A Primer On Fund Investing: What to Ask for and How to Ask for It

Summary

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This article was first published in Compensation and Benefits Review, July/August 2006.

Any lawyer will tell you that the side drafting the contract has an automatic advantage. He (she or it) has the opportunity - and in most cases will use this opportunity - to choose wording that favors their interests. No evil intent is implied; this is human nature.

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A Primer On Fund Investing: What to Ask for and How to Ask for It

How does this rule of human nature apply to investments? An investment in a private equity fund or a hedge fund (called a "fund" in this article) offers a timely example. Press reports at the beginning of 2006 predicted that this would be a year in which more middle and smaller size pension plans subscribing for interests in these funds in hopes of boosting their annual returns.

Each subscriber to a fund is required to sign a contract in which it agrees to the terms of the investment, terms that are found in the fund's operating agreement and sometimes in its private placement memorandum. (For simplicity's sake, we have assumed that our fund is a limited liability company. However, the same comments would apply if the fund were a limited partnership.)

When the investor is an employee benefit plan (in this article we will use the term "pension plan" since more pension plans than welfare benefit plans are investors), the plan's fiduciary must make a determination that the investment is prudent. No plan would invest without a full understanding of the economics and financial risks inherent in an investment. Yet, many plans do not give the same attention to the actual terms by which they become members of the fund. Pension plans, like many other institutional investors, may be unaware that many of these terms may impact the profitability and legality of their investment and, most important, are open to negotiation.

The goal of this article is to highlight several terms that, with some revision, will promote a greater balance between the needs and interests of the fund sponsor (whom we refer to as the "Manager"), on the one hand, and those of the investors (whom we call the "Investors" or "Members"), on the other hand.

Our illustrations come from fund documents we have reviewed. They cover the topics of reports to Members, the valuation of fund assets, the Manager's discharge of its fiduciary duties, redemption or withdrawal procedures, the distribution of side letters and use of most favored nation provisions and as well as specific matters with the Employee ...

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