Joseph W. Bartlett, Co-Chair of VC Experts & Special Counsel, Reitler Kailas & Rosenblatt LLC
The fund raising process for most of the private equity funds … venture, leveraged buyout, secondary and others … is an arduous business. Alan Patricoff remarked several years ago that after he split from Apax to form Greycroft it took him, a Hall of Fame venture capitalist, three years (as I recall) to reach a final closing on the fund he was sponsoring.
Accordingly, it is customary for funds to employ experienced placement agents to assist in the fund raising process. The onus, of course, is on the principals of the fund to display and defend their track record or records in the business and manage face-to-face meetings during the various road shows they undertake. The placement agent, however, is useful as a time saver and a focus group, if you will … arranging meetings, gauging interest and commenting on the placement materials, pointing out the hits, the runs, and the errors in order to enable the fund managers to upgrade the same. In the process of reviewing a placement agent agreement for a recent client, it occurred to me that there needed to be some thought given to one of the conventional sections in the placement agent agreement … the indemnification provisions.
The limited partnership … a/k/a the Fund … should not be a primary party to the agreement with a broker (“Broker”), in my view. In particular, the Indemnification provisions which the Broker asks the Fund to endorse make little sense (to me, anyway) because the waterfall is circular. Let’s say the indemnification claim against the Fund is that the Broker had to respond to the aggrieved parties (who will be the investors in the Fund, of course) who lost money because of inadequate and/or inaccurate information in the placement memo which the Broker had a hand in distributing to the investors. If the principal indemnitor of the Broker for misinformation is the Fund, however, the damages may well (I conclude) undergo a round trip.
A hypothetical illustration
The Broker is sued and is liable, let’s say jointly and severally with the spinouts, for damages in the amount of losses in the portfolio. The Broker then pays the damages and levies a claim for indemnification against the Fund for the same, which the claimant(s) allege were caused by the lack of transparency in the placement memo. The assets of the Fund, however, are comprised of money and property (unrealized portfolio investments) which belong to the plaintiffs in the law suit against the Broker … the LPs in the Fund. Follow the bouncing ball.
Investors (LPs) put $5 million into five investments. The investments stagnate … no exits, contrary to projections in the placement memo which forecast a 2x (at least) return. The Investors sue the Broker for their opportunity costs based on falsified expectations and recover a $2 million award. Where does that come from? The Fund. What is in the Fund? The investors’ property, i.e., the remaining portfolio assets which have not yet gotten off the ground. (If the Fund has insurance, possibly another story; but representations and warranties insurance is expensive … and no party would pay for it.
In fact, the only parties the Broker should go against for misinformation in the solicitation material are the assets of the General Partner and the Management Company and, if the veil can be pierced, then the principals. They are, accordingly, the enterprises which should be selected as the indemnitors. To paraphrase an old maxim, circularity breeds contempt.
In fact, although not expressly on point, I am increasingly suspicious of indemnification obligations in favor of a Broker executed by customers of the Broker. A somewhat bizarre example of how the waterfall can get reversed is found in a case which coincidentally was written up in the NYT on the 17th. Take a look at the attached and see the argument advanced on behalf of Reef to recover legal expenses of $400,000 “or more.” Brokers Countersue to Thwart Suits by Unhappy Investors