Funds vs. Joint Venture Structures Management Mastery Lesson 05

Lesson Five: Fund Structure – Part Two

5.1 Fund Economics

As we continue to form the structure of the fund, we need to be concerned with the economics of the fund. The first consideration is the Promote. Within this consideration, we need to consider the percentage of the profit the fund manager will make. This is typically 20% after the preferred return. Example: A 20% after a 9% preferred return = 20% of the profits after a 9% preferred return.

The second consideration is Catch-Up. In this structure, a different split occurs after the preferred return and before you hit a “whole dollar split.” Example: 100% after the preferred return or 50/50 after the preferred return.

The third consideration is the Claw back Provision. In this Provision, the General Partner promises to make the investors whole, on the promote funding. If at the end, the allocations are not what were promised. This would be due to bad deals at the end of the fund. It is important to note that the claw back is not for profits; it is to protect the 80/20 split.

The final consideration is the Committed vs. Invested Dollar In. The “Committed” is the amount committed to the term. The “Invested” is the amount of money actually invested. It is important to know how fees are based. The industry standard is that fees are based on committed dollars.

5.2 Key Drivers for Promotes

There are six key drivers of the promotes. These drivers are listed below:

  1. Co-Investment Amount
  2. Pari Pasu vs. Subordinate Equity
  3. Preferred Return (The Higher the Preferred Return, the larger the back end split)
  4. Income During Holding Period vs. Terminal Value Profits
  5. Debt – Amount (80% or less is typical)
  6. Borrower Recourse on the Debt
5.3 Not all LPs are Created Equal

When considering the capital formation, it is important to remember that not all LPs are equal. We will group the LPs into two categories: The Lead LP and Other LPs.

For the Lead LP, the lead is the major investor in the fund. This should be a major investor that can raise more capital. They will also seek “special economic terms.” These terms are listed below:

  • Less management fees to you.
  • Less promote to you.
  • An equity investment in the General Partner
  • Usually a large family, endowment, or institution

The Other LPs are the passive investors who invest in your business strategy. These investors make up the core of the fund. These investors will invest various amounts. You will have a minimum and maximum investment amount.

5.4 Lead LP Investment Rights

The Lead LP will have two main investment rights. The first involves Intellectual Capital. Your lead LP is/should be viewed as being smart, and as a result, will make it easier for other investors to get in behind your LP. Consider “Warren Buffet vs. your mother-in-law.” This takes a lot of pressure off your other LPs for due diligence.

The second right involves Preferential Economics. You will not receive the same fee and promote economics, which will probably be considerably less.

5.5 The Players in Your Fund: GPs vs. LP
5.6 The Due Diligence Interrogation Process

As we have mentioned several times in this course, due diligence should be a top priority during this entire process. Due diligence should be a part of the interrogation process. During the due diligence process, there are four areas of concern. These are discussed below:

  1. Track Record: Have you done this before? Do you deserve to manage this capital?
  2. Your Term: Who is going to do the work? What is the progress? How do you all work together? Do you “love” each other?
  3. Deal Flow (Part 1): How do transactions come to you? How do you source business?
  4. Deal Flow (Part 2): Once a deal comes into your shop, how will you manage it?
5.7 Legal Structure

When structuring your Fund Offering Documents, there are a number of considerations to make when determining the Fund Terms. Let’s discuss these terms in greater detail. The first term is Minimum Investment. This will be the minimum investment amount that you will accept from any new investor in the Fund (e.g. $1,000,000). Keep in mind, your fund’s Private Placement Memorandum (PPM) will often contain language that allows investors to become Limited Partners in the fund for a lesser amount than the stated minimum at the “General Partner’s discretion.”

The second term is the Subscription Frequency. This determines how often you will accept new investors into the Fund. It is generally accepted that subscriptions will be accepted on a monthly basis or quarterly basis. The third term the Lockup. There are two type of lockups that are generally used by Investment Managers: Hard Lockup and Soft Lockup.

The Hard Lockup is an agreement between the Limited Partners and the General Partner that the Limited Partner(s) will not have the ability to withdraw partial of the full amount of their Capital Account prior to a minimum lockup. The Soft Lockup is an agreement the Limited Partners and the General Partner that the Limited Partner(s) will have the ability to withdraw partial or the full amount of their Capital Account within the initial Lockup Period. If they do so, they will often have to pay a penalty on the amount of the capital they redeem. Given the turmoil in the global capital markets in 2008, and the subsequent “gating” or “suspension of redemptions” of investor capital by many large hedge funds, investors have demanded that more favorable terms are provided by their hedge funds, investors have demanded that more favorable terms be provided by their hedge fund managers. Investors would rather pay a small penalty and know that they can get their money back versus being gated.

The fourth term is the Redemption Notice. This is a notice period which requires the Limited Partner to give written notice to the investment manager of their intent to redeem partial or full amount of their Capital Account from the Fund. Traditionally, a redemption notice is 30, 45, 60, or 90 days prior to a redemption period.

The fifth term is the Redemption Provision. This provision is a period which the Investment Manager is allowed to close out positions in an orderly fashion so as not to disadvantage the remaining Limited Partners to accommodate the redemption of a partial amount or full amount of a Limited Partner’s capital account.

The sixth term is the Gate Provisions. This is a restriction placed on a hedge fund limiting the amount of withdrawals from the Fund during a particular redemption period. The “gate” is predetermined by the Investment Manager and is fully disclosed in the PPM. The purpose of the gate is to prevent a “run on the fund,” which could cripple its operations, as a large number of withdrawals from the Fund would force the manager to sell off a large number of positions. A gate is much less severe than a Suspension of Redemptions.

The seventh term is the Management Fee. This is an asset based fee charged on a monthly or quarterly basis. Traditionally, Investment Managers have charged a management fee that would be between one percent and two percent.

The final term is the Incentive Fee. The incentive fee is a performance based fee that is a percentage of realized and unrealized gains of the Fund’s assets payable on an annual basis. Traditionally, Investment Managers charge a 20% incentive fee to investors in addition to the Management fee.

5.8 Where the Money Is

Of course, a Fund cannot be funded without the right “people!” So, let’s consider where the money is. The first source is High Net Worth Individuals. Wealthy people who have assets in excess of $1 million should be considered. The “Investable” financial assets are everything except for the primary residence.

The second source is Family Offices. Family offices are private companies that manage investments or trusts for a single, wealthy family. They would manage and provide personal services, such as managing household staff and making travel arrangements. Other services provided include accounting/payroll, legal affairs, investment education, philanthropy, and succession. These offices have costs of $1mm per to year to operate and their net worth usually exceeds $100 million. They have a President, General Counsel, CIO, CFO, and support staff.

The third source is Insurance Companies. These companies have “alternative investment arm” that make lead LP or GP level investments in newer “vintage” funds or “entity-level” investments. Usually monolines, life companies, and reinsurance companies. The typical PE fund term structure is a 5 year investment period with a 1 year extension or a 10 year life with a 2 year extension.

The fourth source is the Pension Funds. These funds include any plan or fund which as a mandate to provide retirement income to is beneficiaries. They are mostly defined benefit plans unlike 401(k)’s that are defined contribution plans. There is over $7 trillion in assets held by the top 300 funds. The largest if the Japan Government Pension Investment Fund.

The fifth source is Endowments. Endowments are found mostly in colleges and universities or cultural institutions, such as museums, libraries, theaters, and hospitals. They generally have investment mandates or stipulations that include the following:

  1. Principal is alternatively invested.
  2. Principal remains intact in perpetuity or over time.
5.9 Investor Transaction Selection Criteria

When considering the investors to be involved with, is important to consider several criteria before making the decision. Let’s review this criteria.

The first criteria is the Numbers. The numbers need to work. Investors need to remember to follow the calculator and not their heart! It is necessary to be dispassionate about the property and focus on the numbers – this is not a time for emotion. Let the numbers lead your decision-making process.

The second criteria is Sponsorship. Value-added transactions have an inherent risk and good operators are a key to success. In a lending situation, good sponsorship is essential, as he/she will have to navigate problems and be adept in refinancing or selling the project as the exit. In lending situation, the sponsor’s financial strength may need to carry the deal during soft periods.

The third criteria is Alignment of Interests. The risks and rewards should be equally disbursed among all those involved in the transaction. This typically means the sponsor’s equity is at risk as the first loss money. If the project does well, everyone should do well. Debt has fixed return and equity has an unlimited return. Understanding where the debt portion of a transaction stops and where the equity begins is a key to making smart investment decisions.

The fourth criteria is the Key Events. It is important to understand the “key events” and the probability of achieving the event. Each transaction typically has one or two “key events” that must take place in order for the project to be successful. Understanding each project’s “key event” is critical to making good real estate decisions. Smart investors understand what has to happen and the probability of it happening. This essentially defines the risk in the transaction.

The final criteria is the Back-Up Plan. Good investors look beyond the key event and understand what the economic outcome is should the key event not happen. In the best deals, the back-up plan has a higher probability than the key event, and if the back-up plan is implemented, it means the project makes little money or breaks even.

5.10 The Fund of Funds Structure