For a management team seeking to raise its first private equity fund, fundraising is a time consuming, costly and challenging process, even during periods of robust capital investment.
When faced with uncertain fundraising prospects, managers may seek alternative strategies to meet their capital needs. Common alternatives include partnering with a core group of investors to form a smaller fund or a joint venture with fund-like terms, and partnering with institutions willing to sponsor the manager or the manager’s fund. Although each alternative does bring immediate benefits and helps alleviate many fundraising uncertainties, managers should consider the long-term consequences as well.
This article discusses a number of the business and legal considerations surrounding these alternatives. Depending on the relative negotiating strength of the parties, managers seeking to hold a quick, fluid close may find themselves in a challenging position, particularly with respect to negotiating key economic and control rights that impact fund operations post-closing.
During economic slowdowns, investors tend to become more risk-averse, opting to invest in proven management teams with demonstrated track records. As evidenced below, overall fundraising was on the decline in the first half of 2008 as compared to the same time in 2007.
Insert Table: U.S. Private Equity Fundraising, 1H08 v. 1H07
A manager seeking to raise, or in the midst of raising, its initial fund in a challenging economic environment may want to consider alternative strategies that, although not always ideal, will facilitate a third-party capital close. Managers in the early stages of fundraising often have already located several strategic investors to form their core investor base. They may want to continue fundraising, but lack the working capital to finance fundraising activities; others may lack deep networks or the reputation to source investors for a first time fund.
When dealing with such adversities, a manager may choose to follow alternative paths to achieve its underlying goals. Some of the more common alternatives are discussed below. Although these alternatives alleviate some fundraising uncertainties, it is imperative that managers consider all the implications associated with these alternatives.
Fund Joint Ventures
The first alternative involves foregoing the fundraising process altogether and closing on commitments from a more limited number of core investors. Ideally, these investors will become passive investors in a fund, albeit a much smaller one, managed solely by the manager. However, negotiations with these investors may result in an investment vehicle that resembles a joint venture rather than a fund.
For certain managers, there are benefits to forming a smaller fund or joint venture with the existing core group of investors in lieu of pursuing a larger fundraise—commitments are locked in immediately, allowing the manager to focus on deploying capital rather than fundraising. Additionally, certain management teams may not be large enough to fundraise while closing new investments. These managers may not be prepared to shut down deal activity during a large portion of the fundraising process because the current deal pipeline may be too valuable to forego.
Drawbacks, however, do exist in this alternative. Bilateral (or trilateral) negotiations of fund terms will be as challenging and time consuming, if not more so, than negotiating fund terms with a large number of prospective investors. Strategic investors will enjoy additional leverage in the negotiating process. The result may be a joint venture arrangement that is more complicated and contains “off-market” fund terms, leaving the manager with less freedom to manage the enterprise. Strategic investors in a joint venture may seek a number of rights to which they would not otherwise expect to be entitled as fund investors, often including the following::
• a seat on the investment committee that grants them some control or a veto right over investment acquisitions and dispositions;
• ability to monitor and approve the expenses or budget of the joint venture; and
• power to review and approve conflict of interest transactions (e.g., approval of any transactions and fees that would result in the payment of portfolio fee income to the sponsor and its affiliated entities) and other material third party contracts.
Forming a joint venture does streamline the fundraising process. But it often results in a joint venture arrangement that, relative to fund agreements, requires a more collaborative investment and fund management process post-closing. Other issues that managers may wish to preliminarily consider, or should expect to negotiate specifically with their prospective joint venture partners, include the following:
• whether the joint venture is capped in terms of commitments or investors, and if not, whether the manager needs approval to admit new investors;
• whether the joint venture partners are required to invest in all deals, or whether they are permitted to opt out of investments on a deal by deal basis;
• whether the manager is limited in its ability to invest in or form investment vehicles or funds that will target investment opportunities outside of the joint venture’s investment objectives;
• whether all joint venture partners are required to offer investment opportunities to the joint venture; and
• whether the joint venture partners are granted priority on co-investment opportunities.
Some new managers may have a team in place to effectively identify, monitor and dispose of investments, while lacking deep networks from which to source investors or administer their fund. A common alternative which works to alleviate these fundraising concerns involves partnering with an institutional sponsor willing to either 1) provide the manager with working capital or access to a network of potential investors, sometimes in exchange for a share of the manager’s economics and governance rights or 2) sponsor the fund, by investing a large commitment in exchange for certain economic and control rights at the fund level, and at times, for a share of the manager as well.
As with joint ventures, managers partnering with sponsors may lose some flexibility and control in administering their fund. For instance, the sponsor may request a seat on the manager’s investment committee, as well as approval rights relating to certain non-investment related determinations. Depending on the relative bargaining positions, experience of the parties and economics involved, other issues that may be raised during the process include the following:
• whether the sponsor agrees to fund all or a portion of the working capital during fundraising;
• whether the sponsor guarantees all or a large portion of its commitment even if fundraising is not successful;
• whether the sponsor commits any resources outside of working capital (e.g., employees or assistance with back office and other administrative functions during or after fund raising);
• whether the sponsor receives a share of carried interest and fee income from the fund and/or from subsequent funds formed by the same manager, but with different investment objectives;
• whether the sponsor agrees to use its best efforts to help fundraise;
• whether the sponsor is prevented from sponsoring competing funds, or if it is required to offer investment opportunities to the fund that meet its investment criteria;
• whether the sponsor is permitted to have any communications with limited partners or portfolio companies; and
• whether the sponsor has any control over hiring and termination determinations by the manager.
Getting To A Close
In an ideal fundraising environment, managers will seek to raise a private equity fund in which they retain general partner control over a blind-pool fund. Given the time and expense of fundraising, a manager facing uncertain fundraising prospects should consider alternative paths to closing on third-party capital, while being mindful of the impact these alternatives may have on the fund post-closing.
The importance of successfully closing on third-party capital cannot be underestimated. Palpable benefits of closing any first-time fund or other closed-end investment vehicle include: establishing a core investor base for subsequent funds; gaining experience in managing third party capital; and establishing a track record.
Managers opting for these routes should first consider the entire package of rights to be requested, and discuss with their prospective partners which points are open to negotiation and which are potential non-starters.
Planning for fundraising involves an analysis of short and long-term goals and prospective investors, as well as alternatives to raising a fund. With careful planning and strategic, realistic goals and alternatives, fundraising for first-time funds will likely be a success, even in the face of an economic downturn.
Scott W. Naidech is a Partner in the Private Funds practice at the law firm of Chadbourne & Parke LLP. Reach him at firstname.lastname@example.org