Photo by Michael Wharley.
In the middle of the last decade, many private fund managers still did not have an internal legal function. That now seems hard to fathom as regulation has become a mainstay component of the industry; indeed, funds are required to have compliance functions under new legislation in the U.S. and the UK.
As part of our inaugural Insights guide to Private Funds, we spoke with Peter Olds, legal director of Actis, a $5 billion fund investing exclusively in Asia, Africa and Latin America, about this changed environment and other issues. Actis was founded in 2004 after spinning out from the Commonwealth Development Corporation.
Its emerging-markets remit is of keen interest to a range of investors globally, meaning that Olds is dealing day-to-day with a huge raft of regulatory issues. The London-based Olds joined Actis in 2009 from Clifford Chance, where he was a senior associate in the private funds group.
Lawdragon: How has the constituency and function of the internal legal team changed over the past 5 years since increased regulation for fund managers?
Peter Olds: Anecdotally and based on my experience at Actis, I would say that teams are more heavily weighted in favor of fundraising and compliance, meaning that relatively speaking there is less hiring for transaction specialists. This can either be as a result of teams growing by adding fundraising or compliance specialists, or as a result of role changes for existing team members. For example, many funds are using secondees from law firms to assist during fundraising and with compliance issues or making new in-house legal hires much more focused on fundraising and/or regulatory compliance issues.
This also flows through to the role of general counsel. Whereas previously a private equity fund general counsel would most commonly have come from a transactional background, increasingly I am seeing job specs asking for more all-round expertise, particularly in relation to compliance and regulatory matters.
LD: Obviously the raft of legislation - some directly aimed at fund managers and some more aimed at business generally - has had a huge impact on the role of the legal teams in funds. Has this sea change made the legal function more pivotal to the business?
PO: I think it has made both the internal and external legal functions more pivotal to the business. It has increased the need for:
One, lawyers who understand the business from the inside, because one of the most important skills in relation to complying with new legislation is integrating it with your existing compliance programs and business practices in a way which causes minimum disruption to what you do already; and
Second, user-friendly external advice, because the huge amount of new legislation is generally almost impossible for in-house teams to cover without help – both in terms of knowing what is out there and what is coming up in the next few months and years. Even if you do know what you need to comply with, there is the issue of how you comply with it. This latter issue has two aspects: what in substance do I need to do in order to comply with the law and what documents and procedures do I need to have in place in order to be sure that I do these things on time and to the necessary standard, and report on them both internally and to the relevant regulator. This is highly specialized knowledge and in truth only external specialists have all of it, in my experience.
LD: Has the increase in legislation made funds more reliant on outside counsel for assistance in interpretation or are teams trying to build up internal expertise?
PO: I would say both. Since MiFID (the EU Markets in Financial Instruments Directive), which now seems like ancient history, we have had AIFMD (the EU Alternative Investment Fund Managers Directive), FATCA (the U.S. Foreign Account Tax Compliance Act), the Dodd-Frank Act, U.S. Commodities Futures Trading Commission Regulation changes, EMIR (European Market Infrastructure Regulation), CRD IV (EU Capital Requirements Directive IV) and the U.S. Securities and Exchange Commission’s increased focus on broker-dealer exemptions.
We have been heavily reliant on outside counsel for advice in all of these areas – and although we have always been this reliant on outside counsel for advice on regulatory matters there is now just so much more of it to deal with. Equally, we have had to build up internal expertise. We have done this in two ways. The lawyers who already worked at Actis have had to become instant experts in financial services regulation – both in what the new regulations are and, most importantly, how they interact with our business – and we have hired a full-time compliance manager to deal with the day-to-day mechanics. This is something that is a long way outside the skill set of us lawyers. It requires specific experience and has been an essential hire for us.
LD: How do you think the legal team in your organization might change over the next five years to cope with the legislative environment?
PO: The big question for us will be how to cope with the increasing regulatory demands without a commensurately increasing budget for lawyers and compliance staff. Before hiring a compliance manager, we had one transaction specialist lawyer, one fundraising specialist lawyer and a general counsel overseeing these and the other legal functions, along with a trainee on secondment from one of our relationship firms. We have since taken on a compliance manager and a part-time lawyer to help with fundraising.
I have seen similar hiring patterns at several of our peers over the last few years: a lot of firms have created or added to a specialist compliance function and several have temporarily beefed up their in-house team during fundraisings, either with fixed contract hires or with secondees (although with the length of fundraisings these days, “temporarily” can mean for years).
I think for us it will be a case of continuing to try to do more with less. This will probably mean bringing people in on a short-term basis to cope with periods of high pressure. The type of specialists we will need may well change over time depending on whether we are fundraising, implementing a new compliance program or something else. So we will need to stay flexible in order to use our budget as wisely as possible.
LD: Has the move to a more regulatory culture changed your relationship with outside counsel?
PO: Most importantly, it has forced us to look outside our regular “panel” of outside counsel for the best regulatory advice we can get. Rather than looking on regulatory advice as an add-on to the advice we receive from our usual relationship law firms, we now look on it as a business area in its own right and so we have sought separate representation for our non-U.S. regulatory matters, including amongst other things AIFMD, CRD IV and EMIR.
We are particularly reliant on U.S. counsel when it comes to fundraising, because of the number of filings that we need to make and certifications we need to give every time we hold a closing. In truth - and I am slightly embarrassed to admit this - despite having worked in funds for nearly 12 years, I no longer know what all the pieces of paper we are signing for the U.S. achieve. I am generally aware that most of them concern either lobbying restrictions, maintaining our private placement exemptions or getting a clean securities opinion from our U.S. lawyers, but I couldn’t always tell you which of them a particular document achieves. This is simply a function of not having the time available to focus on every part of the fundraising, and where this is the case, I am totally reliant on outside counsel.
As we have been raising funds over the last couple of years, I have been breaking down each of our bills to see how much of the bill is made up of our fundraising. Our legal bills are made up of regulatory and legal opinion work that can never be done in-house. A surprisingly high percentage of the total bill, perhaps 20 percent, is work of this kind. All of those $2,000 ERISA bills and $5,000 legal opinions really add up! This is now a substantial transaction cost of raising a fund, which has grown out of all proportion in the last few years with no corresponding increase in commercial benefit to either general partners or investors.
LD: How does this increase in legal and compliance, which is an additional burden of cost, segue with the fund’s duty to create value for its investors?
PO: There is a certain amount of work that needs to be done, both on behalf of our funds and on our own account, and contrary to most non-lawyers’ expectations, a high proportion of it is non-discretionary. You cannot decide not to comply with AIFMD because it’s too expensive, you cannot go without legal representation on deals, and likewise for fundraising.
All of it can be allocated either to an in-house lawyer or to external counsel but again the decision is made for you in many cases. You cannot go without an external law firm on deals because the risk to the fund is too much, you cannot go without an external law firm on fundraisings because the risk is again too high and because the workload is too much for the in-house team.
For everything else however, there is a choice between in-house lawyers and external counsel. For work on our own account (which we pay for), the decision-making process is simple: if we have the time and the skills to do it ourselves, and we don’t need the safety net of an external adviser’s professional indemnity policy, we do it ourselves. However for work on behalf of our funds, which the funds pay for, we are not incentivized to find the most cost-effective provider because if we do it ourselves we pay for it in the sense that we are not paid or reimbursed for the work. But if we use an external firm, the fund pays for it. We are therefore incentivized to use the in-house team for our “internal” work and external lawyers for fund work, which is not necessarily the best outcome for our investors.
In general I think the industry is not all that sophisticated in the way it thinks about using lawyers and that investors could get more for their money if they were willing to move away from the standard model of who pays for what, i.e., the general partner pays the salaries of the in-house lawyers and nothing they do can be charged back to the fund but the fund pays the costs of external lawyers.