Jason Glover and Tom Bell of Simpson Thacher & Bartlett LLP explore the increasingly creative fund structures developed to deal with the decline in private equity fundraising in the past five years.
In the last edition of The International Who’s Who of Private Funds Lawyers, we wrote that a difficult private equity fundraising climate was expected to persist for some time. This statement was made against the backdrop of a decline in overall private equity fundraising of approximately 56 per cent from 2007 to 2011, according to Preqin. Since then, there has been little sign of resurgence in fundraising appetite on the part of investors, while Preqin reports that the number of sponsors seeking to raise funds in the market has reached an all-time high. Historically, when demand from sponsors for private equity capital exceeded supply from investors, fund structuring was generally limited to adjusting the terms of the traditional limited partnership fund structure so as to be more “LP favourable.” However, in today’s fundraising environment, private equity firms and their legal counsel are being forced to develop increasingly creative fund structures in order to appeal to investors who have an appetite for private equity but who do not wish, or are unable, to participate in the standard structure.
Notwithstanding the fall in overall private equity fundraising, the average size of limited partner fund commitments has increased significantly (by some 60 per cent between 2010 and the first half of 2012, according to PitchBook Data). The increase in commitment size is partly due to the participation of new entrants in the form of large sovereign wealth investors, and partly due to limited partners adopting a more concentrated strategy through participation in private equity via fewer managers whilst retaining the overall size of their commitments to the asset class. The increasing commitment size has led some investors to seek their own bespoke “managed account” arrangements. In some cases, these arrangements are completely independent of any broader blind pool fundraising, with potentially different economics and different investment criteria and which, depending upon the nature of the underlying investment strategy, may or may not invest alongside standard investment funds. These arrangements frequently provide for the investor to have some participation in investment decisions. Inevitably, such structures create significant challenges for their fund managers, not least the articulation to their traditional fund investors of the consequences of such managed accounts, particularly as regards the extent of access to deal flow and allocation of investment opportunities. For that reason, many private equity managers have resisted granting managed account arrangements to investors, particularly where the objective of such arrangements has been primarily to secure better economics, a preferential access to co-investment opportunities and/or a limited variation to the investment criteria of a fund. Instead, those investors have typically been accommodated in traditional fund structures, albeit with side letter provisions being used to address specific investor concerns. Nevertheless, it is our expectation that managed account arrangements will increase in popularity over the coming years.
BESPOKE FEEDER/SIDECAR VEHICLES
Historically, a number of investors have been prevented from investing in private equity fund vehicles for tax, regulatory or, in the case of shariah investors, religious reasons. As the fundraising environment has become much tougher, private equity funds have become more willing to investigate ways in which to circumvent or accommodate such impediments. We have encountered recent fund raisings where bespoke feeder structures have been used to facilitate the admission of Chilean investors, and clients continue to assess the potential participation of shariah investors alongside mainstream fund vehicles albeit with limited success to date. Bespoke feeder structures have also recently been used to increase the number of high net worth individual investors that can participate in a fund without requiring the fund to register as a public reporting company under the US Securities Exchange Act of 1934. Going forward, the creation of bespoke sidecar vehicles may provide a potential solution to the challenges arising from the introduction of the AIFM Directive for non-EU based private equity managers. In effect, non-EU managers wishing to market to EU investors under the “passport” regime introduced by the AIFM Directive may seek to create a bespoke sidecar fund vehicle to co-invest alongside their non-EU managed fund for non-EU investors. The bespoke vehicle would itself appoint an EU fund manager (being an EU-based affiliate of the non-EU manager), thereby enabling the “passport” regime to be accessed while at the same time retaining the familiar, less heavily regulated – and therefore less expensive – historic non-EU-managed fund structure for other investors.
DUAL CURRENCY STRUCTURES
The ongoing uncertainty surrounding the continuation of the euro has caused some investors to refrain from committing to euro-denominated funds, notwithstanding that those same investors are keen to secure exposure to underlying European private equity investments. In order to address this concern, private equity firms are seeking to structure their fund offerings so that investors can commit to either a partnership denominated in euros, or a parallel partnership denominated in US dollars which provides a degree of mitigation from the risk of the euro’s collapse. Such structures create a significant degree of complexity, the most obvious of which is the fluctuating extent of participation in transactions by each parallel partnership given the continual shifts of the relative purchasing power of their respective remaining capital commitments. Therefore, the adoption of such structures should only be considered by sponsors that, either internally or through external sources, have the fund administration expertise to handle these complexities, and only where fundraising is believed to be significantly enhanced with such an option.
Investors deterred by the illiquid nature of interests in private equity funds have historically found access to the asset class limited to participation through listed entities. In many cases, such entities have had widely diverse fund portfolios and/or have traded at discounts to net asset value and have therefore been unattractive. A recent innovation has been the introduction of a private matching system through which each investor in a fund has the opportunity at regular intervals to sell all or a portion of its interest to a select group of other investors in the fund that are specialist secondary funds. The perceived benefits of such a scheme are that it should offer greater liquidity for investors by facilitating the sale and purchase amongst existing investors at regular intervals during the life of the fund; it should secure competitive terms for pricing purposes; and as the prospective purchasers are existing investors, the information flow is contained and less diligence is required resulting in potentially quicker sales.
LONG-TERM STRATEGIC/TACTICAL PARTNERSHIPS
The continuing volatility of the global economy means that, to some extent, fundraising success is a function of the fortuity of timing as opposed to the quality of the product offering. Such volatility is highlighting the tremendous value to sponsors (especially publicly traded sponsors for which assets under management are an important valuation metric) in securing long-term commitments from one or two strategic fund investors over multiple fund offerings, whether such offerings are a series of funds with the same investment criteria or distinct funds across a multi-product platform. The benefit to such investors from providing this long-term capital is securing better economic terms and greater access to information. To date, these long-term arrangements have typically taken two forms: the first is in the form of a separate account arrangement whereby the investor has agreed to commit significant capital to a private equity firm with the firm having a large degree of control over how that capital is deployed, typically across a range of its funds. One such example was the commitment made in 2011 by Texas TRS of $3 billion to each of Apollo Global Management and KKR. The second form is a capital contribution to a permanent capital vehicle to be managed by the private equity firm as part of a wider arrangement involving equity participation by the strategic investor in the firm itself. We would expect such arrangements to continue to be highly attractive to PE firms for the foreseeable future and of increased appeal to large investors that wish to manage their private equity asset allocation through fewer private equity firm relationships and who regard the economic benefits of such an arrangement as a worthwhile trade-off for increased illiquidity and manager concentration risk.
DEAL SPECIFIC VEHICLES
For those private equity firms who are unable to raise blind pool funds in the current fundraising market (or perhaps are unwilling to do so in the hope that the fundraising environment will be more favourable when they return to market), several alternative capital raising techniques exist. The most common of these has historically been securing investors on a case-by-case basis in which investors commit to participate in an opportunity only once that opportunity has been identified and presented to investors. Such a structure is attractive to investors for many reasons, including the opportunity to diligence the target investment ahead of any decision to invest and a management fee that is typically charged only on invested capital (as opposed to blind pool funds that charge management fees based on total commitments, whether drawn or undrawn). However, such a structure does have its disadvantages, most notably placing the private equity firm at a competitive disadvantage in auction processes, given the uncertainty of funding as compared to other bidders (including blind pool funds). As a result, private equity firms have considered the adoption of co-investment clubs whereby investors retain the right to decide whether or not to make an investment as part of a club for which they bear a fee for notional commitments. Whilst such a structure does not remove the uncertainty entirely for the private equity firm, the mere fact that investors are paying for access to deal flow gives the private equity firm confidence that the investors are serious about participating in deal opportunities. Neither structure is perfect and, for the private equity manager, presents challenges in ensuring that transactions can be closed out. However, in the absence of raising a blind pool fund, it provides an interim solution so as to enable the private equity firm to return to the fundraising market at a more favourable time.
Inevitably, the creation of bespoke and unconventional structures to accommodate investors is having a significant impact on both the establishment costs associated with fundraisings and the way in which private equity firms are approaching the choice of fund formation counsel. Bespoke and unconventional structures require fund counsel to think “out of the box”, to use the very best technical skills to meet investor demands, to have strong access to information on the very latest practices in private market transactions and to devote substantially more legal time to the structuring of funds. Arguably, this is creating a more bifurcated market for private fund formation practices; on the one hand there are those lawyers who rely upon established market precedent as the basis for their advice and, in the absence of a unique selling point, seek to develop their practice through commoditisation, pricing and scale. On the other hand, there are those private fund formation practitioners who are able to craft innovative, bespoke solutions to meet investor demands and thereby provide a distinctively value added service to private equity firms. In that regard, The International Who’s Who of Private Fund Lawyers continues to be a key reference point in identifying the very best global private fund formation practitioners.