Considerations for Starting a Private Equity Fund
As private equity firms continue to succeed and become ever prevalent in the alternative investment space, more aspiring portfolio managers are joining the race to launch their own private equity fund. While today there are many successful and large private equity firms, many of the firms in this space are small-to-midsize shops with employees ranging from just a few to several hundred. The following summarizes several steps that managers should follow to launch a private equity fund.
Outline Your Business Strategy
Establishing a business strategy requires a significant investment of time, effort, and research to determine and answer many questions. For example, will your fund focus on a specific sector or industry? Will you have a geographic focus, such as on one region of the United States, an individual foreign country, or certain emerging markets? Ultimately, potential investors will want to know more about your fund's strategy, so being prepared to address these and other relevant questions will go a long way in helping you to raise capital for your new fund.
Setting up Operations and a Business Plan
Starting your own private equity fund is in many ways not that different from starting any other business. You're going to need a business plan which, among other things, calculates expected cash flow and establishes your fund's timeline, including the capital-raising period. Private equity funds generally have an average life of 7 to 10 years, although it is usually up to the manager's discretion and the execution of a solid business plan. A sound business plan contains growth strategies, a marketing plan, and a detailed executive summary with a conclusive section tying all these areas together.
Once a business plan has been completed, you should begin to meet with external service providers and consultants, such as accountants, attorneys, and other industry specialists, who can assist you with effectively and efficiently refining and executing your business plan.
Another important step is to form a firm to manage the fund and determine a fund name. The fund manager must decide on the roles and titles of the firm's leaders, such as the role of partner or portfolio manager as well as the establishment of a management team, including the CEO, CFO, CIO, and CCO. At launch, however, it may be wise to outsource some of these functions to allow you time to execute your business plan while keeping costs in check.
If you plan to raise a fund in the U.S., you may already know that fundraising is heavily regulated and that there are numerous legal and regulatory requirements that a fund manager must adhere to in order to comply with securities laws. The Securities & Exchange Commission (SEC) takes this compliance very seriously and a qualified attorney needs to be involved in the process early to make you aware of the rules and regulations associated with fundraising, investing, and managing the fund. Here are some key questions to discuss with your attorney.
- Who will I be able to raise money from?
Regulations offer various options for a fund manager raising money, primarily depending on, and related to, the type of investors, the type of marketing, and the amounts being raised.
- How can I raise the money?
In addition to understanding which investors can participate in a fund, a fund manager should understand how those investors may be approached to invest. The fund manager will need to think carefully about what the message to investors will be and how it will be delivered.
- What kind of money can be invested?
Another concern is the type of money that a fund or fund manager can accept. There are a variety of restrictions in this area, but the two most common are investments from retirement accounts and investments from foreign accounts. Each of these areas creates potential issues regarding how a fund manager can invest, manage and report results to investors.
- How much will the legal work cost?
Every fund and every attorney are different, but you can expect start-up legal costs to run from $50,000 to more than $100,000.
By limiting the fact-finding phase of fund formation, a fund manager can focus their attorney’s time and effort on key compliance questions and avoid expensive discussions and rewrites. Having your fund’s marketing materials and a draft of its investment strategy and fee structure ready for review as you begin the legal process will also help to control legal costs as you look to launch your private equity fund.
Setting Up Your Fund Structure
In the U.S., a fund is typically organized as a limited partnership (LP) or a limited liability company (LLC). As a founder of the fund, you will be a general partner or managing member empowered with the right to decide the investments that make up the fund portfolio. Your investors will be limited partners who will not have the right to make any decisions on behalf of your fund or fund investments. The structure of a private equity fund is dependent on several tax, regulatory and financial considerations, usually driven by the tax needs of the investors. Some private equity fund features and potential structures are discussed briefly below.
Private equity funds are usually closed-end investment vehicles, which means that there is a limited window to raise funds and once this window has expired, no further funds can be raised. Investor capital is typically committed at the onset of the fund and is called by the manager periodically as investments are made. Investors in a closed-end fund are generally not permitted to make withdrawals or additional capital contributions during the life of the fund and after the committed capital period. Some funds may provide for additional contributions for follow on investments in portfolio companies the funds already own. Once funded, an investor’s capital will be returned only upon the sale or restructuring of fund portfolio companies or positive cash flow from portfolio company operations.
With a closed-end fund, once an investment is sold, the sale proceeds generally cannot be reinvested in that fund. Rather, the fund manager would create another fund to allow investors to reinvest, the cost of launching these successive funds can be significantly less than the initial fund since less legal assistance is required and other administrative costs will be shared across all funds.
Fund Structure Options
Most private equity funds domiciled in the U.S. are organized as LPs since such a structure generally avoids double taxation of investment returns and grants limited partners (your investors) limited liability protection, thus shielding them from losing more than their investment. An onshore fund is a U.S.-based investment fund structure that typically includes an LP as the fund vehicle, an LLC as the investment manager of the fund (although an LP or an S corporation may be used and could be more favorable for tax purposes), and a general partner of the fund (managing member in the case of an LLC).
An offshore fund, also known as a blocker fund, blocks offshore and tax-exempt U.S. investors from direct U.S. tax exposure. There are a number of ways to structure your offshore fund and the best option for you will depend mainly on the location of the fund manager, types of investors in your fund, and the type of investments that the fund will make. The three most common structures used for offshore funds are briefly described below.
- Offshore Only - An offshore standalone fund is a structure where only one fund is used and that fund is offshore (generally in Cayman, Bermuda, or the British Virgin Islands). This structure is used by managers who have no U.S. presence and whose fund is solely geared towards non-U.S. investors as well as tax-exempt U.S.-based investors who want to avoid unrelated business taxable income (UBTI).
- Master-Feeder - A master-feeder structure is generally used where there is a U.S. presence and where a manager is looking to raise capital from both U.S. and non-U.S. or tax-exempt U.S. investors. This structure includes a master fund (an offshore fund which is either an LP or a corporate entity, often referred to as an LTD, which makes an election to be treated as a partnership for U.S. tax purposes), which conducts the fund’s trading/investing objectives, and an onshore feeder and offshore feeder that invest all of their assets into the master fund.
- The onshore feeder will generally be structured as a U.S. LP or LLC and is where the U.S. taxable investors will invest. Using an LP or LLC, which is a pass-through entity for U.S. tax purposes, allows the master fund’s profits and losses to be allocated and passed through to the U.S. investors and thus taxed at the investor level. There is no entity tax at the master fund level in the offshore jurisdiction thereby avoiding double taxation.
- The offshore feeder is structured as an offshore fund (see Offshore Only section above) and is where the non-U.S. and U.S. tax-exempt investors will invest. Investment into the offshore feeder means that any U.S. tax exposure arises at the master-feeder fund level and does not affect the offshore feeder investors themselves. Non-U.S. investors who are not generally required to file U.S. tax returns, prefer to invest through an offshore fund to avoid exposure to any U.S. tax or filing obligations. If non-U.S. investors invest directly into a fund structured as a partnership, they could be deemed to be engaged in the business of the fund and, to the extent that this includes any U.S. trades or business, could be required to file a U.S. tax return and be liable to pay U.S. taxes. For similar reasons, U.S. tax-exempt investors invest through the offshore feeder as well. Tax-exempt U.S. investors could be liable for income tax on any income from U.S. trades or businesses which are not substantially related to their tax-exempt purpose, known as UBTI. Therefore, if they invest in a fund that is a partnership, they are treated as participating directly in the activities of the fund, which may include investments in U.S. trades or businesses.
- Side-by-Side - Similar to a master-feeder structure, a side-by-side structure is used when a manager is looking to raise capital from both U.S. investors and non-U.S. or tax-exempt U.S. investors who have differing tax concerns. In this structure, two funds, an offshore and domestic U.S. fund, are formed and both are managed and operated in the same way. The main reason for choosing the side-by-side structure over the master-feeder structure is to enable tax structuring measures for one fund independent of the other. A side-by-side structure generally includes a U.S.-based fund and an offshore-based fund that parallel each other in their trading/investing objectives and have the same investment manager, but that can also maintain separate investment portfolios.
Fund Expenses, Fees and Distribution Waterfall
One of the most important areas to address when forming your private equity fund is to set the fees that will be charged to your investors. Well-thought-out and sound private equity fund offering documents contain terms that look to protect the fund manager and that are amenable to potential investors. Accordingly, the following will focus on private equity fund industry best practices regarding fund expenses, fee terms, and distribution waterfalls.
- Fund Expenses – Expenses such as legal, fund administration, tax preparation, and audit fees are generally the costs to set up and run a private equity fund. The fund generally bears expenses directly related to forming and operating the fund. Overhead expenses are typically the responsibility of the fund manager. Your fund documents should clearly state which expenses will be borne by the fund and its investors and which by the fund manager. Quite often an expense cap is placed on the amount of expenses that can be charged to the fund, with the excess to be paid by the fund manager.
- Management & Incentive Fees – Private equity fund managers generally charge their investors an annual management fee as well as an incentive fee (also known as performance fee or carried interest). Management fees typically range from 1.25% to 2.00% and are generally charged on committed capital, regardless of whether the capital has been called or invested. Incentive fees generally range from 15% to as high as 30% and represent an allocation of appreciation of assets or net profits by the fund. However, for the fund manager to begin receiving carried interest, the fund must first achieve a stated hurdle rate (also known as the preferred return).
- Distribution Waterfall – Defines the economic relationship between the fund manager (general partner) and the investors (limited partners). There are four primary components to a distribution waterfall:
- Return of Capital – All distributions go to the fund investors until they have received back their full committed capital contributed to the fund.
- Preferred Return – Fund investors will continue to receive all distributions until the fund has achieved its preferred return (or hurdle rate). These percentages can range from 6% to 12% of the investor’s contributed capital, are compounded annually, and are generally defined in the fund’s offering documents.
- Catch-up Provision – Once the fund has returned all capital to its investors as well as the preferred return, the fund manager (general partner) is then able to start collecting carried interest. This is generally calculated by going back to the first dollar of net profits of the fund, and allows the fund manager to retain most of the fund’s future profits until it has received its stated share (assume 80% if the carried interest rate was 20%).
- Remaining Distributions – After the fund manager has received its carried interest for fund returns beyond the preferred return, all remaining distributions are then allocated between the limited partners and the fund manager at the rate specified in the fund offering documents. For example, if the carried interest percentage is 20%, the remaining distributions would be allocated 80% to the limited partners and 20% to the fund manager.
While the above four components are standard across most private equity funds, some variations are worth mentioning here. The most common variations are the European waterfall and the American waterfall.
- The European waterfall is where the carried interest is calculated at the fund level across all portfolio company deals. In this scenario, the fund manager does not begin to take any carried interest until the fund has returned all limited partner contributions across all portfolio company deals as well as delivered the preferred return.
- The American waterfall is calculated on a deal-by-deal basis whereby the fund manager is compensated for each successful deal. This allows the fund manager to begin taking carried interest earlier in the life of the fund but can also result in the fund manager receiving carried interest on a fund that is underperforming its preferred return (or hurdle rate), as long as there are individual portfolio company deals that have outperformed the preferred return. For funds that use the American waterfall, a clawback provision is needed and should be included in the fund offering documents. Such a provision allows investors to recoup the carried interest at the end of the fund’s life if the fund underperformed in total and the fund manager collected more than its share of the overall fund’s net profits.
Raising money for a new private equity fund manager can be a formidable task if the fund manager is unprepared. Engaging an experienced attorney and other relevant service providers should assist and help to reduce fears related to this endeavor. Items such as the offering memorandum, subscription agreement, fee terms, marketing materials, and due diligence questionnaires should be prepared in advance of meeting with potential investors.
Potential investors will also want to see a “meaningful” contribution from the fund manager (or fund management group) to better align their interests. Based on our experience and industry standards, fund managers have generally provided at least 1% to 3% of the fund's total capital commitments.
At some point, while raising capital for your fund, you will most likely be asked by one or more potential investors to enter into a side letter. A side letter is an agreement between the fund and an investor to vary the terms of the limited partnership agreement concerning that particular investor. Some of the most common side letter requests from investors are for a partial or complete waiver of the fund’s fees (management fee, carried interest, or both), to reduce the lock-up requirements (which would give them the right to withdraw capital at an earlier date than other investors) and “most favored nation” clauses (which would, in essence, give that investor the right to obtain any benefit granted to other investors via a side letter). Tread lightly and carefully when assessing each side letter request from potential investors and seek legal assistance in drafting and negotiating such agreements.
Audits and Taxes
You will need to engage an accounting firm to perform an annual audit of your fund and to prepare the fund’s tax returns (including Schedule K-1s that you will need to provide to your fund’s investors). It is prudent to meet with a firm like Anchin, which is experienced with start-up private equity funds, before you finalize your legal documents so that you can discuss and better understand the tax issues involved with your particular fund strategy, and fund investors and investments. These include reviewing fund and related-entity structures, identifying requisite Federal and state tax filings, potential issues related to foreign investors, foreign investments, retirement plans, beneficial tax elections, your plan for manager and employee compensation, and the overall tax impact of running your fund. Preferably, you should look to hire a firm to partner with that not only covers the basics for your accounting needs but is also capable of helping as you grow your fund. The firm should be actively working with you to minimize tax exposure and to consult and advise on your operations. Look for a firm with a strong reputation for working with emerging managers, as larger accounting firms may not be initially focused on your start-up needs. A coordinated and experienced audit and tax team focused on your business and personal needs are what you will need as you launch your new fund.
Starting a private equity fund can be challenging, especially for those who don’t have any experience in doing so. It requires partnering with experienced professionals and a tremendous effort to refine your business strategy, develop your business plan and build your team. The above steps can be used as a roadmap for establishing a successful fund. For more information about what is involved in launching and operating a private equity fund and how Anchin’s Emerging Manager Platform can assist, please contact us.