Legal headwinds strengthen for US PFMs

Legal action against US private fund managers is likely to increase in 2017 as a result of growing regulatory and investors demands, according to a report by law firm Proskauer Rose.

In its 2016 annual review and outlook for private funds, it said managers should ensure fees and expenses, valuations and cybersecurity policies were robust, because of precedent for action from regulators on these matters.

In the first instance, firms are advised, at the very least, to update their Form ADV, which includes the primary disclosure document given to investors.

“A critical issue is whether a particular fee/expense was adequately disclosed to investors at, or prior to, the time of the investment decision, which is often viewed in hindsight through the lens of current market practices,” the report said.

Valuation policies should be reviewed to ensure they track the FASB Accounting Standards Codification for Fair Value Measurement, while exposure to operational cybersecurity threats should be evaluated at both the firm and portfolio companies, with experts employed if necessary.

From a portfolio company perspective, the devaluation of tech unicorns – start-ups worth in excess of $1 billion – could be a source of increased private litigation.

“Any significant devaluation of unicorns is likely to amplify the scrutiny of valuation practices, particularly of funds with significant exposure to unicorns. Fund investors will almost certainly focus on sponsors’ adherence to their own valuation policies, as well as discrepancies in valuations between private funds and mutual funds,” the report said.

In general, more investment funds are being named in litigation involving portfolio companies, something that is expected to continue.

“The claims often relate to the management and decision-making of the company involving change of control transactions, conflicts of interest, unfunded pension plans or catastrophic tort-related events,” the report said.

Fund managers were advised to re-examine their professional liability insurance programs in light of the scope of available indemnification rights at a fund and portfolio company level.

“It is clear that the litigation climate for private fund sponsors is rapidly changing. However, sponsors who take early and proactive steps to manage their risk will be well positioned to weather the storm,” the report said.