Agefi Luxembourg - novembre 2024

Novembre 2024 33 AGEFI Luxembourg Fonds d’investissement By Andrei PLACINTA, Senior Associate - Alternative Investment Team,MCSquare Luxembourg Existing Contractual Framework Between Limited Partners (LP) and Fund General Partners (GP) I n the fund industry, LimitedPartners (LPs) andGeneral Partners (GPs) enter into a commitment agreement. Under this agreement, LPs commit toproviding capital contribu- tionswhen calledupon, while GPs undertake responsibility formanaging the fund’s op- erations and investments.Ac- cording to the terms, LPs are obligated tomeet capital calls as requested; failing to do so constitutes a default, re- sulting in forfeiture of prior contri- butions and terminationof their rights within the fund. Conversely, the GP, as outlined in the issuing doc- ument, assumes responsibility for the information contained in theofferingmemorandum,whichout- lines the fund’s operational framework for its term. Standarddisclosureswithin thememorandumtyp- ically include: 1. RegulatoryApproval : “The contents of this docu- menthavenotbeenreviewedorendorsedbyanyreg- ulatory authority in any jurisdiction.” 2. GP Responsibilities : This section details the GP’s managementdutiesbutnotablylacksreferencestoGP performanceobligationsorrisk-sharingmechanisms. Once the contract is signed, LPs are bound to pro- vide their committed funds as called upon. The GP, meanwhile, is obligated to act in good faith, priori- tizing the fund’sbest interests, but retains significant autonomy. The GP is contractually assured steady remuneration regardless of the fund’s performance, bearingminimal riskor consequences related toany potential underperformance. Insummary,thecontractualframeworkentrustsfund management to the GP, relying on their expertise, skills, andexperience toachieve the fund’s objectives. GPCompensatory structure The General Partner (GP) is compensated for its ex- pertise in managing the fund. In most agreements, GP remuneration follows a hybrid structure: a fixed fee (management fee, typically around 2%) and a performance-based variable fee, known as carried interest,which isgenerally20%of any returns above a specified threshold. The fixed management fee is commonly structured as a percentage of committed capital during the in- vestmentperiod,shiftingtoapercentageofNetAsset Value(NAV)orstaysoncommitmentbasisevenpost- investmentperiod.ThissetupallowsGPstoearnfees basedonthemostfavourablemetricatanygiventime. Questions of Legitimacy inFixedFees 1. Fixed Fee on Committed Capital : The first point of contention is the legitimacy of basing GP fees on committed capital, espe- ciallywhen this capital may not be actively deployed, creating no value for Limited Partners (LPs) or the broader investment ecosystem. 2. Fixed Fees During Prolonged Under- performance : Another concern is the ra- tionale behind steady GP remune- ration on this same favourable basisevenduringextendedpe- riods of underperformance, raising questions about the alignment between LP inter- ests andGP compensation. The validity of these fees be- comes even more contentious when considering the broader picture: theGP, agroupof individ- uals steadily compensatedonapref- erential basis throughout the fund’s lifespan (oftenaround10years), does sowithout bearing risk or consequences for underperformance. GPs are contractually obligated only to an obligation of means, rather thananobligationof results,meaning their duty is to apply their expertise rather than guarantee specific outcomes. Broader Implications of the Fee Structure for LPs For LPs, the scenario is further compounded by the fact that, even in cases of sustained underperfor- mance,othersassociatedwiththefund—suchasser- vice providers, auditors, and especially the GP—continuetoprofit.Feesforserviceprovidersare usuallyjustifiableastheyensurefundadministration and fulfil contractual duties. However, GP fees, which are intended to reflect expertise and drive value creation for LPs, become questionable when GPskill andstrategy fall short, deliveringsteady fees to theGP yet limited value to LPs. Ultimately, the topic of LPprotectionwithin fund in- vestments extends beyond the problematic fee struc- ture.Additionallyofbearingtheinvestmentrisks,the LPs are exposed continually to moral hazard which is strengthenedby actual fee structure. LPExposure toMoral Hazard Moralhazardcanarisewhenevertwopartiesenteran agreement,whereeachmayhaveopportunitiestoact contrary to the intendedprinciples of the contract for personal gain. Asoutlined,theofferingmemorandumisparticularly stringent for LimitedPartners (LPs), leavingno room for them to exploit any contractual ambiguities. In contrast, the agreement provides General Partners (GPs)withsufficientflexibility,exposingLPstomoral hazard by allowing GPs to transfer all risks and po- tential losses toLPswhile sharinganygains. Thisun- balanced risk-rewarddistribution inherently favours GPs,astheyfacenoconsequencesforadditionalrisks, thus amplifyingmoral hazard concerns. Moreover, the current fee structure incentivizesGPs to take on higher risk to boost returns or recover losses in certain cases, as their carried interest is strictlyperformance-based.Consequently,GPshave boththeopportunityandincentivetoincreaseLPex- posure to moral hazard—an action which, while contractually compliant, may conflict with the LPs’ best interests. While bearing investment risk is an accepted part of the agreement, moral hazard emerges as a potential consequence of an existing framework that inade- quately regulates GP obligations to LPs, particularly in cases of fund underperformance. Currently, the legal framework governing funds, as set out in offer- ing memorandum and commitment agreements, does little tomitigate thishazard, nordoes regulation requireGPs to act beyond these terms. In summary, LPs face a substantial moral hazard in today’s framework, where GPs operate within con- tractuallypermissibleyetpotentiallyadversepractices. Thelackofmandateddutiesandthesubjectivenature of GP actions can complicate efforts to protect LP in- terestsandmayultimatelyleadtolegalchallengesthat are difficult to resolve in favour of LPs. Legitimacy of Enhancing LP Protection in Fund Investments As previously discussed, Limited Partners (LPs) face significantmoralhazardexposureandarefurtherob- ligated to participate in a fee structure that steadily compensatesGeneralPartners(GPs)underalmostall circumstances,increasingthepotentialformoralhaz- ard.ThisresultsinadisparitywhereLPsupholdtheir contractual commitments, yet an underperforming GPcancontinuereceivingcompensation,despitenot meeting the fund’s intendedobjectives. This imbalance questions the fairness of the existing framework,particularlyconsideringthebroaderim- pactofthesefundswithinacapitalisticsystemreliant oncontinualeconomicandsocietaldevelopment.LP investments indirectly contribute to economic growthasthesefundsareallocatedtoenterprisesex- pected to create societal value. Furthermore, the cir- culation of this capital supports employment and stimulates activityacross various stakeholders, such as regulators, auditors, service providers, and the staff of investee companies. Incontrast,theGPservesasthestewardofthiscapital flow and, both contractually and civically, has a re- sponsibilitytoensurefundsreachcapableandrespon- sible investees capableof creatingvalue forLPswhile contributing toecosystemgrowth. This role implies a duty todirect capital thoughtfully,maximizingvalue creation and fostering economic development. Inconclusion,theGPholdsasignificantresponsibility toward LPs and indirectly impacts ecosystemdevel- opment.Giventhiscriticalrole,itischallengingtojus- tify a contract structure that provides the GP with a steady, derisked income without any obligation to achieveresults.Thisframeworksuggestsaneedtore- assess contractual terms, better align GP incentives with LP objectives, and reinforce protections against moral hazard. EnhancingGPResponsibility in FundManagement Given that fund performance is the most direct and quantifiable measure of a General Partner’s (GP) ef- fectiveness, it could serve as the foundation for bol- stering GP responsibility and, in turn, protecting LimitedPartners(LPs).Whileit’sreasonablethatGPs maintainacertainlevelofincomesecurity,especially given the potential influence of unpredictable exter- nal factors, the current structure—where GPs are largely shielded from risk and benefit from a favourable fee arrangement—does not represent a balanced or fair contractual setup. Measures to address this imbalance could focus on compensation adjustments to better alignGP incen- tives with fund performance. Potential changes could include: 1. Risk-sharing Compensation Structure : One ap- proach is to require GPs to invest a portion of their compensation directly into the fund. This approach alignsGP interestswithLPobjectives anddistributes some of the investment risk toGPs. 2. Performance-basedAdjustments :Another option is to revisit thefixedcompensation tied tocommitted capital, which does not directly reflect fund perfor- mance.Forexample,remunerationcouldbepartially adjusted or scaled back in cases of sustained under- performance, making compensation more reflective of theGP’s actual contribution to fundoutcomes. Ultimately,anysolutionshouldseektoprotectLPin- terests while ensuring GPs remain incentivized and legally accountable for actions taken in bad faith or thatfallshortofthefund’sgoals.Byfosteringaccount- ability and aligning incentives, thesemeasures could create a more balanced partnership, fostering long- termgrowth and stabilitywithin fundmanagement. Potential Benefits of Regulatory Updates for the Fund Industry Strengthening LP protection through targeted regu- latory updates could encourage LPs to view invest- ment funds as a safer andmore attractive option for allocatingtheircapital.EnhancedLPprotectionsmay build LP confidence, potentially increasing the flow of funds into the sector. Suchupdateswouldprovide LPs with greater security and reduce the appeal of fundmanagementforGPswholacksufficientexper- tise or resources to generatemeaningful returns. Key regulatory adjustments, such as limiting steady fees for GPs or implementing broader risk-sharing mechanisms, could discourage underqualified GPs fromentering themarket. These steps could lead to a more refined pool of fundmanagers who are skilled andwell-resourced todeliver consistent value. In turn, theseupdateswouldyieldcollateral benefits. By curbing the establishment of funds managed by high-risk, low-skill GPs, capital would be allocated moreeffectively,contributingpositivelytothebroader investment ecosystem. Rather than being directed to funds where inexperienced GPs seek to exploit a favourable risk-reward imbalance, LP investments couldflowtowardfundsthatprioritizevaluecreation and long-termgrowth. Regulatory Gaps: Refining LPProtections in Fund Management –APath Forward F undcraft, a leader in digital fund operations, announces the final closing of its SeriesA round with a €6million investment ledby 3VCandMid- dleGameVentures. This in- vestment builds on the first closing of €5millionSeries Aannounced inMay 2024, whichwas ledbyAperture Capital withparticipation fromSIXFintechVentures. With a total amount raised of €11million this year, fundcraft is positioned to ac- celerate its product and geo- graphical expansion and cement its standing as Eu- rope’s premier digital fund operations provider. The additional injection reflects continued confidence from in- vestors and thebroadermarket in fundcraft’s innovative approach to re-architecting fundoperations through combining advanced technology and expert services. The success of its innovative ap- proach is reflected in rapid growth: since the initial Series A announcement in May 2024, fundcraft has achieved a 60% in- crease in the number of funds managed, representing more than€8.1 billion in commitments. Julien De Mayer, Founder and CEO of fundcraft, stated: “This additional investment builds on our strong momentum as we continue to deliver on our mis- sion to digitise and transform fund operations for alternative asset managers. Together with co-foundersOlga Porro andVic- tor Martin, we see a unique op- portunity to accelerate our expansion, delivering solutions that no other competitor can cur- rently match. The support and endorsement from 3VC and MiddleGame Ventures, two leading VC firms dedicated to category-defining companies, enables us to scale faster and seize this market opportunity with confidence.” The additional funding will sup- port several key initiatives: - Product development: fundcraft will accelerate thedevelopment of its digital fund operations plat- form,focusingonautomation,op- erational efficiency, and transpa- rency to meet growing demand from alternative investment asset managers—notably mid-market PE funds with complex needs for integrateddigital solutions, build- ingontopofitsalreadyprovenso- lutions for Venture Capital and Fundof Funds. -Geographicexpansion:fundcraft aimstodeepensupportacrossEu- rope,servicingfundsdomiciledin international markets beyond Luxembourg, as the increasing focus on alternative investment markets and the need for digital fund operations rises. - Talent acquisition: fundcraft will continue building top-tier teams infundoperations,digitalproduct development,andsales&market- ing to support client needs and seizemarket opportunities. fund- craftrecentlyhiredCraigPerrinas ChiefRevenueOfficer,leveraging his expertise in securities services and scaling fintech companies to deepenrelationshipswith institu- tional clients and scaling rapidly acrossEurope, theUK, andwider international markets. Eva Arh, Partner at 3VC com- mented: “fundcraft’s product and vision position them as a standout leader in digital fund operations. In a market where fund managers often struggle with cumbersome and inefficient fund admin processes – relying on manual tasks, back-and-forth emails, and Excel sheets – fund- craft brings a proven solution to established firms looking to launch new funds or migrate ex- isting ones on a digital platform. This alignsperfectlywithour the- sis of investing in category-defin- ing products, andwe’re proud to support fundcraft as they scale rapidlyacross Europe, reshaping operations for thenext generation of alternative asset managers.” Pascal Bouvier, Managing Part- ner at MiddleGame Ventures added: “As a strategic investor and a client of fundcraft, we see firsthand how their digital fund operations suite streamlines fund administration. Our investment underscores our confidence in fundcraft’s ability to set newstan- dards in efficiency and trans- parencywithin the industry.” For furtherdetails ,pleasevisitwww.fundcraft.lu fundcraft Increases SeriesA to €11 Million Demonstrating Strong Product-Market Fit