Examining Private Equity and Hedge Fund Structures
Closed-end investment funds (private equity, buy-out, venture capital, real estate, natural resources and energy) differ structurally from the traditional open-end (e.g., hedge fund) model in a number of significant ways. These structural differences are the direct result of the type of portfolio securities held by the respective types of fund.
The open-end fund structure is generally appropriate for any investment vehicle focused on assets with an established trading market and which are predominantly free from restrictions on the transfer thereof (i.e., the assets can be readily marked to market and the portfolio re-balanced regularly to accommodate investor contributions and redemptions).
In contrast, the closed-end fund structure is advisable for investment vehicles focused on investments that are not capable of being marked to market and are generally subject to substantial restrictions on transferability for a period of time. The portfolio investments held by these funds are generally carried at cost until a realization event occurs. These differing characteristics are the cause of the following structural distinctions:
Open-end funds typically have no specific term (subject to the laws of the jurisdiction of formation: while most states, including Delaware, no longer require entities such as limited partnerships to have a finite term, some states may still retain this requirement). In contrast, closed-end funds have a specific term which is typically 10-12 years, and which may be extended for 1-2 year terms in the discretion of the manager/GP entity and/or with the consent of investors (LPs) or an LP advisory committee.
A. Commitment Period
While open-end funds typically require an investor’s capital be contributed upon admission (and thereafter, investors may make additional contributions from time to time), closed-end funds require investors to make a capital commitment that is drawn down from time to time upon a specified period of notice by the GP (typically, 5-10 business days). At the closing at which investors are admitted to the fund, they may not (and typically do not) fund any portion of their investment amount at that time. Commitment periods for closed-end funds typically range from 3-5 years from the final closing date.
B. Investment Period
While open end funds make investments and re-balance their portfolios on an on-going basis, closed-end funds usually have a limited period of time during which new investments may be made. There may also be a separate time limitation on making additional investments in existing portfolio companies. Although the investment period may conceivably mirror the commitment period discussed above, many closed-end funds have an investment period that endures for an extra 1-2 years following the termination of the commitment period in order to permit the recycling of capital, i.e., reinvestment of realized capital.
Due to the ability to market the portfolio securities held by open-end funds, the typical hedge fund structure permits admission of investors and redemption of capital at regular intervals (monthly, quarterly or semi-annually), possibly following some fixed lock-up period. In contrast, closed-end funds display different features regarding the acceptance of investments and redemptions of investor capital.
The typical closed-end fund will hold an initial closing admitting an initial set of 3rd party investors once the manager/GP has obtained sufficient indications of interest through its marketing efforts to have a level of assurance that a specified threshold of capital will be committed to the vehicle. Thereafter, the GP will have the right to hold additional closings to both accept new investors and permit additional commitments from previously admitted investors at such times as it determined, but only within a specified time-frame (typically between 6 and 12 months from the initial closing date).
B. Capital Call Defaults
As mentioned above, investments in closed-end funds are typically drawn down incrementally pursuant to capital calls from the manager during a specified commitment period. Because investors have a contractual obligation to contribute the agreed upon amounts but do not initially fund these investments, closed-end fund documents typically contain onerous penalties on investors who default on this obligation. The provisions typically provide for a limited forgiveness period, where an investor who missed the initial due date may correct the mistake and pay an interest penalty. After the forgiveness period expires, the GP typically retains the right to terminate the investors’ right to contribute subsequent capital, to buy out the defaulting investor for a fraction of the amount previously contributed and/or to actively locate a buyer for the defaulting investor’s interest (which can be other investors who have not defaulted, or 3rd parties who have not invested in the fund previously).
C. Catch-Up Contributions (and Cost of Carry)
Because closed-end funds may have an offering period of up to 1 year (and possibly longer), it is possible that the GP/manager may have called capital from earlier investors at the time a subsequent closing occurs. Because of the illiquid nature of closed-end fund portfolio securities, they cannot be marked to market and subsequent investors admitted at NAV, as with the open-end structure.
Thus, most closed-end funds will require that investors coming into the fund subsequent to one or more capital calls to catch up on their pro rata share of the amount of capital previously drawn down (as if all investors had been admitted at a single initial closing) and also pay an interest charge on such amount (typically, prime + 2%) that is referred to as a cost of carry contribution, in order to compensate initial investors for having funded earlier investments in which the new investors will participate (effectively, they have lent funds to the investors admitted at subsequent closings).
Further, the GP/manager typically has the discretion to keep these funds on hand or return them to the initial investors. If returned to investors, the catch-up contributions are credited against the amount contributed by initial investors such that the amount of capital they are required to subsequently contribute will increase as if the amount returned had never been contributed (this calculation will typically exclude the cost of carry interest charge so that the earlier investors receive the cost of carry as an actual return on their contributed capital).
Closed-end funds do not typically permit redemptions of capital at any time prior to the expiration of the funds specified term, except in extraordinary circumstances (such as ERISA violations or for other regulatory reasons). To offset this possible hardship, the documentation for many closed-end funds provide broader language on the ability of an investor to transfer its interest than is found in open-end funds, and also may contain language providing that the GP/manager will cooperate with an investor seeking to transfer its interest to a third party and possibly will assist the investor in locating a buyer to succeed to its interest in the fund.
E. Tax Distributions
Due to the inability to effect regular redemptions of capital, closed-end funds typically provide for the annual payment of distributions (to the extent there is available cash) to investors in an amount necessary to satisfy investors’ tax obligations with respect to undistributed taxable income.
3. Fee Base and Transaction Fees
Open-end funds typically charge the management fee based on either the funds’ NAV or an investor’s capital account balance (each of which is marked to market). In contrast, closed-end funds tend to feature a tiered management fee, where the management fee during the commitment period is a specified percentage of total capital commitments and following the commitment period is a specified percentage of total capital contributions. Moreover, most closed-end funds charge management fees whereby the actual fee percentage rate declines during the post-commitment period as most, if not all, investments have been identified and many are likely to be nearing the exit stage. A related feature is that most closed-end funds will offset the management fee to be charged to the fund by transaction fees received from portfolio companies (such as advisory fees, break-up fees for unconsummated deals, investment banking fees, directors’ fees for serving on the board of a portfolio company, etc.) so that the total amount of fee income to the GP/manager arising out of its relationship to the fund is capped and investors receive the benefit when the GP/manager and its affiliates receive these kinds of fees.
4. Performance Compensation
In contrast to the performance allocation/fee charged by open-end funds based on the increase in the market value of the funds’ portfolio securities, closed-end funds pay the GP/manager a carried interest based on the profits realized from the disposition of fund investments.
A. Basic PE structure
The carried interest is generally characterized as a distribution waterfall of the fund’s capital. The typical structure is as follows:
- First, Investors first receive a return of contributed capital from realized investments (including fund expenses and any investments that are written down and/or written off) on a pro rata basis;
- Second, Investors then receive an annual preferred return computed like simple interest on their contributed capital, typically in an amount between 5 and 6% per year;
- Third, the GP/manager then receives catch up distributions to ensure that it receives its carried interest percentage on the preferred return to investors in step; and
- Finally All profits in excess of these amounts are split between investors and the GP/manager based on its carried interest percentage (typically 20 – 25% of fund profits).
B. Cumulative vs. Deal-specific
The distribution waterfall in the closed-end fund structure is computed in one of two ways: (1) the first option is the cumulative waterfall, whereby the return of capital, the preferred return, the GP catch up and the profit split is measured over the life of the fund on a cumulative basis, or (2) the second option is the deal-specific waterfall, whereby the computations of returns and profits above is measured based on the performance of each investment in isolation from the others. The deal-specific waterfall has become the industry standard (especially for LBO and VC funds) over the past decade, and is less investor friendly than the cumulative waterfall. This enables the GP to receive a carried interest on profitable investments even when investors may have lost money in the aggregate, whereas the cumulative waterfall ensures the GP does not receive its carried interest unless investors are earning aggregate profits on their investments in the fund.
Because the GP/manager of a closed-end fund may receive interim distributions of profits if the fund is profitable (under either the cumulative or deal-specific waterfall), but subsequent realized losses cause these profits to have been over-distributed to the GP on a look back basis, the documents for closed-end funds typically provide for a clawback mechanism whereby, upon liquidation of the fund, the GP/manager must restore any excess profits received to the investors. Moreover, in order to ensure that this clawback provision is actually effective (because the principals of the GP can dispose of their shares of the carried interest paid to them), many funds require that the principals of the GP/manager and any other person who may share in the carried interest sign a personal guarantee obligating them to restore their personal pro rata share of the clawback amount (i.e., it is a several, not joint, liability).
Because of the potential clawback obligation of the GP/manager, a large minority of closed-end funds have escrow provisions whereby a specified portion of the potential carried interest is required to be held in escrow for a specified period of time, and the amount required to be segregated may fluctuate based on the fair value of the funds’ unrealized investments or the total amount of unrealized capital.
5. Restrictions on Investments
While most open-end funds typically have broad investment mandates and the flexibility to invest in most asset classes, closed-end funds typically have more detailed and stricter restrictions on the fund’s investment program and the portfolio securities in which the fund is permitted to invest.
A. Fixed Income
Closed-end funds typically contain substantial restrictions on the making of temporary investments for cash management purposes, which generally must be money market instruments, cash equivalents and highly-rated commercial paper. The making of these investments is generally only intended to be for cash management purposes (for the payment of fees and expenses and the nimble deployment of investment capital) and ensuring the fund’s idle cash is both secure but also earning some minimal amount of return.
B. Publicly Traded Securities
Closed-end funds, where permitted to invest in publicly traded equity securities, typically include restrictions permitting them to do so only in circumstances where it is done with a view to acquiring a controlling block of securities (e.g., 25% of the public float) or otherwise with the intent to influence the management of the issuer, subject to exception for limited investments (such as 5% of the fund’s invested capital).
C. Diversification/Concentration Limits
Most closed-end funds are subject to greater restrictions than open-end funds with respect to
- geographic regions in which the funds’ portfolio companies are headquartered or from which they derive the bulk of their revenues
- amount that may be invested in portfolio companies focused on any single market sector
- amounts that may be invested in a single portfolio company
Moreover, closed-end funds focused on a particular asset class will generally be prohibited or restricted from investing in other asset classes (e.g., PE funds prohibited from investing in real estate, energy funds being limited in their ability to invest in real estate, real estate funds prohibited from investing in equity securities, VC funds being prohibited from investments in portfolio companies with a certain revenue threshold, etc.).
D. Maximum Fund Size and Invested Capital
While some open-end funds may have a cap on the amount of subscriptions the fund will accept, this kind of limitation is almost invariably incorporated into the constituent documentation for closed-end funds and typically appears in 2 forms (usually both of them): (1) a maximum total amount of committed capital that will be accepted, and (2) a maximum amount of total capital that will be invested in portfolio companies. Committed capital is limited to a set amount in order to ensure the GP only pursues attractive deals and can effectively manage the fund’s investments. Because closed-end funds typically have a limited right to re-invest realized capital, the total amount of invested capital is usually capped at between 110-120% of committed capital.
6. Valuation; LP Committees
Closed-end funds typically appoint an advisory committee composed of investor representatives selected by the GP/manager, although the members are all unaffiliated with management. The purpose of the committee is to meet with management on a somewhat regular basis to discuss developments with respect to portfolio investments, valuation matters and annual performance. The committee also frequently is empowered to approve affiliated transactions that may present a conflict of interest for the GP/manager, as well as to approve certain material changes, such as extensions of the fund’s term or investment period and recycling the proceeds from realized investments.
7. Investor Clawback
Because closed-end funds typically are activist investors that are expected to participate in the management of portfolio companies, liability and indemnification provisions in favor of portfolio companies are of much greater importance in the closed-end fund context. Similar to the GP clawback discussed above, the investors in closed-end funds are also typically subject to certain clawback obligations pursuant to which investors are required to return distributions of investment proceeds to the fund (and the GP is authorized to withhold capital from investor distributions for the purpose of establishing reserves for liabilities) in the event of contingent liabilities and indemnification obligations. This potential clawback obligation is typically limited in both amount and duration (e.g., up to 25% of distributions received during the preceding 2-year period are subject to recall).
8. Conflicts of Interest
Unlike the documentation for the typical open-end fund, which permits the manager to engage in a wide array of outside business activities as long as the fund is treated fairly, the documentation of closed-end funds typically contains substantial restrictions and/or prohibitions on the GP/manager’s ability to
- manage funds or accounts with a similar investment mandate
- offer co-investment opportunities to specific LPs or the principals and affiliates of the GP/manager (including its personnel and other investment vehicles or managed accounts)
- engage in other investment activities similar to those of the fund
- cause the fund to engage in transactions with principals and affiliates of the GP/manager
The first and third restrictions typically only apply during the fund’s investment period or until the fund’s capital has been sufficiently drawn down and invested (typically 75%). The second and fourth restrictions usually apply over the term of the fund, but are also subject to review and/or approval by the LP advisory committee.
9. ERISA / VCOC
Closed-end funds are subject to the same general set of rules under ERISA as are open-end funds and their managers. However, there is one additional tool available to closed-end fund managers in order to avoid potential ERISA duties and liability. Even if participation by benefit plan investors in a closed-end fund is deemed significant (i.e., 25% or more of a class of the fund’s equity securities are held by benefit plan investors subject to ERISA), a funds manager can avoid being deemed an ERISA fiduciary as long as the fund qualifies as a venture capital operating company (VCOC). A VCOC must have at least 50% of its assets held for investment purposes invested in operating companies with respect to which the fund has and exercises management rights. This test is applied from the making of the fund’s first long-term investment and therefore the fund’s first investment generally must be in an operating company.