The Changing Landscape of Private Fund Investing
By Rebecca Carpenter
Ten years ago, private fund terms were relatively standard. That is no longer the case. Not only have things changed greatly from what we saw a decade ago; but now, there is considerable variety between private funds.
How is a private fund structured?
A three-entity structure used to be standard when launching a private fund. The private fund would be a Delaware limited partnership (LP); the general partner of the fund would also be a Delaware LP; and the investment manager to the fund would be a Delaware limited liability company (LLC) that also served as general partner of the fund general partner.
However, the structure now typically reflects the anticipated assets under management, the size of the investor pool, and the domicile of investors. For a smaller fund where the investors largely live in Texas, the manager/general partner entity and the fund entity may be formed in Texas, instead of Delaware, to save on costs since the treatment of entities from a tax and legal perspective is well-settled here. Also, investors have become more comfortable with LLCs, so we often see clients choosing to utilize LLCs at both the fund level and the manager level, instead of LPs.
For smaller funds, it often makes sense, from a cost perspective, for the general partner or managing member of the fund to wear two hats, acting as both the general partner/managing member as well as the investment manager. If a Texas-based fund expects its annual revenues to exceed $1,100,000, we recommend using the three-entity limited partnership structure for franchise tax purposes because passive income is not subject to franchise tax.
Thus, by separating the carried interest, which is passive income, allocated to the general partner/managing member from the management fee earned by the investment manager, this protects the carried interest from being commingled. The carried interest then inadvertently becomes subject to the franchise tax that applies to the management fee if the management fee exceeds $1,100,000.
What fees are charged to the private fund?
Management fees today are varied. Nearly all private funds used to charge an annual 2% management fee. While some funds still do, other funds may only charge a fee upon subscription or even a flat administrative fee. If the management fee is charged on an ongoing basis, it may only be during the investing period or it may step down once the investment period has terminated. These variations in the management fee communicate that as the time required to manage the fund decreases over time, the fee charged should decrease as well.
While we often still see a 20% carried interest going to the general partner/managing member, how that carried interest is allocated or shared has changed. The carried interest is the percentage of the profit from fund investments that is allocated to the fund’s general partner/managing member. A decade ago, the principals would compensate investment committee members, advisers, and the like separately from any income derived from the fund. Now, principals often share a piece of its carried interest with these advisers. This profit sharing is a smart move – the more successful the fund is, the more this arrangement pays off. Thus, those investment committee members and strategic advisers are motivated to work harder for the fund. Further, the principals are not responsible for paying these strategic partners when and where the fund is not experiencing a profit on its investments.
How has the cost of launching a private fund changed?
The cost of launching a private fund has decreased considerably. A decade ago, a private fund needed to have at least $10 million in capital commitments to justify the expenses associated with a launch. One of the largest expenses was associated with preparing the legal documents. Other large expenses included marketing materials as well as travel costs to pitch to potential investors. Now, there are various companies, rather than law firms, that will assist in basic fund formation documentation, and software to create marketing materials is more widely available at a lower cost. Also, there are a number of platforms that allow fund managers to pitch to investors virtually, saving on the cost of travel. The lowered cost on all fronts allows smaller funds to enter the marketplace.
Who can invest in private funds? Is publicly marketing to potential investors still prohibited?
Under the Securities Act of 1933, an offer or sale of securities must be registered with the SEC unless it is exempt. For many years, to be exempt, the offering had to be private, which meant that the fund’s offering could not be marketed to the public. However, with the passage of Rule 506(c), a private fund may now publicly advertise its offering of interests as long as it only accepts “accredited investors.”
The ability to advertise has made it much easier for private funds to raise capital. It has also changed the landscape of how the terms and risks are presented to investors. Previously, when considering investing in a fund, an investor would receive a voluminous private placement memorandum which thoroughly discussed the risks associated with investing in the private fund. Now, that information is often presented on a website, that is more concise – far from the lengthy (and costly) document we saw a short time ago.
As noted, to advertise an offering, a private fund may only accept investors that qualify as “accredited investors.” With respect to individuals, this definition previously focused almost solely on net worth, essentially assuming that individuals with high net worth had the knowledge and experience to evaluate the risks of an investment. In more recent years, the SEC has indirectly acknowledged that this assumption is flawed by expanding the definition of what constitutes an accredited investor. Now, individuals with certain professional certifications, designations, or credentials as well as “knowledgeable employees” qualify as accredited investors. We feel this definition is still unnecessarily narrow given the breadth of knowledge available to individuals now, allowing virtually anyone to become knowledgeable and capable of evaluating investment risk. Hopefully, the SEC will continue to adjust this definition and we will see more and more individuals being able to invest when and where they desire.
What sort of investments are private funds making?
The breadth and motivation for investing has evolved. A decade ago, funds were generally focused solely on money—which investors could provide the most capital and which investments could provide the highest return. Today, we see more and more fund principals who are focused on bettering the world and addressing systematic issues while also earning a solid return for the investors.
The world of private funds has transformed over the past decade, giving variety at nearly every turn. Please let us know if we could help you in your next (or current) private fund offering.