Alternative Private Equity Funds: Pledge Funds,...
Transcript of Alternative Private Equity Funds: Pledge Funds,...
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Presenting a live 90-minute webinar with interactive Q&A
Alternative Private Equity Funds: Pledge
Funds, Managed Accounts, Deal-by-Deal
Co-Investments and Other Hybrids Structuring and Negotiating Alternative Funds for Investment Managers and Investors
Today’s faculty features:
1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific
TUESDAY, MARCH 29, 2016
Mark Proctor, Partner, Vinson & Elkins, New York
Robert Seber, Partner, Vinson & Elkins, New York
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ALTERNATIVE PRIVATE EQUITY FUNDS
www.velaw.com
MARCH 29, 2016
Robert Seber
Mark Proctor
Confidential and Proprietary ©2016 Vinson & Elkins LLP www.velaw.com
AGENDA
1. Pledge Funds
2. Combo Funds
3. Co-Investments
4. Separately Managed Accounts
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• It’s getting tougher for new GPs to raise capital…
– In 2015, 689 PE vehicles raised $288bn
– Just 8% of capital went to new GPs
– 54% of investors would not consider investing in first-time funds over the
next 12 months
PLEDGE FUNDS
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• What is a pledge fund?
– Investors decide whether to participate in investments on deal by deal
basis
– Limited due diligence
– Prearranged terms if participate
PLEDGE FUNDS
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• Basic elements of a pledge fund
– Agreement to give investors a first look at deals, often in exchange for a
fee
– A set process / timeline by which investors decide to participate in each
deal
– Prearranged structure and terms for deals that get executed
PLEDGE FUNDS
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• Advantages
– Gives GP a preferred source of capital
– Enables an investment team to establish a track record without raising a
blind pool
– Enables manager to have some ongoing fee stream
– Allay investor concerns about committing capital to managers with lack
of track record or tarnished track record
PLEDGE FUNDS
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• Disadvantages
– Manager takes on risk that capital will not be available for any given
deal
– Fees are lower than with a blind pool; manager must operate leanly
– Sometimes perceived by potential target companies as “tire kickers” and
not “serious investors” – could be a disadvantage in an auction process
PLEDGE FUNDS
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• Structural Approaches – Multiple SPVs
– IMA signed initially; includes ROFO, “capital commitments” and option
or management fee provisions
– Separate SPV (can be LP or LLC) for each deal; each SPV has its own
waterfall and governance terms
– LPA negotiated upfront at same time as IMA
PLEDGE FUNDS
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• Structural Alternatives – Single Vehicle
– Single LP or LLC that issues multiple classes
– Lets investors opt into or out of each deal – all deals within the same
vehicle
– Vehicle issues a separate class of interest for each deal with a discrete
set of investors
PLEDGE FUNDS
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• Pledge Fund Mechanics
– Each investor subscribes for a specific amount
– Investment manager is obligated to present opportunities to fund up to
the aggregate amount
– Manager presents investors with a due diligence memorandum
describing each investment opportunity. Investors are permitted to opt
into (or out of) each investment – typically have 5 to 10 days
– Each investor may opt into a deal for up to its maximum allotment to the
deal
– Any unsubscribed capacity may either be offered to other pledge fund
investors or third parties
PLEDGE FUNDS
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• Expense Allocation Provisions
– Expenses for deals shared by investors who opt in pro rata based on
deal sharing percentages
– Broken deal expenses allocated depending on when the deal “breaks”:
• If breaks before expiration of the opt-in period: allocated in accordance with
“commitments” to pledge fund
• If breaks after expiration of opt-in period: allocated in accordance with deal
sharing percentages
PLEDGE FUNDS
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• Fees
– “Option” fee on commitments – investors pay a small fee (e.g., 50bps)
for the right to a first look at deals
– Management fee – investors pay a management fee on invested capital
in each partnership
– Carried interest – investors pay carry on a deal by deal basis
• Deal point: whether deals are cross collateralized
PLEDGE FUNDS
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• Key Issues
– Track record: question as to whether returns completely driven by GP’s
investment discretion (since investors can opt out of deals); each
investor has its own returns
– Serial non-participation: how to deal with LPs who don’t fund their share
of deals?
• Three strikes rule with penalty, which can be structured as penalty for each
opt-out, or increase in “option” fee
• Manager should ask for right to terminate investment period if there is
significant lack of participation in deals
PLEDGE FUNDS
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• Key Issues (cont’d)
– Credit for rejected deals
• Manager has incentive to show as many deals as quickly as possible to get
through ROFO obligation
• To keep manager from showing deals that are trash LPs may seek to have
manager receive reduced (or no) credit for deals rejected by a majority of
investors
– Winding Up – it is important for the Manager to be able to terminate the
pledge fund if LPs reject too many deals
– Conversion to Blind Pool – Managers may seek to include mechanism
to convert the pledge fund to a blind pool
PLEDGE FUNDS
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• Investment Advisers Act
– Assets invested in deals count as RAUM
– If pledge fund has nominal commitments (as most do), do nominal
commitments count as RAUM?
• Non-discretionary IMA
– If pledge fund does not state nominal commitments, what result?
PLEDGE FUNDS
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• Overview
– Combination between a pledge fund and a blind pool
– Investors make a capital commitment to the “hub” or blind pool fund and
separate “commitment” to the “spoke” or pledge fund
– Each deal may be allocated to the blind pool fund and, potentially, the
pledge fund
COMBO FUNDS
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• Principal issues
– Allocation of capital between blind pool and pledge fund
– Allocation of deals between blind pool and pledge fund
• Based on investment restrictions in blind pool
• Set allocation
• Unsubscribed investment allocation
– Netting of carried interest
– Management Fee
COMBO FUNDS
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• Not a clearly defined category
Our focus is on LPs investing in deals alongside the PE fund
based on their own investment decision
• How do LPs and GPs view co-investments?
• How have co-investments evolved?
• How are co-investments structured?
• What are the key economic terms of co-investments?
• What are some regulatory issues?
PRIVATE EQUITY CO-INVESTMENTS – OVERVIEW
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TEACHER RETIREMENT SYSTEM OF TEXAS (TRS)
“The past year saw continued growth in the successful Principal Investments Program,
which seeks to take advantage of TRS’s competitive advantages as a large, long-term
investor by initiating high-transparency, low-fee, alpha-producing investment
arrangements with select investment partners. Since the beginning of the program in
2009, the fund has committed $6 billion in more than 50 principal investments across
Private Equity, Real Assets, Energy and Natural Resources, Special Opportunities, and
Internal Public Markets. In addition, the Investment Management Division (IMD) has
committed another $1.2 billion across nearly 70 smaller principal investments in separate
dedicated vehicles managed by select general partners, as well as an even greater
volume of principal investments in side-car vehicles. …
To date, this effort has been highly accretive to the Trust’s returns and it should continue
to be in the future.”
TRS - 2015 Comprehensive Annual Financial Report
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PE Fund of Funds 20%
Public Pension Funds 10%
Family Offices 10%
Insurance Companies 7%
Asset Managers 6%
Private Pension Funds 5%
North America – Based 47%
Europe – Based 22%
Sources: Mergerstat; Prequin
62% Existing LPs
18% Referrals from LPs
10% LPs from prior funds
6% Prospective LPs
THE STATE OF CO-INVESTMENTS – CATEGORIES OF
CO-INVESTORS
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THE STATE OF CO-INVESTMENTS – LP ACTIVITY
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THE STATE OF CO-INVESTMENTS – LP PERSPECTIVES
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THE STATE OF CO-INVESTMENTS – PERFORMANCE
EXPECTATIONS
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THE STATE OF CON-INVESTMENTS: REALITY CHECK
Data from investments by seven large institutional investors.
Source: Fang/Ivashina/Lerner, “The Disintermediation of Financial Markets: Direct Investing in Private Equity” (2014)
Year
Investments
Co-Investment IRR
- Fund IRR
Co-Investment MOIC
- Fund MOIC
1994 1 11.99% -0.44
… … … …
2005 10 2.79% -0.03
2006 18 -10.51% -0.31
2007 33 -16.08% -0.37
2008 9 -25.54% -0.63
2010 8 -1.27% -0.15
2011 6 -13.22% -0.51
Total 103 -8.98% -0.22
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THE STATE OF CO-INVESTMENTS – GP PERSPECTIVES
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THE STATE OF CO-INVESTMENTS – INVESTMENT PARTICIPATION
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CREATION OF CO-INVESTMENTS: RULES OF THE GAME
Legal Effect Concept Frequency
Binding GP is obligated to offer co-
investments
Low
Preferential Certain LPs may have
preferential rights over other
LPs, based on:
early closing
size of commitment
other factors
Medium; can be
turned into a
marketing advantage
by GP
Voluntary Side letters may express
interest by LPs, but co-
investment is in GP’s
discretion
High
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• GP’s need for prompt decision-making v. LPs’ frequent lack of
decision-making capability
• One counsel for all co-investors v. separate counsel for each co-
investor
• Independent evaluation of all due diligence materials (access to data
room) v. reliance reports on prepared by GP or advisors
• Full disclosure and access to information v. limitations set by
confidentiality agreement
CO-INVESTMENT PROCESS: TENSIONS
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Principal Governing Document: Shareholders’ Agreement
CO-INVESTMENT STRUCTURE: DIRECT INVESTMENT IN C-CORP
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Principal Governing Document: LLC Agreement
CO-INVESTMENT STRUCTURE: DIRECT INVESTMENT
IN PASS-THROUGH
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Principal Governing Document: LP (or LLC) Agreement for SPV
CO-INVESTMENT STRUCTURE: SPV
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CO-INVESTMENT TERMS: FEES AND CARRY
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• Drag-Along: Requires the co-investors to sell alongside the GP in the
event of a sale of control
• Tag-Along: Requires the GP to allow the co-investors to participate
in sales by the GP
• Preemptive Rights: Permit the co-investors to maintain their
ownership percentage
• Transfer Restrictions: Limit or prohibit transfers by the co-investors
• Veto Rights: Prohibit or restrict limited types of decisions by the GP
STANDARD CO-INVESTMENT TERMS
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• Governance:
– Representation by co-investor(s) on portfolio company board
– Board or advisory committee at co-investment vehicle
– Observer and other information rights
• Separate audit of co-investment vehicle
• Asymmetric exit rights (e.g., upon portfolio company IPO)
CO-INVESTMENT TERMS: VARIABLES
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• Allocation of investment opportunities between fund and LPs
Policies for decision-making; disclosure
• Preferential co-investment opportunities to certain LPs
Only if provided in LPA or set out in disclosed policy
• Allocation of deal expenses, including broken deal expenses,
between fund and potential co-investors
Policies governing expense allocations in completed and
broken deals
CO-INVESTMENTS: REGULATORY CONCERNS &
RESPONSES
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Washington D.C., June 29, 2015 —
The Securities and Exchange Commission today charged Kohlberg Kravis Roberts & Co. (KKR) with misallocating more than $17 million in so-called “broken deal” expenses to its flagship private equity funds in breach of its fiduciary duty.
KKR agreed to pay nearly $30 million to settle the charges, including a $10 million penalty.
An SEC investigation found that during a six-year period ending in 2011, KKR incurred $338 million in broken deal or diligence expenses related to unsuccessful buyout opportunities and similar expenses. Even though KKR’s co-investors, including KKR executives, participated in the firm’s private equity transactions and benefited from the firm’s deal sourcing efforts, KKR did not allocate any portion of these broken deal expenses to any of them for years. KKR did not expressly disclose in its fund limited partnership agreements or related offering materials that it did not allocate broken deal expenses to the co-investors.
The SEC’s order instituting a settled administrative proceeding also finds that KKR failed to implement a written compliance policy governing its fund expense allocation practices until the end of the six-year period in 2011.
A LEARNING EXPERIENCE
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Separately managed accounts are partnerships that:
• have only the fund manager and the investor as partners within them
• mimic the main fund vehicle but include customized terms on
management fees, carried interest and term
• typically co-invest alongside other funds managed by the fund
manager, but the investor may also retain some discretionary
investment power
• are being increasingly used by investors with significant amounts of
capital, but are still more common at the fund-of-funds level
SEPARATELY MANAGED ACCOUNTS – WHAT ARE
THEY?
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The California Public Employees’ Retirement System, the biggest U.S. pension,
will pursue separately managed accounts for its future investments with private
equity.
“It’s our preference to use these structures moving forward,” spokesman Joe
DeAnda said Thursday in an e-mail.
The managed accounts, where a customer’s capital is invested separately
rather than mixed with that of other clients in a traditional fund, offer cheaper
fees and more control for investors. Clients known as limited partners in turn
agree to commit large sums for longer.
The $303 billion pension fund is working on plans to reduce costs …
To lower fees it pays out, Sacramento, California-based Calpers said on
Monday it will cull the number of external managers it hires to about 100 from
212 over the next five years. The number of private equity managers will fall to
about 30 from 100.
BloombergBusiness, June 12, 2015
CALPERS TURNS TO SEPARATELY RUN PRIVATE
EQUITY ACCOUNTS
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SEPARATELY MANAGED ACCOUNTS: TRENDS
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• Control or influence over investment decisions
• Management fee and carried interest
• Investment horizon
• Liquidity rights
• Environmental, social and governance policies
SEPARATELY MANAGED ACCOUNT TERMS:
VARIABLES
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THANK YOU
Robert Seber
Mark Proctor