Forming and raising a fund

Explanation

Appropriate early-stage design and planning of a fund is vital to its success. The structural elements of the fund must match the intended investment strategy. Advance planning also helps to focus the fundraising team so that effort and cost are not expended inappropriately. Planning during this stage will normally outline all of the fundraising team’s activities up to the first closing of the fund and the key business milestones and regulatory approvals required.

Recommendation

The early-stage planning should address the following issues:

• Fundraising timing including reviewing any restrictions from existing funds or contracts on raising new money, and the availability of the GP’s human and financial resources to market and raise the fund;
• Fundraising budget and costs including consideration of the costs of the fundraising such as legal and regulatory charges, travel and placement adviser costs, and the apportionment of these costs between the fund and the GP;
• Investment strategy including what is the fund’s investment policy and objectives as well as any specific requirements coming from that strategy such as fund size or geographic scope;
• Resources for implementing the strategy including identifying the human resources that will be needed to implement the fund’s objectives and responsibly manage and administer the fund and the GP’s activities while ensuring such individuals are likely to remain committed to the fund for its duration;
• Fund structure including form and jurisdiction as well as key structural terms such as the length of the investment period and term of the fund, minimum and maximum fund sizes and deal flow allocation between other funds managed by the GP;
• Fund economics including the level of management fees, the provisions regarding transaction, advisory or other costs to be incurred by the fund or the GP and the appropriate profit share and carried interest structure, in particular focusing on the apportionment of carried interest, timing of payments and GP clawback mechanisms;
• Marketing strategy including what type of LPs will be targeted for the fund and the resulting regulatory requirements for marketing, the structural impact on the fund, and other specific requirements of the targeted group (such as environmental, social and governance (“ESG”) or other reporting needs); and
• Responsible investment considerations including their incorporation into the GP’s organisation and its investment and portfolio monitoring processes and policies.

Explanation

An efficient and well-planned marketing campaign is vital in ensuring that fundraising is successful. Many European, as well as non-European, jurisdictions regulate the marketing of funds and restrict solicitation to certain types of LP (such as sophisticated and professional investors). In some jurisdictions licences are required to carry out marketing activity and restrictions may apply to early informal discussions with potential LPs. Planning should identify the relevant jurisdictions, including multiple jurisdictions, where regulations need to be analysed and gives the fundraising team the opportunity to obtain appropriate advice to remain in compliance with relevant regulation.

In many jurisdictions there are restrictions on the types of investor to whom it is permissible to market funds. The tests for determining eligibility vary from jurisdiction to jurisdiction. In some areas, the potential investor’s net worth or the minimum size of investment may be criteria for permitting marketing.

Failure to comply with the relevant regulatory requirements may have civil, regulatory and even criminal consequences. The civil consequences can be liability for damages or even the commitment of the LP to invest becoming unenforceable. The regulatory consequences can be public censure, impairment or loss of authorisation and even criminal prosecution.

Recommendation

The GP must ensure and be able to demonstrate it is aware of and compliant with all applicable legal requirements and restrictions on marketing funds in each jurisdiction in which it wants to approach prospective investors.

Investors should be obliged to confirm that they meet the GP’s requirements in terms of eligibility, are suitably experienced and understand and accept the risks of the investment.

The fundraising team should maintain a record of all persons to whom it markets the fund and a record of all information provided to them, in order to be able to provide evidence that it has complied with applicable laws.

Explanation

Although the final structure of a fund will largely be determined by the negotiations and discussions with potential LPs, a proposed structure is necessary from both a regulatory and commercial perspective to allow the fundraising team to market the fund and be able to keep promises made during the fundraising process. Certain categories of target investor may have an impact on the structure and the processes of the fund (such as US-based ERISA investors). The solutions to these issues tend to be similar in all funds and they may be addressed at the planning stage if it is intended to market the fund to such LPs.

Recommendation

The fundraising team should identify a proposed structure for the fund, including suitable vehicle(s) for the fund. Wherever possible, the GP should take account of the likely requirements of targeted investors when considering these structures (including their tax requirements and the regulatory requirements of different vehicles in different jurisdictions). Consideration should also be given to the allocation of any ongoing costs of the maintenance of the fund as a consequence of any structuring.

Explanation

A private equity fundraising is a complex, time and resource-intensive process with many parties, internal and external to the GP, involved. The fundraising team generally takes the lead role in planning, coordinating and executing the fundraising but invariably the process involves many other parts of the firm, including the investment professionals.

The fundraising team will usually have certain responsibilities for the effective execution of the fundraising such as complying with applicable marketing laws, developing the information and documents provided to potential LPs and carrying out anti-money laundering checks.

Private equity remains a people business. In terms of credibility and continuity, LPs often expect the key people, both individuals in the investor relations team and senior investment professionals identified during the fundraising process, to remain involved with the fund after the closing.

Recommendation

Careful consideration is recommended of the resources needed for the fundraising process including how much can be managed in-house by the GP and what roles can be played by advisers and other third parties.

The GP should secure adequate resources to meet the demands of the fundraising process while continuing to be able to fulfil the existing portfolio management, investment and other duties arising from its current funds and portfolio.

Tasks and responsibilities during the fundraising stage should be clearly identified and appropriately apportioned. If specific knowledge is not available in-house, then resources should be complimented with external support as appropriate.

It should also be made clear to potential LPs which responsibilities will be undertaken by the GP (including as appropriate the specific roles of the fundraising team) and which by external advisers once the fund has been raised.

Explanation

On occasion, LPs may request the GP to partially or fully reimburse certain agreed costs of the fund review process (e.g. travel expenses, consultants, advisers, legal fees, etc.).

Recommendation

It is not usual for LPs to have their due diligence costs reimbursed either by the fund or the GP (or by a placement adviser acting on their behalf) when considering an investment in a fund. This practice is likely to be unacceptable to the other committed LPs, who would ultimately bear the burden of these costs, or could leave the GP and the LP in question open to accusations of bribery or improper conduct. If there are exceptional circumstances and the GP does enter into such an arrangement, then it should be properly disclosed to other LPs.

Explanation

The fundraising process can be a costly exercise, with several parties involved including a placement adviser, lawyers, accountants and fund administrators.

Recommendation

It is recommended that the GP ensures that thought goes into budgeting for the fundraising process and is clear about the level of information potential LPs need about adviser remuneration and own fundraising costs.

It is generally accepted in the market that lawyers, accountants and fund administrators can be paid out of the fund formation costs up to an agreed cap, but placement adviser fees should not be paid as part of the fund expenses, formation or otherwise.

Explanation

The fundraising team will normally start by approaching existing LPs if the GP has raised a prior fund, as new investors will typically take comfort from the continuing commitment of existing investors.

The quality and reliability of each LP affects all those investing in a fund, as drawdowns will be made throughout the life of the fund. If one LP defaults, even when suitable penalties are applied, other LPs are likely to be disadvantaged especially if as a result the fund cannot honour an agreement to invest. Managing a default situation will require GP time and will inevitably incur a cost to the fund; in addition, this may reflect negatively on the GP and its reputation.

Moreover, whilst all LPs should be afforded fair treatment, some LPs may require specific opt-out or excuse clauses that will prevent them from participating in certain investments. If these issues are not addressed during the fundraising, the fund may find it more difficult to make investments, or be forced to find additional financing at short notice.

A further consideration is the long-term nature of the relationship with a prospective LP and whether they are likely to invest over multiple fund cycles.

Recommendation

The GP should target potential LPs with the aim of attracting a balanced and, if possible, diversified group of LPs, having regard to the nature of the fund, its objectives, structure and any regulatory requirements. Such diversification, by type and geography of LP, will help to ensure that the fund has a reliable source of capital to fund its strategy and mitigate the impact of a default by an individual LP.

LP default is a relatively rare occurrence, but carries very serious implications. Particular reference is made to the Code of Conduct principle of “acting in fairness” and therefore, robust contractual default provisions are advisable to protect both fellow LP and the GP’s interests.

Similarly, any withdrawal of an LP should be subject to strictly defined and exceptional situations.

Specific reference is made to the “do no harm” principle in the Code of Conduct and therefore fund documents will usually contain an express right to require the withdrawal of an LP who is causing serious legal, regulatory or taxation problems or reputational issues for the fund and its investors.

In accordance with the principle of disclosing conflicts of interest and acting in fairness, the GP should disclose any opt-out rights granted to individual LPs as part of the due diligence process.

Explanation

The definition of what money laundering is and the application of anti-money laundering (AML) legislation can vary from jurisdiction to jurisdiction. However, there are general requirements and common principles with respect to AML legislation stipulated in the guidelines issued by the Financial Action Task Force (FATF) and these include checks not only on the investing entity but also for establishing who is the “beneficial owner” of the investing entity, to prevent the laundering of money through fund investments.

Recommendation

The GP is responsible for ensuring compliance with applicable anti-money laundering requirements.

Irrespective of considerations concerning compliance with law, a GP should take care only to introduce reputable, long-term partners into the fund.

GPs should ensure that the fund documents require LPs to provide any necessary identification information that the GP requires to meet its policies and relevant regulatory and legal requirements, including providing documentation to the authorities during the life of the fund. Failure or refusal to meet this requirement should provide the GP with the right to require the LP to withdraw from the fund.

Legal advice should be obtained on this matter as early as possible to ensure that all relevant money laundering checks are undertaken and properly documented. These checks must in all cases comply with the relevant local rules in the jurisdiction where the fund is domiciled as well as that from which it is administered. In addition, during fundraising, steps should be taken to ensure that capital commitments are not made to facilitate money laundering. Investment should not be accepted where the source of the investment causes concern (e.g. where the investment originates in an FATF black-listed country) or the LP’s (or its beneficial owners’) identity either cannot be verified or is reasonably deemed an internationally sanctioned person or institution, or until further, enhanced due diligence is completed and confirms these factors are not an issue.

Subscription documents should include specific information and confirmation from LPs in the fund regarding the origin of money invested, corroborated by appropriate documentation and supported by suitable warranties where applicable. The fund documents should enable the GP to require LPs to update or expand such information, documentation and warranties as applicable and provide the GP with the right to manage the situation if their failure to provide such information, documentation and/or warranties impairs the ability of the GP and the other LPs to carry on the business of the fund.

Explanation

The terms for investment in a fund will normally be subject to and the result of negotiation. Given the diverse nature of potential LPs in private equity, some LPs may require specific terms to deal with, for instance, their own regulatory obligations.

LPs may also be keen to get certain preferential rights or economic advantages (such as positions on the LPAC, preferential access to co-investment opportunities, reduced management fees or a participation in carried interest). It should also be noted that trade and strategic investors may have different priorities for their investment compared to those of financial investors.

However, in a fund, it is generally presumed that all LPs will be treated fairly (and applicable law may require fair treatment). The AIFMD, for example, provides for mandatory disclosure concerning the differentiated treatment of investors including a description of the preferential treatment and the type of investor who obtained such treatment. Including such disclosure would also be in accordance with the Code of Conduct’s principle of disclosing conflicts of interest.

The extent to which specific LPs are granted influence over the management of the fund should be considered carefully, both by the GP and the LP. Firstly, there is the issue of fairness; where some LPs may have an issue if another LP, rather than the fund manager, has a role in the investment decision-making process. Secondly, if such influence alters the management structure of the fund it can compromise LPs’ limited liability. Substantial influence on the management of a fund (in particular, the decisions to invest or divest) can subject the fund to merger regulations and notification requirements with undesirable consequences for both the fund and its LPs.

Some LPs may also have an issue if another LP, rather than the fund manager, has a role in the investment decision-making process.

Recommendation

The GP should try to ensure that all LPs in the fund benefit from fair treatment. Different terms can be offered to different LPs but, unless there are exceptional reasons, preferential treatment or specific economic benefits to individual LPs or groups of LPs should be justifiable (e.g. with reference to the amount invested by a particular LP or the specific experience of an LP which adds additional value to the fund).

Specific reference is made to the Code of Conduct principle of fairness so GPs must ensure that LPs in the fund benefit from fair treatment. However, fairness does not entail exact equal treatment. Different terms can be set for different LPs, provided this is done in respect of principles of transparency and that reasonable and fair opportunities to agree to such arrangements are offered.

Explanation

Due to the fact that negotiations with potential LPs will usually continue until the final closing of a fund, documents tend to be continually revised to reflect these negotiations. However, certain core elements that describe the offer and its essential characteristics should remain constant.

These core elements will usually be addressed in a combination of documents which will normally include a private placement memorandum (often the main “marketing” document) and the constitutional documents of the fund. Local laws in the jurisdictions where the fund is marketed may set out requirements on the structure and content of the private placement memorandum and fund documents.

The fundraising team will also normally assemble a comprehensive data pack or virtual data room of documents about the fund, its investment strategy and the GP’s prior track record, collectively comprising the due diligence materials. This material will often contain confidential and proprietary information from the GP as well as, potentially, on current portfolio companies that will need to be appropriately handled. In addition, the fundraising team may receive investor questionnaires covering a variety of topics, including for example ESG disclosure.

As a general rule, any changes to the fund documents would require the approval of a certain majority of LPs. However, some fund documents provide a carve-out for changes agreed after the first close with prospective investors in the fund which are not averse to the interests of existing LPs. These changes can in some jurisdictions be made by the GP without LP consent in order to facilitate its fundraising efforts, provided however that where any LP is adversely affected by the change in question then the affected LP would have to consent to the change.

Continuous amendment of documents as negotiations with investors advance and the structure is formalised can create a risk, if not addressed appropriately, that not all LPs will receive the same information about the fund before they make a commitment to the fund. In accordance with the principle of fairness, it is essential to ensure that all LPs receive and acknowledge they have received complete final documentation prior to closing.

The time schedule for the negotiation should allow for any required regulatory approval of amended fund terms (for example, this will often be the case for funds managed by AIFMD-authorised managers).

Recommendation

The fundraising team should ensure that it has sufficient resources to manage the information and documentation demands of the fundraising process, including the preparation of data rooms and responses to investor questionnaires and other inquiries.

A draft private placement memorandum or similar fund documents should be made available to LPs with a finalised version issued prior to first closing, with, where necessary, updates issued prior to each subsequent closing. Draft constitutional documents establishing the fund (e.g. Limited Partnership Agreement, Management Agreement, subscription documents) will also need to be produced and made available to prospective LPs.

Appropriate records should be kept to ensure that all LPs are able to review the same information. The use of due diligence data rooms (physical or virtual) can be an effective way to provide information to prospective LPs, provided that security and confidentiality are maintained. Between the first and final closings this information should be updated if changes are required and such updates should be disclosed to both existing and potential LPs, so that all have had access to the same information.

Appropriate advice should be sought on the requirements of the laws in all jurisdictions where the fund is marketed.

The private placement memorandum must contain full and true information presented in compliance with applicable local laws and in a manner that is clear, fair and not misleading. Appropriate steps should be taken to ensure and record the accuracy and completeness of the memorandum, employing third-party advisers where appropriate (e.g. to independently review a GP’s track record information).

The fundraising team should ensure that it can justify and support expressions of belief and statements made in the fund’s private placement memorandum and marketing materials using reliable documents and research, updating these where necessary until the fund has reached final closing.

Consideration should also be given to the content of the due diligence information to be provided to prospective LPs. The information should clearly disclose any potential conflicts of interest arising out of the GP’s corporate structure. The medium through which it will be delivered should be considered too.

Appropriate measures to ensure confidentiality in disclosure, including possibly entering into non-disclosure agreements should be considered. Thought should also be given as to how meetings with prospective LPs will be held and the level and timing of access to information.

Explanation

Presentations and information provided by the fundraising team that influence LPs’ decisions are often subject to the law of all the jurisdictions where a fund is promoted. These laws will often apply to information provided to LPs, irrespective of the media by which it is communicated.

In some circumstances, presentations may be made to potential LPs at an early stage and the information provided to them may influence their decision to invest, even though they have not yet received any formal fund documents. It is important that potential LPs are made aware of any changes to information provided to them at any point during the fundraising process so that they are able to make a balanced investment decision based on correct information.

Recommendation

As set out in the second question above, the fundraising team must comply with local laws relating to the marketing of funds in all jurisdictions where the fund is promoted and appropriate professional advice should be obtained.

The fundraising team should ensure that information provided to potential LPs and promotional statements made to them in whatever form (e.g. in telephone calls, meetings, slide presentations, letters, emails, websites, etc.), even at an early stage, are correct and fairly presented. Any subsequent material changes to such information must be communicated to potential LPs.

Explanation

The topic of responsible investment is of great significance to the industry. As society is addressing the sustainability agenda, the consideration and management of ESG opportunities and risks in the investment process are becoming more important to GPs and LPs alike to safeguard the long-term performance of investments. Furthermore, there is an increasing interest in the sustainability impact of business activities. It is in the industry’s best interest that industry participants communicate how ESG factors are considered and managed throughout the investment process. Besides the potential to have a positive impact on the long-term performance of a portfolio company, investing responsibly helps ensure that a GP is doing no harm to the industry, the portfolio companies and their stakeholders.

Recommendation

GPs should clearly define and document their responsible investment policy and the procedures for compliance with such policy and will typically be asked by LPs to provide information both during due diligence and throughout the life of the fund. The GP should disclose its industry association memberships and/or other memberships and affiliations.

During fundraising, a GP should seek to disclose information sufficient to enable an LP that has expressed an interest in ESG management to:

1. assess if the GP is aligned with the LP’s ESG-related policy and investment beliefs;

2. assess the GP’s policies, processes, and systems for identifying ESG-related value drivers and managing material ESG-related risks; and to identify possible areas for future development;

3. understand if and how the GP influences and supports its portfolio companies’ management of ESG-related risks and pursuit of ESG-related opportunities;

4. assess how the GP will help the LP to monitor and, where necessary, ensure that the GP is acting consistently with the agreed-upon ESG-related policies and practices as set forth at fund formation;

5. assess the GP’s approach to managing and disclosing material incidents at the GP and portfolio companies.

For more information, please also see the Invest Europe Responsible Investment Bibliography.

Explanation

Potential LPs will expect detailed track record information for the GP to be made available as part of the due diligence process. It is an important part of acting with integrity that the track record properly represents the GP’s prior performance and is both complete and accurate. It is possible for such material to be misread or to mislead potential LPs, particularly in view of changing circumstances for the GP or if there is a selective presentation of material.

Recommendation

Information with respect to the track record must not be presented on the basis of selective or incomplete data that is unrepresentative or misleading. The basis of all such statements should be fully disclosed in the fund documents. In particular, the period to which any track record information relates and any unusual factors that might influence the returns presented should be disclosed. Gross and net track record information should be calculated and compiled in accordance with the valuation and accounting standards appropriate for the fund’s jurisdiction. Any use of benchmarks must be appropriate, consistent and clearly defined.

The fundraising team should ensure that when there is any material change that affects such information prior to final closing, it is disclosed to all LPs.

Track record information may be confidential (for example, to previous employers or portfolio companies) and the fundraising team should ensure that appropriate consent is obtained before it is used.

Explanation

The fundraising team may wish to make forecasts regarding likely performance in the fund’s chosen sectors, target IRR and money multiple. However, it is very easy for such material to be misread or to mislead potential LPs, particularly in view of changing circumstances or if there is a selective presentation of material.

Recommendation

Forecasts are not required by law or regulation in institutional products/private placements and are therefore not a typical feature of the fund documents. The making of forecasts within the fund documents is ultimately a business and economic decision of the GP and its fundraising team when marketing the specific product.

If the GP and its fundraising team decide to include forecasts in an offering document, such forecasts must not be made on the basis of data that is unrepresentative, misleading or incomplete. Further, the relevant data, the assumptions and the approach taken to produce the forecasts should be fully disclosed in the fund documents.

Explanation

It is important that fundraising does not continue indefinitely, as this can prevent the GP from implementing the fund’s investment strategy, while resources continue to be committed to marketing. There may also be time limits imposed by certain laws and regulations.

Between first and final closing a GP may make investments for the fund. Should this period become extended any portfolio created has a greater potential to change in value, raising the question of fairness in the division of gains and losses between first and the following close investors. There may also be tax implications from such value changes.

Recommendation

The fundraising team and the GP should ensure that fundraising is completed within a reasonable time after the first closing of the fund. Market terms typically dictate that a final close should take place within a prescribed period of the first close, unless changed by LPs’ consent.

Consideration should be given to levying an equalising interest payment from LPs who commit to the fund after the first closing to reflect the cost of money for LPs committing at an earlier stage of the fundraising process. The purpose of this is so that all LPs can be treated as if they had committed at the first closing. The equalising payments are generally credited pro rata among the existing LPs and not treated as an asset of the fund.

If the fund makes investments between the first and final closing, consideration should be given to how to allocate any gain or loss during that period and any resulting tax implications that might arise.