Bible for the Emerging Private Equity and Venture Capital Manager
By Ron Geffner and Paul Marino,
Partners, Sadis & Goldberg
May 1, 2018
Chapter one: Structuring the Private Equity & Venture Capital Fund
The initial step of each successful private equity or venture capital fund launch begins with knowing and targeting the right investor group. To do that you’ll also need to know what vehicle will appeal to those groups and structure your fund in a manner befitting to each. It is this reason why you need to understand what your investors are looking for in a fund vehicle and what each investor needs as a return profile (e.g., a pension fund has a different return profile/targeted return than an endowment and a family office and/or high net worth investor has a different return profile/targeted return than both—more on that in our next article).
Sponsoring a private equity or venture capital fund is a natural progression for ambitious investment managers. The creation of a fund and committed capital provides: (i) the manager with greater flexibility to make immediate and time sensitive decisions with opportunistic investments; (ii) the manager with a more secure capital base, allowing the ability to scale the manager’s investment operations to more effectively oversee the portfolio investments; (iii) greater portfolio diversification; and (iv) the ability to access debt instruments that may enhance the manager’s and the investors’ range of investment opportunities.
Successfully launching a private equity or venture capital fund is dependent upon a number of factors. Selecting the proper corporate structure and complying with regulations promulgated by regulatory agencies that govern funds and their managers is often the initial step in the process of launching a private fund.
Structuring a fund involves both the creation of one or more entities through which investments will be made (domestic and offshore funds), as well as the management entities through which the advisory services will be provided to the funds (the general partner and/or the investment manager). The structure and domicile of the fund is primarily dependent upon two variables: (i) the nature and demographics of the prospective investors, and (ii) the investment strategy employed by the manager. The structure and domicile of the manager is primarily determined by the citizenship and tax considerations of its principals, as well as the regulatory regime of the domicile.
Nature of Prospective Investors
Investors can be divided into three classes: (i) U.S. taxable investors, (ii) U.S. tax exempt investors, and (iii) non-U.S. investors. In the majority of circumstances, if the investors are U.S. taxable investors, the fund will be formed as a U.S. limited partnership. The U.S. fund is often referred to as a “domestic fund.” Most domestic funds are organized in Delaware. If the investors are US tax-exempt investors or non-US investors, the fund generally will be formed in a jurisdiction outside of the U.S. as a corporation (or other analogous entity). The non-U.S. entity is often referred to as an “offshore fund” or “blocker”. Most offshore funds organized on behalf of U.S. based managers are organized in the Cayman Islands or the British Virgin Islands.
U.S. tax-exempt investors typically prefer to invest in an offshore fund set up as a corporation because U.S. tax-exempt investors are liable for income tax on any income derived from a trade or business which is regularly carried on and not substantially related to their tax-exempt purpose. This is known as “unrelated business taxable income” (“UBTI”). If a U.S. tax exempt investor invests in a fund which is taxed as a partnership, the U.S. tax exempt investor will be treated as if they are participating directly in the activities of the fund and some or all of the income derived from those activities will have U.S. tax liability. The blocker allows U.S. tax-exempt investor to receive dividends from the blocker without being subject to UBTI. Non-US investors who are not generally required to file U.S. tax returns prefer to invest through a blocker to avoid triggering U.S. tax obligations. If non-US investors invest directly into a fund structured as a partnership they are treated as being engaged in the business of the fund and, to the extent that this includes any U.S. trade or business, will need to file a U.S. tax return and will bear U.S. tax liability.
Exemption from Registering the Fund as an Investment Company
The overwhelming majority of private equity and venture capital funds are exempt from registering as an investment company under the Investment Company Act of 1940 (“Company Act”) pursuant to either sections 3(c)(1) or 3(c)(7). Both sections 3(c)(1) and 3(c)(7) prohibit a private fund from conducting a public offering. This is commonly referred to as the prohibition against general solicitation. The prohibition against general solicitation prevents private fund managers from soliciting investors they do not already know. Thus, a private fund manager needs to have a “substantive preexisting relationship” with the investor prior to solicitation. A “substantive preexisting relationship” is generally defined as a relationship whereby the private fund manager understands the investor’s financial circumstances and level of sophistication in financial matters prior to the solicitation. Merely knowing that an investor was wealthy or otherwise qualified as an accredited investor (for example, by reviewing a list of Fortune 500 CEOs) does not suffice, in the absence of a further relationship with such investor.
Pursuant to section 3(c)(1), the fund may have no more than 100 investors, whereas a fund relying on section 3(c)(7) must have fewer than 2,000 investors to avoid having to register as a public company pursuant to section 12(g) of the Securities Exchange Act of 1934. To avoid from engaging in a public offering, private funds typically issue interests in their funds to investors pursuant to a private placement exemption under Rule 506 of Regulation D. Rule 506 is a safe harbor under the Securities Act of 1933 (“Securities Act”). Although Rule 506 allows fund interests to be purchased by up to 35 non-accredited investors, most issuers avoid taking non-accredited investors because of the additional disclosure requirements which must be met, as well as the additional regulatory risk. Therefore, 3(c)(1) fund interests are generally offered and sold only to accredited investors. Conversely, 3(c)(7) fund interests are offered exclusively to persons who, at the time of acquisition of such securities, are qualified purchasers.
The initial step of each successful private equity or venture capital fund launch begins with knowing and targeting the right investor group. To do that you’ll also need to know what vehicle will appeal to those groups and structure your fund in a manner befitting to each. It is this reason why you need to understand what your investors are looking for in a fund vehicle and what each investor needs as a return profile (e.g., a pension fund has a different return profile/targeted return than an endowment and a family office and/or high net worth investor has a different return profile/targeted return than both—more on that in our next article). In short, it is critically important, especially for emerging managers to select the appropriate service providers to help guide you through that process. It is important to engage and partner with firms that have relevant and commercial experience, a good reputation in the marketplace and are eager to work with you. For example (and it is because we deal with this leg of your journey) legal counsel will provide services to the fund prior and subsequent to its launch; it will be able to advise the sponsor not only with the appropriate structure, but will also guide the sponsor with regard to negotiations with investors, partners and employees, as well regulatory requirements and tax efficiency, commercial terms and trends, and introduction to and retention of appropriate service providers. Remember—you want superlative service at a fair price—not fair service at a superlative price.
- An “accredited investor” is defined under the Securities Act as (1) an individual with income in excess of $200,000 in each of the two most recent years or joint income with a spouse in excess of $300,000 in each of those years, or (2) at least $1,000,000 net worth, excluding the value of a principal residence.
- The definition of “qualified purchaser” is defined in the Company Act and, in part, includes: (i) any natural person who owns not less than $ 5,000,000 in investments; (ii) any company that owns not less than $ 5,000,000 in investments and that is owned directly or indirectly by 2 or more natural persons who are related as siblings or spouse (including former spouses), or direct lineal descendants by birth or adoption; (iii) any trust not covered by clause (ii) which was not formed for the purpose of acquiring the securities offered, and the trustee and each person who has contributed assets to the trust, is a person described in clause (i), (ii), or (iv); (iv) any person, acting for its own account or the accounts of other qualified purchasers, who in the aggregate owns and invests on a discretionary basis, not less than $ 25,000,000 in investments, and (v) “knowledgeable employees” of the manager. For the purposes of the definition of qualified purchaser, the term “investments”, in part, means: (1) securities other than securities of an issuer that is controlled by or is under common control with, the prospective qualified purchaser; (2) real estate held for investment purposes; (3) commodity interests held for investment purposes; (4) physical commodities held for investment purposes; and (5) cash and cash equivalents (including foreign currencies) held for investment purposes. Cash and cash equivalents include: (i) bank deposits and certificates of deposit held for investment purposes; and (ii) the net cash surrender value of an insurance policy.