Private funds frequently negotiate for special rights when making an investment in a portfolio company, such as the right to appoint one or more board directors, voting rights, and liquidation preferences. Fund sponsors often focus solely on the positive aspects of these special rights, such as increased control, without considering fully other implications. As the Peter Parker principle reminds us, with great power comes great responsibility. In the fund context, sponsors should remember the portfolio company corollary: with greater control comes greater exposure to liability.
The Portfolio Company Playbook – Chapter 1: A Fund Sponsor’s Guide to Navigating Risks, Conflicts, and Regulatory Concerns Arising from Portfolio Companies
Over the last few years, we have seen an uptick in litigation claims against sponsors and funds arising out of their interests in portfolio companies. A fund sponsor’s participation on a portfolio company board, in particular, is a risk factor for the entire investment structure (the GP, the Management Company, individual members of the GP and Management Company, and the Fund) due to conflicts of interest, whether real or perceived, and related competing fiduciary duties. There are, however, steps that fund sponsors can take to manage and reduce their risks. The first step is to develop a full understanding of where, and why, risks lie in the investment structure. With that understanding, sponsors can develop and implement practices to manage and reduce those risks.