Trends in Fund Documentation

Originally published in Private Equity Law: Fund Structures

Until recently Finnish-sponsored private equity and venture capital funds were extremely simple both in terms of structures and in terms of the depth of legal documentation. Even the largest funds (on a Finnish scale at that time, close to 200 million euros) successfully raised money with partnership agreements no longer than a measly 15 pages. And even now as the market has witnessed a touch of "evolution" (or as a conventional fund manager might say, judicial corruption), most firms manage their funds with a surprisingly simple structure: one or several funds managed by a single general partner company without separate advisory or "carried interest" companies.

The simplicity of fund terms has probably been upheld by the closed nature of the Finnish fund market: according to the Finnish Venture Capital Association (FVCA) 73% of the money raised by Finnish funds in 2002 was still coming from domestic sources. Since the record-breaking fund-raising year 2002 there has been a downturn in fund-raising – 814 million euros raised in 2002 (657 million euros committed to funds) compared to, according to preliminary figures of 2003, 202 million euros in 2003 (of which 114 million euros committed to funds). To a certain extent there has been a "flight for quality" as regards not only financial performance but also as regards the transparency and quality of the investment process up to market standard fund raising and fund documentation. However, the FVCA has not been concerned about the figures turning down, as the amount of money under management has remained at an even level.

Now it seems, however, that more complex structures and more demanding contractual arrangements have permanently come ashore. This is probably partly due to Finnish investors becoming increasingly aware of the contractual praxis in, for example, UK funds. Although no statistics have been gathered, the general impression seems to be that over the past years Finnish institutions have become more active in investing abroad, and in doing so, more rigorous in doing their due diligence.

Even generally speaking, fund-raising has transformed from a set of friendly lunches over a few weeks to months of dealing with detailed requests from potential investors, often making it necessary for the sponsors to recreate all cash flows and investment/exit rationales for all previous funds in form requested by the investors. As an example of a novelty (perhaps save for certain exceptions) pushed in by investors is the whole concept of a no-fault divorce provision. Although this has now been introduced to a number of funds, sometimes together with more detailed provisions on the entitlement to carried interest in different situations, the thresholds for pushing through a no-fault termination may still be higher than in some foreign funds. Many players have also faced the fact that they no longer can raise a fund without a "market standard" key man clause.

On the other hand, also the management companies have learned that it may be in their interest to include i.a. provisions on indemnification, limited partner clawbacks and the ability to make distributions in specie. Management companies seem to also have accepted the fact that attracting foreign money will require attention on several issues that earlier were not issues at all. Pleasing foreign investors has lead to setting up funds offshore — in which practice requires advisory structures. The same factor has pushed managers to ponder on different fund-raising structures and vehicles and forced lawyers to put their minds on structures resembling a mixture of mutual funds and securitisation.

As the industry slowly comes of age, and funds generate carried interest and new people come in, Finnish fund managers could be expected to soon take a new look at their management fee and carried interest structures. Although there have been some signs of product development (i.a. in the form of investment team co-investment vehicles and general partner share classes following the performances of different funds under management), the market standard seems to be very far from foreign models with "carried interest limited partners" and vesting structures. The lack of innovations is not least due to the general uncertainty relating to the taxation of fund management structures.

It seems that slowly, at least with respect to the private equity funds as compared to venture capital funds, the Finnish fund terms are aligning with the market standards in the other European countries. The two issues that still would seem likely to remain a factor differentiating Finnish funds from other funds are the powers of the investment committees (or in some cases "advisory boards") and profit distribution provisions.

Having usually at least a veto on all investment decisions, sometimes also on exits, in Finnish-sponsored funds the investment committee as a general rule has more power than the average European investor is likely to be accustomed to. Contrary to some countries, based on the Finnish Partnerships Act this will not compromise the limited liability of limited partners. The Finnish Partnerships Act is indeed in this respect (and many other respects) more flexible than e.g. the UK Partnerships Act.

The flexible Finnish Partnership Act, combined with the fact that the private equity and venture capital industry is currently entirely unregulated in Finland, allows considerable freedom for product development. If the current tax problem relating to a foreign investor in a Finnish fund having a permanent establishment in Finland is solved (as indicated by the government), Finland could become "a hub" for Nordic and especially Baltic funds. First Fenno-Baltic structures with Finnish and Nordic investors have already been established.

As regards profit distribution waterfalls, Finnish management companies have rarely introduced catch-up provisions, merely having a 20/80 split after a defined preferred return instead of a true 20/80 split of profits. On the other hand some funds apply a higher carried interest percentage after generating the limited partners a defined return of IRR somewhere between 10 and 20% p.a. In some earlier funds some GP’s went ahead with a waterfall providing a payment equal to commitments to the limited partners before any possibility to carried interest – even without considering the necessity of a limited partner clawback in a situation where all the commitments would not have been drawn down. In principle this could (without the relaxed non-lawyerish atmosphere) have been quite hazardous given that the investment committee would have a veto on all investments.