Private investment funds are likely to face increased regulatory scrutiny and litigation risk in 2016, not only based on the Securities and Exchange Commission’s focus on the industry but also due to transparency and compliance initiatives of limited partners and other market developments. We have highlighted several areas that should be on the top of every private fund sponsor’s list – and how to assess and manage the associated risks.
Private equity fund sponsors are facing increased litigation risk from regulators and private parties, including limited partners and stakeholders in portfolio companies. As a result, private equity firms should re-examine their professional liability insurance policies to ensure that their coverage is properly aligned with this increasing risk.
Private equity funds, and individuals affiliated with fund sponsors, are increasingly being named as defendants in lawsuits involving their portfolio companies. This litigation risk arises most frequently where a fund controls one or more board seats on the portfolio company, or where an individual affiliated with the fund sponsor serves as a senior executive at the portfolio company.
When a fund sponsor (or an individual affiliated with a fund sponsor) is named as a defendant in a lawsuit involving a portfolio company, the initial assessment of the claims, risks, insurance coverage, and indemnification rights is critical. Some of the key questions for that early assessment are:
- What are the board designee’s indemnity rights? Typically, the board designee has indemnity rights at multiple levels, including the portfolio company level, the fund level, and potentially the management company/sponsor level. The interplay between the rights at different levels, and the priority of the indemnitors’ obligations, requires careful assessment. Also, it is important to understand that an indemnity right is subject to “credit risk,” as the indemnity is only as strong as the balance sheet of the indemnitor.
The public scrutiny on private equity fund sponsors has continued to intensify this month, evidenced by at least three recent events.
First, the government announced that it was probing performance figures at private equity funds: SEC Probing Private Equity Performance Figures. This focus on performance should not come as a surprise. Financial performance is what drives the industry. Moreover, the SEC has made it clear that private equity fund sponsors are a regulatory and enforcement priority. And if that weren’t enough, two separate academic white papers have raised questions about performance claims in the private equity industry. After the options backdating scandal a decade ago, the catalyst of which was an academic white paper, the SEC had no choice but to probe performance claims.
Andrew J. Bowden, the Director of the SEC’s Office of Compliance Inspections and Examinations, gave a speech entitled “Spreading Sunshine in Private Equity” in May 2014. While sounding cheery, the “spreading sunshine” metaphor was an ironic evocation of Justice Brandeis’s…