Private Equity Fund Formation in...
Transcript of Private Equity Fund Formation in...
Private Equity Fund Formation in 2012 Navigating Capital Raising Under a New Regulatory Landscape:
Dodd Frank, JOBS Act, the Volcker Rule, and ILPA Revised Principles
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WEDNESDAY, SEPTEMBER 12, 2012
Presenting a live 90-minute webinar with interactive Q&A
Scott W. Naidech, Partner, Chadbourne & Parke, New York
Adam D. Gale, Counsel, Chadbourne & Parke, New York
L. Charles Bartz, Senior Advisor, Berchwood Partners, New York
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Strafford Webinar: Private Equity Fund Formation in 2012
Presentation by
Scott Naidech, Chadbourne & Parke LLP
Adam Gale, Chadbourne & Parke LLP
L. Charles Bartz, BerchWood Partners
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Goals of Presentation
• Describe significant changes impacting private equity fundraising
in 2012
• Describe recent market trends, including structural changes
taking place in the market
• Summarize certain new regulations impacting private funds
(including Dodd Frank, Volcker Rule and JOBS Act)
• Highlight changes in “market” terms, including ILPA changes and
other market impacts
1. What do we mean by “Private Funds”?
• Any (i) “blind pool” vehicle (ii) invested by a sponsor (iii) who
often receives a management fee and profit participation (known
as a carried interest or performance fee) (iv) offered to qualified
high net worth investors only
• For purposes of this presentation, “Private Funds” means
“Private Equity Funds”. For example, Venture Capital Funds,
Growth Equity Funds, Buyout Funds, Real Estate Funds,
Distressed Debt Funds, Mezzanine Funds, etc., investing in
illiquid securities
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2. Key incentives for raising a Private Fund?
• Key Economic Incentives for Sponsor Raising a Fund: Access to
private capital from alternative sources; Carried Interest and
Management Fee
• Key Economic Incentives for a Limited Partner Investing in a
Fund: Access to a diversified pool of investments in a targeted
geographic region and/or industry being managed by a specified
team of experts
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Recent changes in key incentives…
• Ten years ago, most fund negotiations focused on economics;
five years ago…governance; in 2012…back to economics
• Impacts on incentives altering the standard “2 and 20” model –
economy and fund size.
• Volume: currently over 1,800 Private Equity and Real Estate
Funds looking to raise capital, seeking roughly $800 billion
• Total amount of probable commitments from this pool: only $250
billion/year.
• Conclusion: less than one-half of fundraises will successfully
raise their target amounts.
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Changes of key incentives…
• Pressure on established managers too
• Private Equity International released the “PEI 300” in May 2012:
1. TPG (Fort Worth, TX): raised $49.897 billion in capital for their Private Funds
over the last five years
2. The Blackstone Group (New York): $49.638 billion
3. Kohlberg Kravis Roberts (New York): $47.689 billion
4. Goldman Sachs Principal Investment Area (New York): $43.469 billion
5. Apollo Global Management (New York): $34.710 billion
6. The Carlyle Group (Wash DC): $30.741 billion
7. CVC Capital Partners (London): $25.068 billion
8. Apax Partners (London): $21.035 billion
9. Bain Capital (Boston): $21.033 billion
10.Oaktree Capital Management (Los Angeles): $17.633 billion
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Changes of key incentives…
• Larger managers compete for the same capital (from government
plan, pension plans, foreign institutions, sovereign wealth funds)
• Face same pressures, which increases LP leverage in
negotiations
• Pace of investment slowed creating “dry powder”
• Management fees have provided greatest share of GP economics
• Fund sizes are being capped at lower amounts
• Greater competition for capital = lower fees and carry, greater LP
controls, increased fundraising periods, higher customization
• Still, sponsors increase their negotiating leverage through certain
key differentiators, including higher performance, strategy
diversification, oversubscription, better terms
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Fee envy…
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US Buyout
Fund I
US Buyout
Fund II
Asia
Fund
US Mezz
Fund
US Real
Estate Fund
GP GP GP GP GP
Investment Adviser
Sponsor
Each Fund pays a Management Fee to the Investment Adviser…can result in large aggregate fees that alter
incentives (from carried interest based to fee based); thus downward fee pressure
Each Fund pays a Carried Interest to the GP
(or an affiliated entity)
Carry
Management Fees
Zombies!
• Pressure on smaller and mid-sized managers to reduce fees and
fundraise
• Given the reduction in commitments and increased pressure, it is
possible that a significant portion of existing fund managers will
cease to continue meaningful operations, becoming so-called
“zombie funds”
• Governance provisions in some fund agreements may be
inadequate to handle orderly liquidations/terminations/Key
Person events/removal events (fund agreements often infer that
the team will remain in place to raise a subsequent fund)
• While the process may be clear, the cost of implementing may
discourage a single LP from pursuing.
• There may be little or no economic incentive for the GP to initiate the
process.
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Fee anxiety…
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Fund I ? ? ? ?
GP ? ? ? ?
Investment Adviser
Sponsor
For advisers with fewer funds under management, downward pressure on fees by the “market” means
smaller budget, leaner staff, harder to pay consultants and advisors…less overall fees to manage the team.
Carry
Management Fees
Results…
• Overall result:
• increased LP leverage and lower capital commitments alter dynamics
of negotiation
• longer fundraising periods
• greater investment strategy definition
• lower fees and carry
• greater LP participation in investment process
• co-investment rights
• deal-by-deal opt-outs and investment vetoes
• (some of these are covered later in presentation from a legal perspective)
• “Classes of LPs”: concern that larger LPs have leverage and can
therefore negotiate better terms in side letters, or in separate
parallel or co-investment funds
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LP portfolio managers (like sponsors) face pressures too…
• Because of the economic turmoil of the past four years, investors
are unable to achieve adequate returns from more traditional
portfolio allocations, e.g., publicly-traded strategies
• Lack of new contributions to trusts
• Uncertain performance of North American and European stocks
• Levels of distrust in Asian and Indian issuers and political
environments
• Challenge: where to find new markets/or strategies for investment
that can provide one or more:
• Current cash flow
• Stability in interim valuations
• Shorter investment horizons
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2. Dodd-Frank Act
• Dodd-Frank Act, effective as of July 21, 2011:
– Eliminates the private investment adviser exemption (formerly
203(b)(3))
– Requires registration unless an exemption is available under new
203(m) and the proposed rules thereunder
– Different rules apply depending on whether you manage any of
the funds from the US, how much you have under management
and amount of investments from US investors
– Venture capital exemption: Exemption for advisers who solely
advise “venture capital” funds
– Real Estate Funds: No specific exemption for real estate ("RE")
fund managers, but depending on what the RE fund invests in,
and how the investments are structured, the rules may not apply.
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Dodd Frank cont’d
– Exempt reporting advisers: Exemption for advisers who solely
advise private funds with assets under management in the US of
less than $150mm
– In calculating assets under management, include both uncalled
capital commitments and outstanding investments; must calculate
on a gross basis (i.e., amounts borrowed are included)
– Even exempt managers still need to make an initial and annual
update filings with the SEC will now be subject to record keeping
and reporting requirements and be subject to SEC audit
requirements
– Fund managers who are exempt from SEC registration still need
to check the investment adviser registration requirements of the
state of their principal office and place of business
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Dodd Frank cont’d
Non-US Fund Managers:
– Foreign private advisers: Exemption for non-US advisers to
private funds with small US client and investor bases (less than
$25mm under management and less than 15 clients and investors
in the US), and no place of business in the US
– No filing at all required if meet that exemption.
– Otherwise, should fit within the $150mm exemption, as long
as not managing $150mm from an office in the US.
Fund GPs:
- Can rely on the Investment Manager’s filing, if certain
requirements are met
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3. Volcker Rule
• The Volcker Rule generally prohibits banking entities,
including affiliates of banks, from engaging in, sponsoring or
investing in private equity funds (and hedge funds), but the
Rule is subject to a number of exceptions.
• Volcker Rule also prohibits a bank from engaging in
"proprietary trading," but those are less relevant to funds.
• Rule does not go into effect until July 21, 2014, and we are
waiting for final rules to be promulgated.
• Grandfather Provision: Regulators may, upon application by
any banking entity, extend the period
(i) for up to 5 years (until 2019)
(ii) to the "extent necessary to fulfill a contractual obligation
that was in effect on May 1, 2010” if fund is an “illiquid fund”.
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Volcker Rule (Con’t)
The 3% Exception to the General Prohibition:
• A banking entity may acquire or retain an ownership interest in
a covered fund if, among other things, it:
(i) owns not more than 3% of the total ownership interests in
any single fund; and
(ii) invests an aggregate amount not exceeding 3% of the
banking entity's Tier 1 capital (i.e., the bank's regulatory
capital) in covered funds as a whole.
• Seed Investment Exception: There is an exception to the 3%
rule to allow the banking entity to make a seed investment in a
fund (in which case it can own 100% of the fund) - provided
that within one year of the covered fund's establishment, the
banking entity must reduce its ownership to no more than 3%
of the total ownership interests in the covered fund.
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Volcker Rule (con’t)
Potential Alternative for Bank Investments:
• Although a bank cannot invest at all in a private fund it does not
sponsor (other than under the Grandfather Provision), a bank
could make a co-investment alongside a private fund directly into
an operating company.
• Co-investment could not be made pursuant to a co-investment
fund, as that fund investment would violate the Volcker Rule.
• There would be no violation, however, if there was a direct
investment, and the bank could enter into a separate advisory
agreement with the fund manager whereby the bank agrees to
pay fees to the fund manager for advising the bank on the co-
investment.
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4. JOBS Act
• Under current rules, private equity funds may not engage in any
general solicitation or advertising when raising a fund.
• JOBS Act eliminates this prohibition, provided that:
- everyone who ends up investing in the fund is an “accredited
investor”
- the fund takes “reasonable steps” to verify that all of the
investors are accredited investors, and
- fund relies on Rule 506
• JOBS Act does not become effective until SEC issues final rules.
On August 29, 2012, SEC issued proposed rules, and final rules
are expected in October. Until then, prohibitions on general
solicitation and advertising still apply.
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JOBS Act (Con’t)
SEC’s Proposed Rules
• SEC’s proposed rules leave up to the fund to determine what
steps are “reasonable” to verify accredited investor status
• But SEC’s release suggests that some due diligence is expected
beyond just relying on a representation from the investor.
• Notably, the proposed rules did not place any further restrictions,
as some had feared would be the case.
Effect of Lifting of Prohibition
• Funds can freely advertise and market
• No need to restrict website access (but note non-US laws)
• Fund managers can speak more freely to press and conferences
• Freely use social media
• No need to number PPMs
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JOBS Act (Con’t)
Potential Pitfalls
• For smaller fund managers who are relying on certain state
exemptions from registering as an investment adviser,
restrictions on public advertising might still apply
• For fund managers who engage in commodities trading, CFTC
registration exemptions might also have restrictions
• Will need to be careful about what is stated in publicly available
materials
• For registered advisers, need to keep records of all publicly
available materials
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5. Recent Structures and Changes in Legal Terms
• Institutional Limited Partners Association (ILPA)
• Download ILPA Principals from www.ilpa.org
• Private Equity Principles 1.0 published in Sept 09
• Private Equity Principles 2.0 published in Jan 2011
• Goals: to establish “best practices” regarding fund partnerships
between GPs and LPs
• Three guiding principles:
• Alignment of Interests
• Governance
• Transparency
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ILPA: a pretty good outline of issues and considerations…
• ILPA: Outlines Key Principles and Concepts, along with reporting
templates
• Economics:
• carried interest calculation and waterfall structures (deal-by-deal vs.
aggregate-return waterfall structures and considerations)
• Management fee considerations, along with GP Expenses and Fee
Income offsets
• Clawbacks: Principles 2.0 contains detailed Appendix on Carry Clawback
Best Practices (e.g., considerations such as a guarantee or escrow;
clarification that the GP clawback is net of taxes paid; other
considerations based on the waterfall structure)
• Governance:
• Key Man events considerations
• Investment Strategy considerations
• Conflicts of interest, fiduciary duties and LP Advisory Committee
(Appendix A)
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…but not a checklist!
• Transparency
• Fee disclosures
• ILPA standardized templates
• Capital call and distribution notices
• Annual and quarterly reports
• Appendix C covers additional considerations on reporting
• Not a laundry list of must-haves
• ILPA: our terms are not to be applied as a “checklist”; each partnership
should be considered separately and holistically
• Goal is to provide terms and principles to be considered and that will result in
better investment returns and a more sustainable private equity industry
• Generally, considered more “pro-LP” and not the “market standard”; the ILPA
terms continue to be discussed, debated and augmented
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Other “hot” items: Bespoke Funds
• Co-investment Vehicles
• Pro Rata vs. GP Discretion
• Fee and Carry reductions
• Governance and Disclosure
• LP Agreement
• Side Letters
• PPM
• Special Vehicles for select investors • Private Equity Fund Managed Accounts: Teachers Retirement System
(KKR and Apollo)
• How are investments allocated; sharing of expenses; other governance
and disclosure issues
• Benefits/detriments: concerns regarding alignment of interests and new
“classes of LP” with different incentives
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Other “hot” items: Bespoke Fees
• Fees and Fee options
• Fee Options
• Bain Fund XI: offers fee options to investors
• Benefits/detriments
• New trend?
• General trend:
• Downward fee pressure in all directions (carry, fund level
fees, portfolio fee income)…while Regulations increase
compliance costs
• LP seek to reduce overall blended fee rates and increase
IRRs
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Other trends…
• For smaller fund managers, fewer, smaller funds = lower
management fees = overall budget concerns and
constraints
• For LPs, lower fees = alignment of interests and higher
IRR
• Alignment of Interests
• Deal-by-deal vs. aggregate-return waterfall
• Fee offsets and portfolio company fee income
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Hot areas for investments…
• Hot Sectors
• Healthcare
• Technology
• Energy & infrastructure
• Hot Geographies
• LatAm
• Energy and Infrastructure
• Brazil; Peru; Chile; Colombia
• Turkey and MENA
• Africa
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Other key terms…
• Key Man
• New funds
• Established funds
• Removal Events
• For Cause/other than for Cause
• Mechanics and Voting
• Clawbacks
• Reporting
• ILPA forcing standardization
• Pipeline
• Disclosure
• Securities concerns
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6. Public investments in alternative asset managers
• Larger asset managers have over the last few years gone public
• The Blackstone Group (NYSE: BX)
• Kohlberg Kravis Roberts & Co. (NYSE: KKR)
• Apollo Global Management (NYSE: APO)
• Oaktree Capital Group (NYSE: OAK)
• The Carlyle Group (NASDAQ: CG)
• An investment in these shares may (or may not) relate to an
investment in their managed funds, carried interest, management
fees, portfolio fee income, or other revenue streams
• Public filings provide a wealth of information on the detail and
scope of their operations and aspirations
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Scott W. Naidech: Scott is a Partner at Chadbourne & Parke LLP. He represents
domestic and international sponsors (with a particular focus on Latin America and other
emerging markets) in the structuring, establishment and operation of their private equity
funds. He has formed buyout, growth capital, real estate, energy, infrastructure,
mezzanine and venture capital funds, among others, ranging in size from $50 million to
over $16 billion of committed capital. He also advises clients on leveraged buyouts,
acquisitions, recapitalizations and divestitures, and general corporate matters. He was
recently recognized in the 2013 edition of Best Lawyers in America for his work in private
funds law. He can be reached at [email protected].
Adam Gale: Adam is a Senior Counsel at Chadbourne & Parke LLP. He provides
regulatory and compliance advice to hedge funds, private equity funds, broker-dealers,
banks and registered investment companies. He also forms and structures private funds
and registered funds. He is the head of firm's hedge fund practice group, and also
represents both well-established and start-up entities. He can be reached at
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L. Charles Bartz: Charlie is a Senior Advisor at Berchwood Partners, a global placement
agent dedicated to raising capital for alternative asset managers. He has 30 years of
experience in institutional investments, both as a plan sponsor and as a placement
agent. He has focused on alternative investments over the last 15 years, working with a
broad range of domestic and international investment strategies and products, including
private equity/buyouts, venture capital, mezzanine, distressed debt, infrastructure, hedge
funds, and real estate. He can be reached at [email protected].
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