Legal lowdown: Sam Kay, Travers Smith

The Drawdown (TDD): You joined Travers Smith as a trainee in 1998 and became partner in the private funds team in 2008. What are the key changes you’ve noticed in PE?

Sam Kay (SK): When I started out, fund structuring tax and regulation was far more straightforward. In the late 90s/early 2000s, there wasn’t much to think about regarding regulatory requirements. The Financial Services and Markets Act only came into force in the UK in 2000.

Second, the operational impact of fund size and scale on the fundraising process. Nowadays, it’s standard for funds to be upwards of $1bn, meaning more complexity in structuring and investor requirements. For example, larger LPs impose more bespoke requirements on funds. That’s hugely impacted how GPs consider running a fundraise because the work has increased exponentially. There’s far more individual negotiations, including side letters and LPA terms.

Third, how team mobility has changed views on manager and fund jurisdictions. As funds now target numerous jurisdictions, teams are based in multiple places. This creates sophistication and complexity for structured arrangements behind funds, the investment advisory agreements, how you comply with tax and regulations, and so on.

Fourth, GPs are diversifying the tools being used, for example GP-leds and subscription lines. In the early 2000s, the latter would have been very unusual. LPs and GPs were equally hesitant about increasing the amount of debt into funds because there’d be debt in the underlying portfolio. Nowadays it’s commonplace.

TDD: You advise on carry schemes. It’s been suggested PE must account for generational differences when it comes to financial incentives. What are your thoughts?

SK: Carried interest is a very useful, long-standing tool PE uses to attract and retain talent. LPs like to see that incentive arrangement because it increases the LP-GP alignment. Furthermore, it retains people within the GP until carry is paid out. Since it’s been a key part of private funds success, I don’t see it changing.

However, LPs want to ensure GP teams are incentivised and retained for the life of the fund. There’s a push from LPs to ensure GPs’ junior employees are able to receive their share of the carry.

A number of PE houses have put tools in place to allow the wider team to participate in carry. For example, where a carry entitlement is stapled to the proportion an individual provides for the GP commitment, some GPs put debt facilities in place for individuals to borrow from so they can fund their share of the GP commitment, thus receive a larger tranche of carry. Other GPs think ahead to the next vintage fund. If they can ensure juniors receive carry from prior funds, they’ll be able to reinvest that capital into the next fund, again, promoting GP and LP alignment.

TDD: Ireland’s ILP went through in September 2020. However, there is yet to be an influx of PE managers and funds moving to Ireland. What are your thoughts?

SK: I'm still positive that over time, Ireland will be seen as a suitable alternative for PE, but I think the whole process will take time. Quite a few of our clients have established their AIFMs in Ireland, but we haven't yet seen that translate into the fund vehicle itself being established there.

It will need one or two people to make a change, then the floodgates will open, and that will be very healthy for the industry. Having to focus only on one jurisdiction is a problem, as it concentrates things too much.

TDD: Firms complying with SFDR and the Taxonomy Regulation have to label their funds. How helpful is this?

SK: The regulation is all about disclosure rather than having the label, and I think it’s so important the industry remembers this. The regulations are intended to say, these are the particular disclosures you need to make to your investors and the regulator if you are going to operate in the following way.

However, the way the regulations are being implemented, it’s created an approach where people apply the label to a fund. But this was never the intention.

This could create problems because investors are assuming if there’s a particular label attached, there’ll be a particular investment thesis. But that’s not correct. If people are thinking about it as a label, you could end up with some funds which don’t meet investor expectations, because investors think there’s a label. There could be huge misunderstandings around this which could lead to disputes and claims in due course, because investors think they’ve been mis-sold a product.

On the other hand, regulators will have to tighten the regulations to make this clearer.

TDD: What do you envisage as key trends for the next six to 12 months?

SK: We can't get away from the macro environment where we've got rising interest rates, rising inflation. That is going to impact all markets, including private funds. I think that could have an impact on certain fund terms, such as hurdle rates. LPs could say, unless the GP can generate higher returns for them than they could receive by popping their cash into a bank account, they won’t commit capital. GPs may be forced to push up their hurdle rates to attract investors.

You could also see some investor protection terms move more in favour of LPs as the market becomes more competitive. For example to attract LPs, GPs may need to give them slightly enhanced terms, which could change the way fund terms play out.

I think there could be an increased focus on providing an option to realise cash. I'd expect, over the next six to nine months, to see an increasing move towards more GP-led deals to repay some cash to LPs earlier than they otherwise would be able to.

Any period of instability promotes change. While that could focus on diversifying investment strategies, it could also change fund structuring and domiciling. As a result, GPs consider alternative options, rather than doing the same thing they've done during the last 10 or so years.