How to starta PrivateEquity Fundwww.cummingslaw.com
www.cummingslaw.comIntroductionWhen setting up a private equityfund, the following matters will needto be looked at and considered:• regulatory authorisation• fund structure and jurisdiction• eligible investors• carry arrangements• other key fund terms• service providers• investment structuringIn order to address these issues, you will needto seek professional advice from legal counsel.Regulatory authorisationIn most jurisdictions, the investment managerof a private equity fund will require regulatoryauthorisation or licensing in order to be ableto carry out its activities lawfully. In the UK,the investment manager will generally need toapply to the FSA (from 1 April 2013, the FCA).The investment manager will also need tocomply with the regulatory regime imposedby the Alternative Investment Fund Manager’sDirective (“AIFMD”) when it comes intoforce in the UK in July 2013. However, ifthe investment manager manages assets ofless than €500 million, it will only need tocomply with a light form of regulation.Fund structure and jurisdictionIf the fund is set up in the UK it will not need tobe authorised by the FSA. In other countries itmany need to register with the local regulator.For example, in the Cayman Islands the fundwould register with the Cayman IslandsMonetary Authority, and in the Channel Islandswith the Guernsey or the Jersey FinancialServices Commission, as is appropriate.The standard structure for a private equityfund is a limited partnership. This structureallows profits to be distributed to investors ascapital rather than as income profits. Limitedpartnerships also offer only very few, if any,redemption rights and so suit an investmentin illiquid assets which will be held for a longtime. Some private equity funds are structuredas closed-ended companies with a listing, butthey are relatively few and far-between.The investors in a limited partnership willhave no rights to control the partnership,and will be “sleeping partners”. Their liabilityis limited to the amount of capital theyhave committed, or agreed to commit.The limited partnership is run by anotherentity, the general partner, who has unlimitedliability for the partnership’s obligations tothird parties. To tackle the issue of unlimitedliability, the general partner is often a companywhich is set up specifically to act as generalpartner and, as part of its role, delegatesall its investment management duties to aregulated investment manager. The investmentmanager is often paid its fee from themoney received by the general partner.It is common for investment managers toset up the fund offshore, which may bemore appealing to non-UK investors (whomay be more accustomed to investing inoffshore private equity vehicles). Popularjurisdictions are the Cayman Islands,Guernsey, Jersey, British Virgin Islands andthe Isle of Man. There are AIFMD issues tobe considered in deciding on the jurisdictionand legal advice is needed on this point.In the UK, limited partners almost always investin a limited partnership in cash and debt, withHow to start a PrivateEquity Fund
www.cummingslaw.comthe great majority of the contribution being loan.This is because under English law, if the capitalof a limited partnership is returned to investorsbefore liquidation of the partnership, then theinvestors lose their unlimited liability to theextent of the capital returned. This issue doesnot generally arise in most offshore structures.Eligible investorsIn the UK, private equity funds may only bemarketed to certain restricted categoriesof investor. As a result, they are generallydirected at institutional investors, such aspension funds, and sophisticated high networth individuals or family offices, andare not available to the general public.Carry arrangementsOne of the most crucial aspects of thestructure of a private equity fund, and onewhich greatly influences the drafting of thelimited partnership agreement and offerdocumentation, is the fee structure andthe use of a carried interest, or carry.Typically, this is a special profit share (normally20%, or 10% in a fund of funds structure)which is paid out to the general partner orinvestment manager once investors havereached a specified level of return (normally thiswill be once they have received distributionsof an amount equal to their drawn-downcapital together with an annual “preferredreturn” thereon from draw-down).There is normally a “claw-back” mechanism, witha proportion of the carry being held in escrowto allow carry to be repaid if, later in the fund’slife, it is found that the investment managerhas been paid too much. This can commonlyhappen when a fund has begun to distributethe carried interest in advance of its expectedtermination date, but an under-performinginvestment is later realised and impacts adverselyon the investment manager’s entitlement.There are also generally provisions for theset-off of any other remuneration, for instancenetting off advisory fees received by theinvestment manager, or expenses relating toany “broken deals”, against the carried interest,either in part or wholly. It is common for carryentitlements to be awarded to individualmembers of the investment manager team asan incentive, typically through tax-effectivecarry vehicles such as limited partnerships.This is highly tax-sensitive, particularlyin the UK, where carried interest maybe liable to be taxed to income asemoluments unless properly structured.Other key fund termsLimited partnership agreements are lengthy andcomplex, and their terms are generally influencedby a range of market-standard expectations onmatters such as the length of the fund and theability to remove the investment manager orterminate the fund. For example, investorsmay want to restrict the investment managerfrom setting up any competing fund until thefund is at least 75% invested, or may want theinvestment period (the initial four or five-yearterm during which the investments are scheduledto be made) to be frozen if “key men” depart,perhaps leading to termination of the fund ifthat individual is not satisfactorily replaced.Where sovereign wealth investment is likely,there may be so-called “excuse rights” aimed atexcusing investors from being required to committo any investment which contravenes relevantreligious, ethical or statutory restrictions.The fund may also appoint an investor committeeto act as a forum allowing investors to monitorthe performance and activity of the investmentmanager and any potential conflicts of interest. Itshould be noted that this body is not allowed tohave any input into the management of the fund.The fund may also have an advisorycommittee which has powers to liaise withand advise the investment manager oninvestment, though the advisory committeemay not give binding investment advice.
www.cummingslaw.comService providersIn addition to the investment manager, thefund will normally have an administrator,who will be responsible for liaising withinvestors, arranging limited partner, investorcommittee or advisory committee meetings,valuing the assets of the fund, calculatingcarry payments and arranging distributions.The AIFMD will impact on many of theduties and activities of administrators, asregards EU-based funds. The AIFMD alsorequires EU-based funds, or funds promotedin the EU, to have a depositary, to holdthe assets of the fund, monitor cash flowsand supervise the manager’s activities.In some cases, there may also be an investmentadvisor, to advise the manager, for instanceon investment in any jurisdiction beyondthe manager’s specific knowledge.The fund will also need lawyers, who willbe responsible for establishing the fund andpreparing and negotiating the various funddocuments, including the limited partnershipagreement, offering memorandum (orequivalent), management agreement,any investment advisory agreementand subscription documentation.The fund may also require tax advisors, to enablethe manager to determine the right structureand help structure the carry arrangements.Investment structuringA further important aspect is the structuringof the actual investments to be made by thefund, particularly where those investmentsare to be leveraged by borrowings. Thisis another tax sensitive area and it maybe necessary to set up special purposevehicles to optimise the tax position.TimingA private equity fund can take an average ofapproximately three months to set up and holdits first closing, but this timing depends on anumber of factors, not least the responsivenessand cooperation of the relevant parties,whether or not the investment manager isauthorised and the progress (or otherwise)of any negotiations with any key investors.
www.cummingslaw.comAPPENDIXDiagrammatic example of a typical fund structureINVESTORSFUNDINVESTEECOMPANIESGENERALPARTNERINVESTMENTMANAGER
42 Brook Street, London W1K 5DB +44 20 7585 1406 | Neuhofstrasse 3d, CH-6340 Baar +41 41 544 5549Regulated by the Solicitors Regulation AuthorityThis document is for general guidance only. It does not constitute adviceFebruary 2013