Family Office Investment Programs: Special Legal Considerations When Investing in Alternative Investment Funds
As part of their diversified investment programs, many family offices invest in private alternative investment funds, which may include real estate funds, hedge funds, private equity funds, venture funds and impact investment funds. While family offices are generally very strong in the financial diligence of these investments, some are not as well-prepared to do legal diligence on them. Some family office-focused legal considerations, as well as some generally useful resources, when making alternative investments include:
Negotiating Terms and Side Letters. Some family offices are not aware of the extent of their ability to negotiate fund terms. For example, most fund managers are willing to negotiate side letter terms, even with relatively small investors. At a minimum, it generally makes sense to ask for a "Most Favored Nations" (also called a MFN) side letter provision, which will grant the family office investor the same side letter rights as other investors who have committed the same or a lesser amount of capital to the fund than has the family office. However, if the family office investor is a more significant investor in the fund, and particularly if it is an early investor in the fund, the family office investor may also have leverage to negotiate the terms of the fund's governing documents.
Privacy Concerns. More than other alternative investment fund investors, family office investors often have heightened privacy concerns. For example, they may not want the fund manager to inform other potential fund investors, existing fund investors or third parties that the family office investor is an investor in the fund. Most fund managers will agree to a side letter provision that to some degree limits the fund's ability to inform others that the family office investor is an investor in the fund. If so requested, some fund managers will also agree not to ask for or share the family office investor's financials with potential lenders to the fund, except in certain delineated circumstances.
Transfer Provisions. Also more than other alternative investment fund investors, family office investors may have a need for relatively flexible transfer rights. For example, they may seek to obtain side letter provisions that provide an individual family member the right to transfer the fund interest to a trust or other estate planning vehicle with only a limited need for the fund manager's consent.
Personal Liability. Family office investors are often more concerned than other alternative fund investors about obtaining assurances that they will not be personally liable for the obligations of the fund in an amount exceeding their investments in and certain distributions from the fund. While funds formed under Delaware law should provide such limitations on liability, it can be particularly important to receive assurances (in the form of a legal opinion or otherwise) of limited liability protection where the fund is formed in an offshore jurisdiction.
Background Checks. Because many family offices do not have the resources to do as much diligence on the fund and its managers as larger institutional investors, many family offices consider it a best practice to run background checks on the principals of funds in which they are considering investing. Background checks will generally reveal such matters as the principal's legal history (both as a plaintiff and as a defendant) and financial history (e.g., any past bankruptcies, tax liens, etc.). There are legal requirements regarding the information that background checkers may report without the consent of the person being investigated, but generally the level of information that can be found without the need to seek consent is sufficient for investor purposes.
ILPA Standards. The Institutional Limited Partners Association (ILPA) has created a number of documents that outline private equity fund best practices. These documents (which can be found here) also generally apply to other closed-end alternative investment funds, such as real estate funds and venture funds. These documents include: (i) the ILPA Private Equity Principles, which outline a number of key provisions that ILPA expects to see in the governing documents of such funds (although as a practical matter, few fund managers incorporate all the principles into their governing documents, and therefore each investor must prioritize for itself which of those principles it deems to be most important); (ii) reporting best practices, which are a series of guidelines and templates designed to increase transparency in fund reporting; and (iii) a due diligence questionnaire, which standardizes questions asked by investors (and may prove useful to investors who do not have their own due diligence questionnaires).
The discussion above is only a summary of certain key legal considerations to be considered by, as well as of resources available to, family offices when investing in alternative investment funds. For more information, please contact one of our Arnold & Porter Kaye Scholer private client services attorneys.