in these cases. However, things could just as easily remain unchanged, as inertia is at times a strong force acting on private equity fund terms. Time will tell.

About the Author

Peter Olds is Counsel at Cleary Gottlieb Steen & Hamilton LLP