Essential Terms of Fund Formation

Essential Terms of Fund FormationJuly 19-20, 2005

Materials have been abridged from laws, court decisions, and administrative rulings and should not be considered as legal opinions on specific facts or as a substitute for legal counsel.

Moderator:Robert M. Friedman, Dechert LLP

Panelist:John Aiello, VP & General CounselPrivate Equity Group, Goldman Sachs & Co.

2005 Private Equity Strategic Financial Management Conference 2

I. Offering Process


Private Offering – Not Registered Under Securities Act of 1933• No general solicitation or general advertising

– Concern regarding interviews, seminar talks

– Websites; password protection

• Safe Harbor exemption under Regulation D for offers and sales only to “Accredited Investors”– Institutions with $5 million in total assets not formed for the purpose

– Individuals with $1 million net worth (or joint with spouse) or income above $200,000 ($300,000 with spouse) for past 2 years and expectation of same for current year

– Entity owned solely by Accredited Investors


Private Offering – Not Registered Under Securities Act of 1933• Safe harbor exemption under Regulation S for offers and

sales only to non-U.S. persons– Offers not made to persons in the United States

– Buyer is outside the United States or seller reasonably believes him to be

– No directed selling efforts in the United States

– Offering materials to advise purchasers that interests may not be offered or sold in U.S. or to U.S. persons without registration or exemption

• Regulation D and Regulation S may be relied on for concurrent sales to different groups


• Private Investment Funds exempt from registration as “investment company” pursuant to one of the following exceptions:

– 3(c)(1) Fund – no more than 100 partners

– 3(c)(7) Fund – limited to Qualified Purchasers• Institutions with $25 million in investments

• Individuals with $5 million in investments

– Parallel 3(c)(1) and 3(c)(7) Funds

Investment Company Act of 1940


Investment Company Act of 1940

• Non-U.S. Funds – only count U.S. persons toward 100 partner limit and only U.S. persons need be Qualified Purchasers. U.S. Funds count all partners (including non-U.S. persons) for purposes of Sections 3(c)(1) and 3(c)(7)

• Knowledgeable Employees – do not count toward 100 partner limit and need not be Qualified Purchasers

– Issue in granting carried interest with requirement for capital contribution to persons who are not qualified purchasers or knowledgeable employees


Investment Advisers Act of 1940

• Registration required if 15 or more clients

– Each partnership counts as one client

• Issue regarding how to treat parallel funds

• Qualified clients

– Net worth (together with spouse) in excess of $1.5 million

– $750,000 under management with the advisor


ERISA Considerations

• Venture Capital Operating Company

– First investment legal opinion

• Issues regarding calling capital prior to first long-term investment

– Direct payment to General Partner

– Escrow

– Don’t call capital until first investment is ready to be made


Private Placement Memorandum

• Description of investment program– What differentiates management group from others

– Special expertise or focus

– Investment objective/management capacity tied to projected size of Fund

• Deal sourcing

• Investment Team – Cohesiveness

– Responsibility for track record



• Track Record– State assumptions clearly regarding historical performance and

projections of future results; how are unrealized investments valued (e.g., values of public securities in portfolio; subsidiaries not subject to limitations on sale)?

– Descriptions range from good faith judgment of GP to detailed valuation methodology

– Reporting of IRR performance – net or gross of fees and expenses, carried interest, organization costs?

– Past performance is no guarantee of future results

• Reporting Selected Investments – cross-reference to chart reporting entire Fund performance



• Risk factors

• Disclosure of conflicts of interest

• Disclosure of claims against key persons or GP for breaches of fiduciary duties or mismanagement of assets

• Use of confidential information in PPM

– Fiduciary responsibility to portfolio companies whose information is disclosed



• Executive Summary – qualified in entirety by more detailed summary of terms and by Limited Partnership Agreement– Size of offering– Minimum subscription– Investor qualifications– Term– GP capital commitment– GP carried interest– Distribution methodology– Management fee– Cap on organizational expenses– Specific business strategy– Special conflict of interest concerns


II. Deal Terms


Distribution Waterfall – What Amount Must Be Distributed to Limited Partners Before General Partner Receives Carried Interest?• Deal by Deal (allows for earliest distribution of carried

interest)– Return of capital invested in realized deals

– Return of capital permanently written off

– Return of amounts written down by GP (consider permitting future write – ups, but not above cost, to reduce the amount required to be returned to LPs)

– Return of proportionate amount of expenses and management fees

– Preferred return on capital distributed to LPs


Distribution Waterfall – What Amount Must Be Distributed to Limited Partners Before General Partner Receives Carried Interest?• Total Return (more dollars distributed earlier to LPs)

– More typical in European Funds and Fund of Funds

– Return of all contributed capital and preferred return on all contributed capital

– Return of all committed capital and preferred return on all contributed capital (need to cover circumstance in which all committed capital is not called)

• Preferred Return on some funds ceases to accrue once committed capital has been returned


Issues to Consider Regarding Timing of Carried Interest Distributions

• Distributions to GP of carried interest earlier in the term of a Fund increases potential for GP clawback

• Delaying distributions to GP causes partners of GP to delay rewards of successful performance; time value of money (Note, however, that holdback requirements effectively may limit actual cash benefit of early distributions to receipt only of tax payment1 and an incremental additional amount)

1. Clawbacks are typically net of taxes (as carried interest recipients do not keep those amounts) and clawback guarantees cover only net awards actually distributed to carry recipients


Issues to Consider Regarding Timing of Carried Interest Distributions

• Distribution in kind

– Delayed GP distributions may result in GP not participating in early distributions in kind

• Delaying distributions to GP and accelerating distributions to LPs reduces amount of preferred return due to Limited Partners and increases IRR of Fund


GP Clawback/Managing Carried Interest

• Neither Fund Limited Partners nor Partners of GP want to chase carry recipients for excess distributions

• Several or Joint Liability – Guarantee of Carried Interest recipients

• Escrow Account – portion of carry distributions put into escrow account to secure clawback obligation

– What percentage of distributions is placed in escrow? • 25% / 30% / 50%

– Who controls escrow account? • Limits on securities into which escrow account be invested – only secure investments

which tend to produce low return– When can escrow be broken and further distributions made to carry recipients?



• Periodic or Annual True-up – GP clawback is due on termination of Fund

– LPs may require escrowed money be put back into Partnership based on amount GP would have to return if Partnership terminated at true-up date

– Requirement for carry recipients to go out-of-pocket pre-termination of Partnership (GP may prefer this as it may obviate requirement to chase people)



• Breaking Escrow – Multiple of committed capital returned to LPs (115%-125%)

– Net Asset Value Test – take account of all distributions and unrealized appreciation to determine if carried interest may be distributed out of escrow to GP



• What does clawback protect?

– GP not receiving in excess of 20% of profits

– LP receiving preferred return

• Clawback obligation net of taxes

– Net of tax liabilities due on sale of securities distributed in kind


Management Fees

• Percentage of committed capital during Investment Period

• Step Down of Base (and sometimes percentage) after

– Investment Period

– Formation of a Successor Fund

– Key person event

– “Tail” if LPs vote to terminate Investment Period early


No Fault and For Cause Terminations• Percentage to trigger

• GP Removal or Fund Termination

• “Cause” definition

– Felony conviction of key principal

– Gross negligence

– Material breach of LPA

– Bankruptcy of GP

– “Key person” event

• Treatment of GP carry


Investment Limitations• Diversification

– Limits on investment in single issuer

– Limits on investment in single industry

• Geographical Focus – limits on investment outside specified geographic focus of Fund

• Leverage – limits on borrowing and guarantees

• Public Securities – limits on investments in securities of Public Companies (Do negotiated investments count?)

• Investments in Other Funds – concern on multiple layers of fees


Reinvestment of Capital

• Objective that at least 100% of capital commitments be invested in portfolio companies at least once (possibly not the case on account of management fees and expenses); some funds permit reinvestment in excess of 100% of capital

• Generally reinvest only returns of capital but not profits

• Ability to recall distributions for reinvestment

• Reinvestment only during Investment Period


• Separate provision for reinvestment of “quick turns” on investments and for loans and bridge investments (12-18 months)

• Effect of reinvestment may be to delay further the receipt of carried interest by GP; effect is also to free more LP dollars at risk if recycling dollars that could have been LP carried interest

• Reinvestment may result in increased base for management fee calculation after the Investment Period

Reinvestment of Capital


Vesting in Carried Interest

• Important item for LP due diligence: How is carry allocated among management team and what are vesting provisions? (ties to key person provisions)

• Keep carried interest participants focused on the Fund during its entire term

• Reserve to reward superior performance

• Reserve for replacement Partners of GP and new hires


• Pace of vesting – ratably over Investment Period; over term of Fund; something in between

• Deal by deal vesting

– Percentage determined for each deal; allows for economic benefits to be granted in each case to persons who contributed most to a deal

– No sharing in deals done before person becomes a carry recipient or after withdrawal



• Fixed percentage– Over life of Fund

– Determined annually

– Discretion to change during year in respect of unfunded investments

• Cliff to start vesting

• Accelerated vesting– Senior professionals

– Participants in fundraising

– Long-term employees

– Active Participant when deal is realized



• Delayed vesting – vest in a percentage of carried interest only at termination of Fund

• Distribution Holdback – whether or not an escrow is required by Fund, the General Partner may determine to withhold a portion of distributions as a reserve to fund clawback

• Extra vesting – termination on death; disability; termination without cause; good reason termination



• Post withdrawal – only retain interest in deals done prior to withdrawal

• Institutional Goal – departing partners may not do better based only on deals in which they have an interest than they would have based on entire portfolio

• Forfeiture – termination for cause; violate non-compete with Fund

• Loss Allocations – if carry participants have interests in different deals, need to determine how to allocate subsequent losses on other deals



Departing Partners of GP

• In anticipation of Partners of GP departing prior to termination of Fund, the GP Agreement should address some or all of the following:

– Restrictive Covenants

• Non-compete (time limits; geographical and industry-specific limitations; enforceability)

• Non-solicitation of Fund Limited Partners

• Non-solicitation of employees or portfolio company management

• Confidentiality and proprietary nature of track record


Departing Partners of GP

– Non-disparagement

– Releases

– Cooperation in connection with Fund matters

• Separation Agreements – often covers the above matters as well as economic agreement upon departure


Conflicts of Interest

• General Duty of Loyalty to Limited Partners under Delaware law to act in their best interests– Hard to demonstrate, so best to have agreed upon practices in

conflict situations

• Investing in portfolio companies in which a principal of Fund holds an interest– Passive or active investment

– Size of investment

• Investing in portfolio companies in which affiliates have made investments at different levels of capital structure


• Follow-on investments in portfolio companies in which a prior fund has made an investment

– Limit to a percentage of committed capital

– Require Board of Advisor approval

– Require third party investor to take a minimum percentage of the deal

– Independent Appraisal



• Fund Manager earning fees on account of portfolio investments

– Management fee offset (50% / 80% 100%)

– Possibly treat fees differently – Transaction fees; Monitoring fees; Breakup fees; Directors’ fees

– How to treat broken deal expenses

– Affiliates’ arms-length services



Co-investment

• No “cherry picking” by GP and its affiliates – Annual Fixed Percentage for GP co-investment in all deals

• LP first look at co-investments

• Permitted to show co-investments exclusively to certain parties that provide some strategic importance to the Fund


Side Letters

• MFN Clauses – Who gets benefits of side letters?

– All Limited Partners

– Similarly situated Limited Partners

– Only those Limited Partners who committed capital equal to or greater than recipient of side letter

• Disclosure of side letters


Key Person Provision

• Trigger – withdrawal; failure to play an active role in management (consider expertise expressed in investment decisions and general advice versus active sourcing and management of investments)

• Determining who is a key person

– Few individuals and loss of any one triggers key person event

– Is the PE firm viewed as an institution?


• Balancing desire for larger group to avoid key person trigger against giving leverage as a key person to non-senior members



• Consequences of key person event

– Termination of Fund unless specified percentage of LPs vote to continue

– Suspension of investment period unless specified percentage of LPs vote to continue

– Removal of GP

– No consequences unless LPs vote to terminate Fund or suspend investment period



• Consider eliminating key person concept after Investment Period

• GP right to designate new key persons

– Who determines: percentage of LPs or Advisory Board?

• Related Point – restriction on principal’s right to transfer interests in GP



General Partner Internal Issues

• Division of carried interest

• Division of management fee

– Often management fee is paid to a separate company owned by senior members of management team

• Division of clawback liabilities


General Partner Internal Issues

• Vesting

• Decision making process

– Investments

– Internal governance

– Carried interest allocation

Economy & Finance

Essential Terms of Fund Formation