This article originally appeared in The Legal Supplement: Expert Commentary (Spring 2020) published by Private Equity International (PEI). It is republished here with permission.

The private equity industry longs for hard and fast rules on transparency, a guarantee of sorts that the transparency provided to investors will both satisfy investors and regulators and not create unintended consequences or impossible expectations for the discloser. Each day, private equity managers are faced with new, and sometimes complicated, reporting requests and general information requests. Applying the proper standard of care, determining the right balance of transparency and maintaining good investor relations is sometimes the most difficult deal of the day.

Transparency is a perpetual buzzword in the private equity industry. But what does having a culture of transparency really mean to an investment manager and its clients? How does an investment manager determine the right amount of transparency while protecting the rights of its investors, the manager and, often times, underlying investments?

Transparency is not a goal but a culture, which will assist an investment manager in attaining long-term relationships with investors. Lack of it is bad, but can there be too much? What do investors really need to know; what do they want to know; what should they know? When and how do investors cross the line between what is appropriate for managing and evaluating an investment and having too much information? What do managers share with investors? What should they share? What must they share? These are daily questions posed to legal counsel. The right answer lies in what is an appropriate exercise of fiduciary duty, what is required for compliance with applicable laws, what is good for investor relations and whether there are adequate alternatives to manage information. This article is about some (not all) of these judgment calls and their associated costs and benefits.

What this article is not about is data privacy and associated regulations, cybersecurity, data analytics, AI or similar. Those are very important topics but we’re going "old school" here and starting with the building blocks of transparency: fiduciary duty and looking at how that shapes conflict disclosures and everyday investment management.

Fiduciary Duty

The general principles of fiduciary duty for investment managers are well established. They start with the familiar corporate principles of duty of care and loyalty. But limited partnership and limited liability company statutes allow for those to be changed by contract. Many investment managers think that is a good idea – it protects the firm. Counsel, who is required by professional responsibility laws to provide zealous representation of their client, advises that the fund adopt a reduced standard based on good faith and reasonableness. Institutional investors generally raise this as an issue and a negotiation ensues between fund and investor legal counsel early in the onboarding process. The shadow cast from that process can be harmful if not handled carefully. Investors view it as asking for a contractual commitment to act reasonably and getting a "no" answer.

In addition, managers need to pay attention to potentially conflicting fiduciary duties. Imagine a fund manager that has a "reduced duty" to act in good faith and reasonably to a fund which makes a minority investment in a company, appoints a fund manager to its board and the portfolio company has full fiduciary duties. There is an inherent conflict of interest in how that board member must act with respect to the portfolio company and how the manager must act with respect to the fund. Then imagine how that risk is exacerbated if the portfolio company is a public company.

These risks/conflicts are inherent in the PE business and are sometimes disclosed in risk factors, but are often not given much thought absent a later problem. Fund disclosures can alert investors to the potential conflict and how you would propose to address it (which usually involved use of the Limited Partner Advisory Committee to cleanse an issue), but portfolio company governing documents may prevent disclosure of matters outside its board. It is important for fund managers on portfolio company boards to have the right to disclose portfolio company information to the LPAC.

The regulatory posture towards fiduciary duty is also critically important. In its examinations of investment managers over the past decade, the Securities Exchange Commission has consistently focused intensely on conflicts, disclosures and fiduciary duties. Regulators do not accept contractual limitations on duty or liability and can find breach of duty in, and require restitution for, negligent behaviour.

Investment Advisers Act

To manage duties and disclosures appropriately, investment managers need to be knowledgeable of the different standards for risk under Sections 206 and 207 of the Investment Advisers Ct of 1940 (IAA). Section 206 proscribes fraud. Section 206(1) requires that the act be intentional (a "scienter" requirement), whereas Section 206(2) applies a negligence standard. Section 207, which generally governs disclosures, requires a "willful" act or omission.

These standards were recently tested in Robare Group Ltd vs SEC, an SEC enforcement case that started in 2014 and made its way to the DC Circuit Court of Appeals which issued its decision in April 2019. In Robare, investment advisors allegedly failed to disclose they were investing client funds in products sponsored by persons with whom they had a revenue sharing arrangement. Robare Group won at trial and the SEC Enforcement Division sought de novo review, which resulted in the SEC disagreeing with the trial court and finding that Robare Group had violated Sections 206(1), 206(2) and 207.

Robare Group appealed to the DC Circuit Court, which agreed with the SEC in part and deviated in part from the SEC’s conclusions. For Section 206, the DC Circuit Court found the Robare Group’s disclosures insufficient and that the Robare Group’s principals engaged in negligent conduct, citing a "standard of reasonable prudence" against which to measure whether actions are negligent. The DC Circuit Court did not find a Rule 207 violation. It considered – without opining – that "willful" means intentionally committing an act but does not require that the actor know the act violates the law, and said the intent required by this "willful" definition – ie, Section 207’s "willful" – cannot be established by merely negligent acts.

Robare criticised the use of the word "may" in the advisor’s disclosure that it "may" receive compensation by investing client funds in certain products. This is a major difference between fund managers and investment advisors who do not advise funds. When forming a fund, disclosures are made so far in advance of the behaviours that the use of "may" in disclosures of potential conflicts of interest is critically important. Saying "will" and not doing it is more risky than saying "may" and doing it. The judgment call will be to say "may," but regulators will likely view that as insufficient.

Finally, while both fund managers and investment advisors without private fund clients are required to update their Form ADVs annually and upon certain material changes, disclosure in an updated Form ADV for a fund manager is not helpful to remedying previously inadequate disclosures. The fund investor has made its investment decision long before the ADV update. That is not to say the update should not be done – it should – but it doesn’t alleviate risk from having failed to disclose previously.

Marketing Information and the Advertising Rule

In November 2019, the SEC released proposed amendments to the IAA’s Rule 206(4)-1 (Advertising Rule). The rule has not changed substantively since its adoption in 1961. It is due for an update. There are many interesting aspects of the proposed rule, including modification on use of testimonials in marketing materials, disclosures of compensation types, etc, many of which are geared towards non-fund investment advisors and whether they advise retail or non-retail investors.

More interesting to fund managers is the proposed rule’s modifications about use of performance data. It would allow the presentation of a less than 100 percent comprehensive track record subject to certain conditions that prohibit exaggeration, offer more information on request, and subject the disclosure to policies and procedures that assure relevance and understandability. It would give fund managers more flexibility in handling track record disclosures of gross and net returns from pooled investment entities with different economic profiles and allow use of hypothetical scenarios. However, the proposed rule’s distinction between retail and non-retail investors may mean that hypothetical performance information could not be distributed in a private placement undertaken under Rule 506(c) of the Securities Act of 1933 (which allows private placements of securities with investors who do not have a pre-existing relationship with the manager).

The proposed rule also would require fund managers to assure regulatory compliance by having a compliance person review and sign off on the advertising material. The reviewer cannot be the same person as created the material. Even without the proposed rules, this would be a recommended information management policy.

Books and Records Requests

A books and records request is a request for access to fund information. Most state partnership, limited liability company and corporate statutes contain a provision that allows a fund investor to have access to the records of the fund for a valid business reason related to the fund.

The fund’s response may be subject to such reasonable conditions as the fund manager decides to impose. If a manager actually receives a formal books and records request, there has been an acute failure of transparency, the wagons circle to protect the fund, a litigation mentality sets in and a closed environment emerges. Investors are generally best served not making a formal books and records request except as a last resort.

Appropriately, books and records requests are rare. Not responding fulsomely to a books and records request is dangerous, but there are ways to control the information and protect the firm and the other investors. One is to provide only access that is physically limited; another is to require that the requesting investor bear all costs and pay them in advance. One item frequently requested is a list of all the partners in the fund. Whether to provide it is a judgment call. Some investors require that their names and contact information not be given out. If that is not a pre-existing limitation, the manager needs to decide whether to ask the investors if it can provide their name. That is also a dangerous path. If not accommodated, a more formal request may come along in the form of a complaint and subpoena.

LPAC

Many private equity managers are engaged in frequent dialogue with one or more of their LPAC members regarding fund-related items including management fee, conflicts of interest, valuations and fee offsets. The composition of the LPAC is typically heavily negotiated with investors. Often, large investors are well represented with other positions being occupied by strategically beneficial members (ie, operating skill set or market knowledge). While transparency with the LPAC is critical, it is also critical to remember it does not replace transparency with the investor base as a whole.

Many negotiated reporting provisions, as well as industry reporting templates, provide for greater transparency into certain fees and expenses. In addition, the annual financials are an effective tool for providing details pertaining to many items, including fees and expenses. However, it is worth considering providing additional real time disclosure to the LPAC about how fees have been calculated, for example. It will be a first line of protection against subsequent investor complaints regarding such items.

As an example, if there is a material change in fee reimbursement or expense allocation and the terms of the governing documents dictate that such material change be vetted and approved with the LPAC but the governing document is silent as to providing information to the investor group as a whole, it may benefit the investment manager to err on the side of increased transparency and provide a summary of the material changes to all investors in the next quarterly report. Thus, while the approval is maintained at the LPAC level, the disclosure is to the larger group. Such ongoing disclosures cannot correct overt deficiencies in marketing documents, but lack of objection to an ongoing disclosure is useful in shoring up an interpretation of the fund’s governing documents.

Transparency for the sake of being transparent is not always a good thing. However, experience has shown that the disclosure of material facts on an ongoing basis to not only the LPAC but the investor group as a whole, often benefits the investment manager both culturally and legally.

Investor Confidentiality and Reporting Requests

Investment managers both cheer, and cringe, at the receipt of large pension money for one reason in particular: confidentiality. While creating a culture of transparency is a desired end result, reading your portfolio company information online is not. Therefore, it is important for fund managers to understand their investors’ limitations on maintaining confidentiality and to exercise sound judgment in providing information to them on an ongoing basis.

Investors frequently have a laundry list of items on which they do due diligence and want regular reporting. Most are reasonable and easily accommodated, particularly in the diligence phase. It is appropriate to require notice about events that could trigger rights under the fund’s governing documents where the investor may not have any other way of learning of the event. It is not appropriate to continually look so hard into the management company that the manager feels it is no longer running its business.

One particular point of concern surrounds SEC deficiency letters. Examinations are common and so are deficiency letters. Investors often want particulars on the examination and a copy of the deficiency letter. The request for them is made at the time of investment, when a manager seeks to be most accommodating. While there is a legitimate interest in knowing whether a manager has transgressed applicable regulatory requirements, too much information here can jeopardise attorney client privilege and/or cause reputational harm to the manager. A manager should weigh carefully whether to provide SEC examination deficiency letters and their responses.

Key Takeaways

Too much of a good thing is sometimes just that – too much. While a culture of transparency is to be encouraged, each investment manager must take the time to understand and appreciate how a culture of transparency best operates given its own bespoke investor pool, its own reporting obligations and its underlying confidentiality obligations to its portfolio companies. Paramount to the culture of transparency is the guiding principle of providing accurate and timely material information to investors and LPACs in accordance with the terms of the negotiated governing documents. When in doubt, disclose – but be cautious and consider all risks and benefits taking a long-term view.