Red flags

by Silvia Saccardi 25 September 2023

Picture this: on an idyllic island retreat somewhere exotic (insert preferred destination), you are basking under the sun, eyes watching the undulating waves move in and out, ears listening to the soft crashing of the sea foam as it reaches the shore.

Nothing would complete this daydream better than a quick dip in the ocean. Just as you rise up from your blissful stupor, you realise not all is as it seems. There is commotion in the ocean. Lifeguards hasten to put up red flags. Danger ahead.

Wake up CFO! Summer is over and you are not at the beach. Your colleague is alerting you to some grey areas about some prospective LPs. The real red flags are at your desk. What do you do?

PEP talk
Scenario one is the case of the politically exposed person (PEP). The LP in question represents a well-known family office. They have been known to donate large amounts of money to a particular political party. Their personal interests do not align with your own in the slightest. When does signing an LPA with this investor constitute a significant reputational risk to your firm?

This is just a fictional scenario, but the grey area around PEPs resurfaced recently when exclusive bank Coutt’s decided to close former UKIP leader Nigel Farage’s account for “commercial reasons”. As the story unfolded, the bank’s decision was found to be based on the politician’s political views rather than material evidence of financial misconduct. NatWest chief executive Dame Alison Rose swiftly resigned.

While there is no standardised global definition of a PEP, the House of Commons defines them as individuals with “prominent public functions”. If GPs find themselves collaborating with PEPs, then all that is required are enhanced due diligence measures.

Phoenix Equity Partners’ CFO Steve Darrington shares where he believes the line in the sand lies: “There are PEPs who have allegedly channelled money away from governments and aid organisations in order to furnish their own wealth, and there are PEPs that are simply politically motivated and have given money to a political party in the hope of doing some good. These are very different.” Performing enhanced KYC checks can alert managers as to whether a PEP is a cause for concern or not.

Reputation, reputation, reputation!
Scenario two is the case of the difficult LP. This institution has a tarnished reputation and has found itself collecting bad press during its decades in action. Despite this, in recent years the firm has kept out of the limelight and has re-evaluated its governance procedures. It looks like the storm has been weathered. Is the flag turning green?

The answer is unclear without further digging. After all, the purpose of due diligence is to assess the ability to comply with certain fiduciary obligations. But as a GP, do you really want to risk getting embroiled in bad press?

Kroll’s managing director David Larsen shares the importance of aligning GP and LP motivations: “A red flag could be if an LP does not play well in the sandbox. In other words, they don’t work well with other investors or other GPs. And some of those difficult players may have large checks associated with them.”

Treating KYC and AML as tick-box exercises can lead to overlooking crucial information, according to IDR’s global operations director Karen Bee. She explains: “KYC procedures are not just about fulfilling regulatory obligations, they’re essential tools for understanding clients, their financial activities and evidencing where funds come from and where wealth is derived from. Taking it one step further by digging deeper into financial history, connections and transactions can help institutions build up a clearer picture of the client's financial behaviour, enabling them to detect unusual patterns or activities.”

Whatever decision is made, going in blind is not advisable. Larsen stresses the need to know your unknowns before any agreement is made: “It’s time to say no when there is no explanation for any unwelcome information you have.”

As the adage goes, a good reputation is hard to earn and easy to lose.

On the dotted line
Scenario three is all about the LPA. In a tough fundraising environment, LPs are gaining some bargaining power when it comes to certain terms. Are you willing to forgo some traditional clauses to secure an investor?

According to Colmore’s senior vice-president Paul O’Shea, some terms have been evolving to reflect LP pushback in the current climate. For example, O’Shea explains: “New LPAs tend to have a GP ‘removal without cause’ clause, whereby a certain threshold of LPs can agree to remove a GP even if there has been no fraud or criminal offence committed.”

In addition, O’Shea has started to see some LPAs without a catchup clause in place. Although these are very few instances, it demonstrates instances of increased LP agency and a more developed understanding of the agreement itself.

Finally, according to Colmore’s latest research on the matter, very few LPAs specifically exclude travel expenses in relation to deal sourcing, networking and preliminary due diligence from partnership expenses. This goes against ILPA principles, which recommend GPs should cover such costs under the management fee.

As more LPs become aware of this grey area, O’Shea has noticed some LP pushback on travel costs. He says: “Some LPs will request use of commercial airlines instead of charter flights.”

Negotiating the finer details of LPAs can bring up some potential red flags. Fund managers need to decide what they are willing to sacrifice and what terms are absolute deal breakers.

Two-way process
Just as red flags in the ocean denote the dangers of choppy waters, GPs need to assess their own red flags when it comes to investor onboarding. While LPs will also carry out their own due diligence processes to vet fund managers, it is a two-way process with evolving risks.

The first step is to consult the regulation at hand in the jurisdiction in question. Guides such as the Joint Money Laundering Steering Group are great for outlining definite warning signs.

After that, each GP must align its chosen LPs with its own philosophies and assess their suitability on a case-by-case basis. Otherwise, a calm sea can quickly turn into choppy waters.

Categories: AnalysisESGESG policyFundraising & fund structuringODD / DDQOutsourcingLegal & compliance advisory

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