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The perfect storm: Alternative asset managers face unparalleled pressure on legal resources

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As every sector of the economy reels in its own way from the impact of the global Covid-19 pandemic, there are few quite so universally affected as alternative asset managers.

Sitting on portfolios that in many cases represent a microcosm of economic activity, they are simultaneously responding to serious challenges at an operational level among their existing investments while also looking to take advantage of market dislocation and deploy capital and execute new transactions.

With significant regulatory and political attention on the alternatives industry, growing calls from investors for enhanced transparency and reporting, a spotlight on environmental, social and governance (ESG) issues and an ongoing commitment to lean and agile operating models, it is little wonder resourcing challenges are moving up the agenda.

Peter Myners, a partner with Allen & Overy in Luxembourg who advises many alternative asset managers, says: “Obviously Covid has had a big impact in terms of current behaviour, both from the defensive perspective of managers taking care of existing investments, injecting liquidity and even potentially pulling out of some investments, but also from an offensive perspective. This market is creating opportunities and many of the big players have been waiting for something to happen to create dislocation. It had become massively competitive in terms of sourcing and bidding on deals.”

With some managers heavily exposed to severely impacted sectors such as travel, tourism, leisure and retail, there is the potential for them to be feeling both bruised and bullish in equal measure.

When we talk about alternatives, we include a wide range of asset classes ranging from private equity and credit through to real estate, infrastructure, hedge and distressed debt. While distressed strategies are in particularly high demand today, all are expecting investors to continue making sizeable allocations as they seek out higher risk-adjusted returns in the face of an ongoing low interest rate environment and public market volatility.

“We are continuing to see alternative investment firms diversify,” says Myners. “They are adding different strategies either organically or by acquiring other asset managers, and they are also diversifying across geographies and deepening their sector knowledge. At the same time they are becoming more institutional in the way that they operate and more organised in the way that they look to source legal services.”

The pressures on their legal and compliance capabilities are so fluid, however, that the greater deployment of interim talent is becoming a more common way to manage increasing demands on in-house legal whilst managing costs.
 

Regulatory pressure

The alternatives industry has long been under pressure and scrutiny from financial markets watchdogs around the world. The market is becoming subject to increased regulation while at the same time facing public scrutiny overtaking government support for portfolio companies, for example.

Myners says the biggest regulatory issue facing these firms in Europe right now is Brexit: “Clearly that is a big topic for some managers, and it is back on the table” he says. “That is obviously not triggered by the pandemic crisis, but it looks like it is going to hit harder now. These funds are back into contingency planning for a hard Brexit. One of the key features of that planning has been the extent to which you can delegate to different markets or countries to comply with authorisation requirements, and some of the solutions are impacted now that travel has become so challenging.”

Private debt funds are currently subject to relatively light regulation but as their role as an alternative to bank lenders increases, and with the potential for loan defaults and challenging times ahead, managers may find themselves under greater regulatory scrutiny. Likewise, in the pipeline for all alternative investment funds is the European Commission’s latest iteration of the Alternative Investment Funds Directive (AIFM), with new rules due to come into effect in 2021.

Paul Loynes, an experienced private equity lawyer who has worked in general counsel roles at SoftBank Investment Advisers and Apollo Global Management, is bullish on the regulatory issues. He says: “People feared that, because alternative asset managers had expanded so much and many had effectively become shadow banks, more regulation might be coming. I suspect governments are going to be too busy to really crackdown on the industry, but instead I can see more pressure coming from investors.”

Limited partners are making heightened demands when it comes to transparency, more in-depth and frequent reporting, and better embedding of ESG, and with so many managers to choose from, they are able to be increasingly picky about where they put their money to work. Many in the market anticipate a flight to quality as larger, more established fund managers continue to receive commitments from big investors while first-time funds and smaller players will need to be creative to stand out against long track records and scale.

“Investors are likely to be asking a lot more questions about ESG, about how firms have treated employees during lockdown, for example, and about community involvement,” says Loynes. “The pressures on compliance at these firms will only increase, albeit coming not so much from legislation but from investors.”

ESG is a hot topic, calling on fund managers to plan, manage and implement both sophisticated strategies and better reporting. Myners says: “Most fund managers are now embedding ESG much more structurally into their investment decision-making processes, making it a key element of diligence and ongoing reporting and being very transparent about it to meet investor demands.”
 

Fundraising demands

This growing pressure from investors also plays out in the fundraising phase, which is becoming an ever-more intensive crunch point for in-house teams at alternative investment managers. While investments, portfolio management, and exits demand extensive legal input, many in-house functions come under particular pressure at key points in the five- to eight-year fund lifecycle.

Most challenging is the fundraising process: “Investors are demanding more and more specific terms,” says Myners, “which may mean an increasing number of bespoke terms and side letters being negotiated, as well as greater resourcing needs around due diligence, investor onboarding requirements and reporting. Alternative investment managers often require additional legal and compliance capacity to be able to respond to those requests. We see a lot of managers looking for secondments from law firms during the fundraising stage.”

Further resourcing challenges can arise when new regulations are introduced, such as AIFMD II, or if managers face regulatory investigation.

Loynes says: “If you’re raising a fund, you need a different type of additional legal support to when you’re in spending mode. If you are putting a fund finance facility in place, you will only ever do that once in the life of the fund but you will need legal support to do that. If the average life of a fund is seven years, you spend a year setting up, four years deploying capital, and the final two managing and exiting those investments. During that time, your legal needs are going to vary enormously.”
 

Keeping lean

Alternative asset managers have so far shown no inclination to emulate the big banks or corporates and build large internal legal resources. Instead, managers prefer to run lean and focused operations.

Myners says: “One distinct feature of this industry is the leanness of these organisations. As a result, some of these players are starting to get much more sophisticated about how they approach legal services.”

While the industry has historically had little problem attracting from the elite talent pool in the market, remuneration may become an issue for some funds in the face of lower performance, growing scrutiny of overheads, and management fees. Likewise, permanent hiring may prove difficult at a time when risk-averse individuals will be more likely to stay in their current roles.

With so many pressures on internal legal and compliance resources right now, gaps could be best filled by making use of interim access to a top-level skills base while simultaneously continuing to recruit in the market for the best people.

As these funds grow and diversify, they are starting to institutionalise and explore new options for meeting short-term legal requirements.

Loynes concludes: “This is the time for these funds to get their housekeeping in order. They have been travelling around the world doing deals for the last few years, but now they can pause to look at their infrastructure and think about how they will cope with the next wave of transactions, which will inevitably come in around nine months’ time. The good firms are looking inward now and thinking about how they can best structure their legal functions to be nimble and capable of turning things around quickly. It is highly likely that will involve the greater use of interim legal resources.”

He adds: “What is certain is that the ones who succeed will be the ones at the block ready to go on the next deal-making frenzy, even though no one really knows when the starting gun will fire.”

To find out how your business can benefit from interim resources contact Catriona Blamire