Beneficial legal considerations of private investments: the game may be worth the candle
First published in ADGMQ’s Le Sablier magazine (May 2019)
Philippe Levac, lawyer and principal, Normandin Beaudry
Martin Neveu, lawyer and principal, Normandin Beaudry
Private investments, so-called alternative investment funds, have been gaining popularity for more than a decade. These investments have proven to be a very interesting addition to traditional bonds and equities for institutional investors.
“Private investments” are funds that, in essence, are not traded on public markets, like a stock exchange. These are mainly found in the areas of infrastructure, real estate and private debt, and are generally available to institutional clients.
This article will expose, from a legal standpoint, the benefits of private investments compared to funds traded on public markets. Then we will discuss certain additional complexities from a contractual standpoint.
Private investments have some legal benefits, two of which are addressed below. These benefits are seen in private investments that are organized into a limited partnership, which is the preferred vehicle for this type of investment. This is not the case for funds traded on public markets, save some exceptions.
The first of these benefits is the possibility for investors to participate directly (rather than indirectly through a public market) in sophisticated funds without having to have specific knowledge or expertise, or to be involved in the management.
For investors, this benefit can be essentially explained by the very foundation and key features of the limited partnership. This partnership is created by contract, primarily between two types of partners: the general partner and the limited partners. The general partner, who usually brings its financial or investment expertise to the limited partnership, is tasked with its administration and, in principle, has unlimited liability in this role. The limited partners are essentially the investors who contribute their capital to the limited partnership and, as such, are afforded limited liability up to their invested capital.
The second benefit is the limited partnership’s fiscal transparency regarding private investments structured as such. This means that the limited partnership is not considered to be a taxpayer and each investor enjoys its own tax treatment. For example, investors that are inherently tax exempt abroad under tax treaties can take advantage of this exemption, thereby potentially increasing their returns down the line.
The sophisticated nature of private investments usually involves more complex and extensive contractual and regulatory documentation than what is required for funds traded on public markets.
To the extent that it sets the stakeholders’ rights and obligations, the documentation should be subject to due diligence by the investor. While it is our belief that this due diligence exercise should be standard in all circumstances, it is especially important for those who invest as administrators of the property of others, as they are required to, among other things, exercise care and diligence.
Examples of documents that bind the limited partners to the general partner include the subscription agreement, the partnership agreement and the offering memorandum.
While each case must be analyzed, especially based on the investment type, duration and specific conditions, here are some elements that, in our experience, should be kept in mind when reviewing and finalizing the documentation.
Firstly, at the subscription stage, the investor should make the required representations accordingly, especially those relating to its tax status and securities regulations. This is important because, usually, the investor must indemnify the general partner for costs, expenses or damages caused by any misrepresentations on its part.
In addition, with regard to the partnership agreement, topics such as the general partner’s standard of conduct and the indemnification of said general partner, the terms of transfer or redemption and the ramifications of the departures of the general partner’s or manager’s key employees are all elements that have to be verified to ensure that the contractual documentation meets the investor’s standards and protects the investor adequately. Moreover, a side letter can be negotiated, when appropriate, with the general partner to reflect some of the investor’s characteristics (e.g., restrictions on certain types of investments) or extend benefits to the investor beyond the contractual documentation that applies to all investors.
The offering memorandum can also be interesting to assess the general partner’s investment strategy and the risk factors resulting from the funds.
We believe that private investments are more than a simple trend; they are now firmly anchored in the investment world. In our experience, institutional investors usually consider private investments as part of their investment activities. While private investments do provide undeniable benefits, they also come with their share of challenges, especially with regard to the complexity of the documentation inherent to these sophisticated funds. However, this challenge can be easily overcome by institutional investors conducting their due diligence of said documentation, thereby allowing them to invest while ensuring that such documentation meets expectations and provides adequate protection from a contractual and fiscal standpoint.