Alternative Private Equity Funds: Pledge Funds, …media.straffordpub.com/products/alternative-private...2016/03/29 · TUESDAY, MARCH 29, 2016 Mark Proctor, Partner, Vinson & Elkins,

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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

6


• 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

7


• 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

8


• 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

9


• 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

10


• 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

11


• 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

12


• 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

13


• 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

14


• 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

15


• 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

16


• 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

17


• 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

18


• 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

19


• 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

20


• 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

21


• 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

22


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

23


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

24


THE STATE OF CO-INVESTMENTS – LP ACTIVITY

25


THE STATE OF CO-INVESTMENTS – LP PERSPECTIVES

26


THE STATE OF CO-INVESTMENTS – PERFORMANCE

EXPECTATIONS

27


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

28


THE STATE OF CO-INVESTMENTS – GP PERSPECTIVES

29


THE STATE OF CO-INVESTMENTS – INVESTMENT PARTICIPATION

30


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

31


• 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

32


Principal Governing Document: Shareholders’ Agreement

CO-INVESTMENT STRUCTURE: DIRECT INVESTMENT IN C-CORP

33


Principal Governing Document: LLC Agreement

CO-INVESTMENT STRUCTURE: DIRECT INVESTMENT

IN PASS-THROUGH

34


Principal Governing Document: LP (or LLC) Agreement for SPV

CO-INVESTMENT STRUCTURE: SPV

35


CO-INVESTMENT TERMS: FEES AND CARRY

36


• 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

37


• 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

38


• 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

39


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

40


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?

41


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

42


SEPARATELY MANAGED ACCOUNTS: TRENDS

43


• 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

44



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THANK YOU

Robert Seber

[email protected]

Mark Proctor

[email protected]

Documents

Alternative Private Equity Funds: Pledge Funds, …media.straffordpub.com/products/alternative-private...2016/03/29 · TUESDAY, MARCH 29, 2016 Mark Proctor, Partner, Vinson & Elkins,