Private Equity

What is a Private Equity Fund:

No Uniform definition.

Historically, PE Funds invested in “equity” of non-publicly traded operating companies.

Today, term “Private Equity” covers waterfront. It includes several different investment strategies

??buyouts (leveraged)

??buy-ins(leveraged)

??Real Estate

??debit/credit

??mezzanine

??secondary à Buying from Other investors

??opportunistic à Buying distressed businesses or assets. Taking advantage of situation. This umbrella would have other non-equity assets as well.

Private Fund is a Collective Investment Vehicle (CIT) where there are multiple individuals, entities and pooling their money and it is invested for them.

Lot of disclosure on Long Term investments. Sometimes Funds have Geographic focus only.

Typically, only very sophisticated Investors come into these types of Products. They are exempted from many traditional Security and Regulatory regulations for Capital Market. Investors typically include US/Non-US Institutional Funds, Sovereign Funds, Universities, Endowment Funds, Pension Funds, Family Offices and High Net Worth individuals.

Terms and Structure driven by strategy, Investment Portfolio / Liquidity, Tax Considerations and Market / Sponsor conventions. For Ex: Blackstone approach, Carlisle approach, approach based on Geography which will detect the structure. Other factor which will impact the structure is the tenure or duration of investments and type of Funds. (For Ex: Real Estate Vs Infrastructure...)

Fund Parties:

Limited Partnership Structure:

Jurisdiction selection is typically driven by Tax, strategy, and geographic focus.

(** There are Limited Liability Company structures as well, but LP is most common)

The most common Jurisdictions to setup this are Delaware, Cayman Islands and Luxemburg.

Fund Sponsor

(General Partners and Investment managers / Registered Investment Advisor)

Fund Sponsor(s) control the fund as General Partner (GP) and as Investment Manager or RIA. Responsible for making Investment decisions.

Limited Partners (Limited Partners or Investors)

Third party limited partners (LPs) put up lion’s share of Capital and agree to compensate the Fund Sponsor for Managing the Fund and making Investments. They really Fund the capital.

Fee Structures:

Management Fees:

·???????Often 1-2% of LP’s commitment during Investment Period and invested capital thereafter. (from the beginning for certain strategies.)

Performance based compensation (“Carried Interest”)

·???????A specified % of Fund’s profits attributable to the capital invested by the LPs (Typically, 20%)

·???????Typically taken on the realized Investments (often subject to a hurdle and clawback)

·???????Often subject to a preferred return or hurdle rate (Ex: 8% per annum)

Return on Invested Capital

·???????Profits generated on capital invested in Fund-by-Fund Sponsor.

Other Functions and Characteristics:

“Just in Time” Funding of commitments as needed for Investments. This is done when additional investments are needed. We have seen that lot during COVID.

Proceeds are distributed generally in Cash upon disposition of Investments or when current Income is received.

Some reinvestments of Gains (e.g.: recycling) is permitted (often during Investment Period only.) . Here sponsors can reinvest some of the gains. There is a limitation on how much of the gains can be reinvested and how long they can do that though. This allows FPs to invest more than what LPs have committed over life of the Fund.

Closed-end Fund with limited Transfer and withdrawal rights. That means, there is a lifetime to the Fund, and it will dissolve once it’s term is over. That makes these Funds highly illiquid. Transfer process is particularly drawn out and not typically practiced or encouraged. This is typically tied to regulatory needs or violation.

·???????Fixed Subscription period (e.g.: 1 Year) often with subsequent closing equalization mechanism. This is the timeframe when LPs can come into the Fund and make commitments into the Fund.

·???????Typically has an Investment Period of 3-6 years and terms of 8-12 years.

Fund Structure (Private Equity):

??Firm (Managing Members) and Sponsor Parent Company (Managing Members) --> XYZ Capital LLC (General Partner)

??XYZ Advisor LLC (Investment Advisor) --> Employ Firm Principals and Professionals

??XYZ Capital LLC (General Partner) --> XYZ Partners A(LP) “Main Fund” **

??Limited Partners --> XYZ Partners A(LP) “Main Fund” **

??Limited Partners --> deal Specific Co-investment (Limited Partnership)

??XYZ Capital LLC (General Partner) --> deal Specific Co-investment (Limited Partnership)

??deal Specific Co-investment (Limited Partnership) --> Portfolio Investments

??XYZ Partners A(LP) “Main Fund” --> Portfolio Investments **

??XYZ Capital LLC (General Partner) --> XYZ Partners B(LP) “Main Fund”. ?***

??Single Investor or small group of Investors --> XYZ Partners B(LP) “Main Fund” ***

??Employ Firm Principals and Professionals --> ?XYZ Partners A(LP) “Main Fund” ****

??Employ Firm Principals and Professionals --> ?XYZ Partners B(LP) “Main Fund” ****

** Majority of Capital Commitments

*** One or more parallel funds formed to accommodate specific Tax, regulatory or Business interest of a single investor or group of Investors.

**** Advisory contracts.

Deal Specific Co-Investments are created for specific Investments.

Generally General Partners are more active and Limited Partners are comparatively less active.

Each Geography can have slightly different structure.

*Cayman Island vehicle is very popular for Asian Funds and Hong Kong is coming up fast. There is no one size fit all.

Earlier Sponsors used to be public banks, but now there are non-banking Asset Managers and that too private like Blackrock, Carlisle or KKR. Majority these days are independent privately owner Advisors. They use one or more strategies for investments. There are handful of Investment Bank in this Business-like Goldman Sachs and Morgan Stanley. So, Sponsors are private Advisors or large public institutes.

Life Cycle:

??Typical Lifecycle will be like this:

??Sponsors decide to start the Fund.

??Investors provide capital $ to PE Firm to invest using Subscription documents from Sponsor.

??PE Firm (Fund Sponsors) find company to invest $

??Fund Sponsors invest $ in the company.

??Sponsors improve company, -- new management, market expansion etc.

??Sponsors hold the investment and sell Investment (Company) 3-7 years later, hopefully at a profit.

??Sponsors return all the capital and 80% of profits to Investors –

??Sponsors keep 20% of profits as rewards.

Fund Raising Process and Closing:

??Initial Kick off meeting

??Preparation and issuance of offering documents containing Business disclosures including Marketing overview. (PPM, LPA, subscription docs etc..). It will also have information about Professional managing sponsor and their track records. There will be term sheet with terms of the offering. Partnership document is main governing document for the Fund.

??Negotiation and execution of engagement letter with placement agent (if applicable)?????????

??Once documents are mailed to them, Investors commence business and legal due diligence.

??Comment negotiations (LPA & side letters.). ?Investors would like to negotiate certain terms, due to certain obligations. For instance, Pension Funds will have certain reporting obligations.

??Initial closing usually happens at least after couple of months after negotiations. Finalize side letters with investors and finalize Partnership agreement. Once the subscription documents are completed, Sponsor acknowledges to Investors that their commitments are accepted.

??Investment Period commences and Sponsor can start deploying Capital.

??Subsequent closings

·???????Side letter MFN process.

·???????Subsequent closing LPA amendments

Fund Documents:

Primary Fund Documents

1.?????Private Placement Memorandum: Primary Offering and disclosure document for LPs, serving dual Business and legal purpose. It is the main offering document. Risk in conflict here is most important section. It helps protect sponsor against the Risk. The key aspect is to draft all potential risks (ex: risk related to COVID) in the areas of Liquidity of Assets, Performance of Investments and what Investors can expect of Sponsor’s Performance

2.?????Limited Partnership Agreement: Contract governing rights and obligations of the partners. Investors can negotiate terms if they don’t completely agree.

3.?????Subscription Agreement: Contract pursuant to LPs purchase interest in the fund. It starts with representation and warranty section. It’s a disclosure that, Investors meet all the requirements, and they are making an informed decision. They declare their ERISA status. There are also provisions about governing laws of the agreement. Then there is a questionnaire. Investors will make representation of what type of entity they are. It’s also included contact information and bank details.

4.?????Side Letters: Often entered to address the ancillary matters specific to LPs; may supplement or override LPA. They are used to negotiate specific provisions from Partnership Agreement in #2 above. It supplements LPA.

5.?????Investment advisory agreement: Contract between advisor and fund pursuant to which advisor receives management fees and details fee offset provisions. This is the contract between Advisor and Sponsors.

6.?????Ancillary Offering Materials: Pitchbook, due diligence questionnaire and other diligence materials.

Fund Types:

Types of Private Equity Funds and Other Common Funds

??Traditional Private Equity (Buyout) Funds

o??Typically acquire substantial or “controlling” stakes in private companies or public companies that are taken private.

o??Public investing is not as common as such. They are highly illiquid based on the inherent nature of the investments. Once you Invest in a company, you cannot get the money until you sell it. It creates all kind of legal and regulatory issues if you come in and out of fund. You will have to pay penalties and may not get money for premature exit. In terms of control and stake if you buy more than 50% of the company or any smaller percentage will get voting rights. Basically some of the people from General Partner and Advisor are put on board of these acquired companies to decide future direction.

??Real estate opportunity Funds

o??Formed to opportunistically acquire interests in real property or real estate related companies (e.g.: hotels, casinos etc...) It’s still like Traditional fund above, but only Asset s

??Infrastructure Funds

o??Formed to acquire Infrastructure assets (ex: pipelines, bridges, toll roads etc...), very similar where focus is on Infrastructure asset.

??Tactical Opportunity Funds

o??Typically pursue investments on an opportunistic basis. (Ex: multi asset class based on prevailing market conditions) , for example : conditions caused due to COVID.

??Debt Funds

o??Typically pursue non-controlling strategies that seek to make debt investments in Portfolio issuers.

??Hedge Funds

o??Typically make passive investments in “liquid” or publicly traded stocks or bonds.

??Open-Ended Real Estate Funds

o??Formed to acquire more stable real estate assets for the long term. For Ex: Rental Property.

??Registered / Publicly Traded Funds

o??Publicly registered and/or exchange listed funds; mutual funds; permanent

??Other Common Types of Funds

o??Venture Capital Funds, Hybrid Funds, Secondary Funds (buying interest of already invested investors), Funds of Funds (Fund invest in other Funds as strategy), Co-Investment Vehicles (co-investing strategies), Minority Stake Vehicles (opposite of Traditional full buyouts)

Regulatory Framework:

Basic Regulatory Framework and Tax Considerations.

US Securities act of 1933. (As investing in Fund is like investing in Securities and still governed by SEC compliance)

??Funds typically have narrow list of offerings compared to a typical retail fund.

??Funds typically offer LP interests in reliance on Reg D offering (US) and/or Reg.S offering (non-US)

??Some SMAs offered under section 4(a)(2)

??Funds relying on Reg D must comply with Bad actors’ rules.

??Offering generally limited to accredited investors (establish general sophistication level). There are number of ways to qualify as a accredited investor. SEC uses this as their proxy for sophistication assessment. Minimum wealth qualification would come into play here. But accredited investing is not only tied to minimum wealth standards. You also need to be qualified purchaser for the offering and that has minimum wealth requirements as such.

??Generally, no offering by “General Solicitation” or “General Advertising” (No Public offering) (except JOBS Act)

US Investments Company Act of 1940.

??Requires registration of any issuer which is primarily engaged in the Business of Investing, Reinvesting or Trading in Securities unless exemption is available.

??3(c)(7) exemption: Limit offering to qualify purchasers ($5 mill. For individuals and $25 mill for entities)

??3(c)(1) exemption: limit offering to 100 beneficial owners of securities. In this you don’t need to be a Qualified Purchaser.

??7(d): non-US issuers owned by non-US investors or US Investors that are Qualified Purchasers.

??Knowledgeable Employee Carve-outs. This exempts you from minimum wealth standards, but you must be an employee of the sponsor.

??SEC exemptions for employees’ securities companies.

?

US Investments Advisors Act of 1940.

??Unless a sponsor qualifies for the exemption, must be registered as an Investment Advisor with SEC.

??Investments Advisors have a fiduciary duty to clients – utmost good faith to act in best interest of clients and make full disclosure of all material facts.

??Subject to various rules and requirements, including that advertising (including track record presentations) cannot be false or misleading.

??Section 206 (anti-fraud provisions) apply to all advisers whether registered or not.

For example, 206(3) – prohibition on “Principal Transactions” without client consent – sponsor acting for own account buying from/selling to a “client”

US Securities and Exchange Act of 1934

??Post JOBS Act limit of 2000 holders of records of any class of securities to avoid 12(g) registration. This is a limitation which does not often come into play.

CFTC

??Many sponsors rely on “de minimis” exemption for limited commodity trading post -2012 repeal of 4.13(a)(4). Inclusion of “swaps” as commodities put additional pressure for sponsors. For illiquid strategies commodities don’t come into play.

Basic Regulatory Framework and Tax Considerations.

ERISA

??To avoid managing plan assets, many funds rely on 25% (25% of the investments) test or VCOC/REOC exemption. (depend on structure / nature of deals) . It governs retirement assets.

Tax

??Funds typically treated as partnerships for US Tax purposes.

??Ability to use alternative vehicles and “blockers” for certain types of investors to block certain types of income and filing requirements

World Sky / AIFMD

??Prior to marketing in non-US jurisdictions, must comply with securities law in such jurisdictions, including by notifying or registering with local regulators. These include marketing regulations as well. There are local registration requirements ,especially in Europe after passage of AIFMD framework.

Blue Sky

??Must comply with Securities laws for each US State in which such funds offer interests, including by registering such offerings with certain state regulators.

This article out of sequence from two previous articles, but nonetheless, it is tied to the broader Transformation journey. Typical Asset Manager manages varying eco-system of entities including Retail Funds, Institutional Funds, Hedge Funds and Private Funds. Private Funds (Private Equity most popular flavor of it) landscape is very unique and it has some key design considerations for broader Data strategy and design, which will discuss in upcoming articles. Here I thought giving a high-level overview of Private Fund (Equity) business landscape and specific aspects of it.?Fund structures, Fees and other aspects changes according to Jurisdictions, Investments, and many other factors. This article does not claim to cover every detail of it, but rather it’s humble attempt to give general overview of understanding of this unique Market I have developed in my various leadership roles over the years.?

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