We are often asked by managers why investor fund disputes happen and how they can be prevented. It’s a bit like asking, “can car accidents be avoided?” and I’d answer both questions with a “Not always, but there are certainly situations that can be avoided.” As my old headmaster used to say to me “be in the right place at the right time”, (although more often than not I wasn't…). As an investor and as a manager, you absolutely need to be. I guess that’s why I became a lawyer instead!
Investor fund disputes come in all shapes and sizes, from issues regarding valuation of fund assets, fund liquidity, inter-fund transactions, insider trading, ponzi-schemes, to undisclosed manager fees, misallocated expenses and undisclosed conflicts of interest, to name just a few. One of the most common forms of investor fund disputes revolves around the use of side letters, particularly relating to enforceability, inconsistencies between side letters and offering/constitutional documents, and the use of nominees to enter into side letters on the investor’s behalf. Another difficult question relates to the investor’s ability to challenge audit holdbacks, and when excessive use of holdbacks constitutes a red flag to investors.
Investor fund disputes are almost always driven by a combination of uncertainty and distrust by the investor. During the DDQ process as an investor, the general advice is that if you feel even the slightest niggle of uncertainty or distrust, walk away, regardless of the performance profile in front of you. Rely upon your gut instinct, even if there’s nothing pointing to anything concrete. There are plenty of other managers hungry for your capital.
As to why fund investor disputes happen, although poor performance from the wrong strategy, bad timing or simply unforeseen global macro events can be a trigger (because no one is ever happy about losing money), they only tend to escalate when the manager’s response to losing money is not as quick or as clear as the investor would like. Here it's all about communication with investors.
Often, the reason a manager loses the investor’s confidence and trust has nothing to do with the underlying losses but whether the manager is perceived to be covering any exposure he may think he has rather than acting in investors’ best interests. The main two factors that contribute to this perception are not knowing what the fund’s options are in any given situation and a lack of communication with investors. Here it’s down to the experience of the manager and that is a key factor in the decision making process as to whether to invest from the outset.
Therefore, the more a manager knows of the likely pitfalls that can occur during the life-cycle and day-to-day operation of the fund, the less likely they will end-up with an investor fund dispute.
Of course, managers need to stay on top of legal issues and developments. We see a big difference between managers who dedicate resources to legal (eg in-house GCs or regular discussions with outside counsel) and those who tend to rely on intuition or advice they have received in the past or from a buddy. Understandably, most businesses shy away from taking external legal advice unless they absolutely have to, but invariably it costs more in the long run because there is always more legal work to carry out when dealing with an emergency rather than something we have seen and discussed beforehand. Budgeting for strategy discussions with onshore and offshore counsel before taking any important step in the life-cycle of the fund is a sensible way to approach things, combined with a healthy respect for the constitutional documents, and better equips managers to deal with the dispute process.
There will always be situations you cannot avoid, but a manager who finds time to stay more or less on top of the legal issues affecting their business will be more confident when the pressure is on. Managers should expect to be stress tested by investors to see how they would react to a scenario given to them by a potential investor. It can be a great way for the manager to show-case their experience in avoiding an investor dispute and get the investor across the line with their investment.
In short and yes, it's a cliché, but prevention is better than a cure. Managers who develop robust policies and procedures to help spot potential problems quickly and bring in onshore and offshore counsel as early as possible are going to fare much better. The timing of advice from onshore and offshore counsel is often critical to preserve the client’s options in these scenarios, as well as knowing which points to focus on in correspondence and which not to.
A well-informed letter or circular from the manager sends the right message and saves time and money by getting straight to the point. For investors, lack of access to information can be frustrating, so again, and I simply can’t repeat this enough, effective communication is vital. For managers, keeping up to speed with legal and regulatory developments in the jurisdiction of the fund’s formation is the only sure way to gain protection from angry investors and remain focused on matters at hand.
In my next blog next week, I’ll address what to do when an unavoidable fund dispute arises.