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Opinion

Governance models for funds – achieving the right balance

Angeli Arora, Africa Regional Leader, Dentons
Oct. 2, 2019, 9:34 p.m.
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Word count: 734

How does a fund construct its governance model so that it allows investors effective oversight over the activities of the general partner and fund manager, but does not go so far that it ends up jeopardizing the limited liability status of the investors? We explore this important question below.

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How does a fund construct its governance model so that it allows investors effective oversight over the activities of the general partner and fund manager, but does not go so far that it ends up jeopardizing the limited liability status of the investors? We explore this important question below.

The balancing act

Let’s first remind ourselves of the essential features of a fund: at its simplest, a fund is a pool of capital, contributed by a group of investors, which is invested by a professional management team in line with the chosen strategy of the fund.

It is key for investors that their liability in relation to the fund does not exceed the amount of their capital contributions. In a number of jurisdictions, to achieve this in a partnership context, investors participate in the fund as limited partners, which enjoy limited liability status but play a passive role in the business of the fund. The professional management team takes on the role of general partner and is in charge of managing the business and affairs of the fund (delegating some of these responsibilities to the fund manager). The general partner is liable for the business of the partnership.

Investors will want an adequate level of oversight in relation to the activities of the professional management team, in order to hold them accountable for any malfeasance and to ensure stakeholder interests remain protected. However, in some jurisdictions, investors must be careful not to “cross a line” and end up playing an active part in the management of the fund themselves, since this could result in them inadvertently incurring the liabilities associated with that management function and/or risking their limited liability status.

How does a fund achieve the “right balance” in practice?

One key structure which enables investors to hold the professional management team accountable for their actions – without “crossing the line”- is for the limited partners to set up an advisory committee (of limited partners only) to provide input to the general partner/fund manager on certain key fund matters. The list of “key fund matters” must be carefully negotiated between the general partner and limited partners to achieve the “right balance”. In our experience, key fund matters can include conflict of interest matters between the interests of the general partner/fund manager and the interests of the fund/investors; related party transactions; changes to the auditors; changes to the key employees of the general partner/fund manager; extending the term of the fund or changing the fund size; approving the valuation methodologies; matters concerning certain key tests of investment strategy (for example concentration limitations) and approving changes to the general partner’s fees.

Generally, the advisory committee should not approve or disapprove of entering into or disposing of investments made by the fund or else it will risk “crossing the line”. However, it can appoint independent third persons to act alongside the professional management team on any investment committee, which decides whether to enter into or dispose of investments. These independent third persons provide certain “checks and balances” in respect of the powers of the professional management team. In order to be effective, the independent third persons should be free from any relationships that could, in the opinion of a reasonable and informed outside party, affect their objectivity as a member of the investment committee.

Also, investors should be given approval rights/voting powers which they can exercise as a group (in an investor meeting) in relation to certain fundamental matters relating to the fund. We typically see these rights including removing the general partner, dissolving the fund, material amendments to the limited partnership agreement and certain substantial changes to the investment period or term of the fund.

Finally, investors should be given comprehensive and timely information on the fund, its investments/assets and its portfolio companies, including quarterly and annual reports. There should also be full transparency with respect to fee/capital call/distribution calculations.

In summary, the above structures and practices are some of the key strategies that have been developed to enable investors in a fund to ensure that they can monitor the activities of the professional management team whilst striving to protect their limited liability status.

(Dentons bears no liability for the information provided in this article. Legal advice should always be sought in connection with the same. Dentons has no obligation to update the information above in the event that relevant laws and practices change over time.)

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