10 Issues to Consider in Creating a Private Equity Fund

2 septembre 2013

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A range of issues characteristically arise in the creation of a private equity fund. While obviously far from exhaustive, the 10 items discussed below tend, in our experience, to be among the more common issues that arise in PE fund formation in Canada.

By way of background, private equity funds established in Canada are typically structured as limited partnerships (LPs) to allow flow-through tax treatment for fund gains and losses. As in any limited partnership, PE funds have both a General Partner and a number of Limited Partners. At a high level, the roles of the General Partner and the limited partners at the formation stage are as follows: when a fund goes to market for the first time, the General Partner typically prepares a term sheet summarizing the structure of the fund. This term sheet is typically reviewed by one or two potential “anchor” Limited Partners. Once the term sheet has been negotiated to their satisfaction, an offering memorandum incorporating the terms is generally prepared and a more detailed marketing process is undertaken for investment by other potential Limited Partners. At that point, drafting of the limited partnership agreement will typically begin. During the negotiation and drafting process, the 10 issues below are frequently front and centre.

1. General Partner Contribution

Limited Partners like to see a meaningful contribution from the General Partner group in order to seek to ensure an alignment of interest between the Limited Partners and the General Partner. Typically, this is in the range of 1% to 5% (the exact figure may depend, in part, upon the financial circumstances of the General Partner group). Also, Limited Partners typically fund organizational expenses to a cap, with any amounts expended above that cap being the responsibility of the General Partner. Note that contributions by the General Partner are typically made by a related entity investing as a Limited Partner.

2. Carried Interest

The General Partner is typically entitled to a certain interest in the returns made by the fund. Compensation by way of a “carried interest” in the returns made by the fund is a means of helping to ensure that the General Partner’s motives are aligned with those of the Limited Partners – i.e. maximization of ROI in the fund. While the carried interest is calculated on the fund’s returns, the fund will likely be required to have returned all of the capital contributed by the Limited Partners (taking into account write-downs on unrealized investments) plus an agreed priority return (often between 6% and 10% per annum) before the General Partner is entitled to its “carry”. Carry is traditionally 20%, though some highly successful subsequent funds may have higher carry rates.

3. Management Fees

Typically, management fees are up to 2% of committed capital of the fund, and may decline once the commitment period (usually 5 to 6 years and often subject to extension) has been completed. These fees are generally thought of as covering expenses of the General Partner (including the basic costs of running and administering the fund – salaries, office expenses, investment development, travel and entertainment) and are therefore not meant to provide material upside compensation. For very large funds, there is often pressure to reduce the fees to help align the General Partner’s interests with the Limited Partners’ goal of return on investment. Conversely, for smaller funds there may be upward pressure, as many costs of these types are fixed and are thus incurred no matter how big the fund is. Fees received by the General Partner or related persons (such as break-up fees, monitoring fees, consulting fees, directory fees and other similar fees) may be deducted in whole or in part from the management fee. Creative ideas with respect to management fees include exchanging lower management fees for a greater carried interest percentage, scaling down management fees as the fund’s investment period winds down and offering lower management fees to anchor Limited Partners. First-time funds may even see requests for management fees based on a budget of expected expenses.

4. Clawback

Because distributions are made on the basis of sales of investments (most private equity investments, even those in public companies, have liquidity constraints), most partnership agreements provide for some kind of clawback or escrow provision to seek to ensure that the General Partner is not overpaid with respect to its entitlement to carried interest. The clawback or escrow requires that the General Partner hold back a certain portion of its carry to guard against the risk of overpayment if subsequent investments do not turn out well. If this is not contemplated at the fund level, it may be necessary at the General Partner level to seek to ensure any repayment required can be funded and to avoid General Partner group member guarantees. Since waiting until the dissolution of the fund to receive carried interest is obviously not desirable for the General Partner (this would often be more than 10 years from the first closing), there is often an annual true-up or a deal-by-deal true-up.

5. Size of the Fund

While most General Partners might think it best to raise as much money as possible, it is important to consider how much money can reasonably be invested in the permitted investment period of the fund, given the number of investment professionals, the size of investments anticipated and the “sweet spot” of investment by the fund. Since fund performance will make or break the General Partner’s success and ability to raise future funds, it is important not to be under pressure to invest too fast or in deals larger than (or in industries different from) those with which the General Partner has experience. Consider using minimum and maximum overall fund size in fund documents to enable more flexibility in the fundraising process. Also remember that, because of the need to keep money aside for follow-on investments in existing portfolio companies (among other reasons), it is unlikely that a fund will draw down 100% of its committed capital. Additionally, funds typically specify a minimum Limited Partner investment required to participate in the fund (although General Partners may be given the ability to bring in “special investors” at lower investment levels for strategic or other purposes).

6. Co-Investment Opportunities

Limited Partners will often ask for the ability to co-invest in the event the deal size would enable additional investment beyond the amount invested by the fund. General Partners generally commit on either a “hard” or “soft” basis to offer co-investment to some or all of the Limited Partners. Where General Partners or their personnel also have co-investment rights, there is often pressure to co-invest in all deals to prevent “cherry-picking” of the best investments for co-investment purposes. In some cases, there is no carry or management fee paid by co-investors on co-investments. Transaction fees may also apply.

7. Limited Partner Involvement

In order for Limited Partners to maintain their limited liability status under Ontario law, they are generally not permitted to be involved in the business of the partnership. While certain other jurisdictions in Canada, such as Manitoba, provide other means to limit liability while still enabling Limited Partners to be involved in the business, Limited Partners are understandably cautious about risking their limited liability status in any way. As a result, most Limited Partners have very limited involvement in the business of the fund. Funds often have advisory committees consisting of Limited Partner representatives whose role is to give input on (and in some cases consent to) such things as mark-ups and mark-downs of investments, valuations, conflict of interest issues and default remedies, without being involved in such things as investment and disposition decisions, which are considered to be the business of the fund.

8. Investment Restrictions

Some funds choose to focus on certain industries or markets. Often, investment restrictions are permissive rather than obligatory to preclude the need for the cumbersome process of seeking Limited Partner consent if what is perceived as a great deal arises outside the predetermined investment parameters. Investment restrictions may also allow that the advisory committee may consent to waive such restrictions in appropriate circumstances. Some restrictions may be imposed in recognition of tax or other investment restrictions to which the Limited Partners may be subject. Investment restrictions may include limits on investments in public companies (fees are often higher with private equity funds than public money managers), majority ownership requirements (minority investments often lack necessary control), limits on the amount of the fund that can be invested in any one portfolio company (to ensure diversification), geographical limitations (to ensure diversification), tax-related and/or ERISA limits, investments in existing investments of a prior fund or investments made by a subsequent fund (which have conflict issues and may require advisory committee approval) and borrowing/ guarantee limits.

9. Defaulting Limited Partners

Given that most funds have capital call provisions for contributions and require only a small percentage of committed capital, if any, to be provided to the fund up front at closing, there is often a concern that a Limited Partner might not follow through on its investment commitment when the capital call is made. This concern is sometimes addressed by requiring the escrow of capital contributions, particularly for Limited Partners committing smaller amounts. Guarantees or other credit support may also be required in certain cases. Moreover, typically somewhat harsh consequences may apply to Limited Partners who default, including (among others) forfeiture of some or all of their interest in the fund, forced transfer of their interest at a discount to other Limited Partners (who fund their default) and/or forfeiture of some or all of partnership profits.

10. Key-Person Provisions and Succession Issues

The skill and experience of the General Partner is typically critically important to a Limited Partner’s decision to invest in a fund. As a result, Limited Partners often request termination provisions (unless consent is provided by a certain percentage of the Limited Partners) tied to significant management changes or key-person departures. These range from prohibiting further capital calls until new management acceptable to a specified percentage of Limited Partners is in place to termination of the fund at the request of a specified percentage of Limited Partners. Key-person termination provisions are often dependent upon what other termination provisions, if any, have been negotiated. The timing for raising a subsequent fund is also often subject to much negotiation, as the General Partner will typically want to be able to raise another fund soon after the bulk of the current fund has been invested, while Limited Partners will naturally want to ensure that the General Partner remains sufficiently focused on the current fund. Typically, a certain percentage (75% or more) of the fund’s committed capital must be invested prior to raising a subsequent fund, and agreements may specify certain standards regarding time to be spent on the current fund once such subsequent fund is up and running. There are also conflicts issues regarding investing by both funds in the same companies and sectors, and allocation of opportunities issues, which may require input of or approval by the advisory committee(s).

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