This article was first published in the April 2014 edition of PEI's Private Equity International: The Legal Special 2014. It is reprinted here with permission.
Investors in private equity funds (Funds) typically invest in blind pools, under which passive investors commit to invest a designated amount of cash in a Fund over an investment period while relying solely upon the Fund’s sponsor (Sponsor) to source, acquire, manage and divest the Fund’s investments.
Sponsors often decide, for various reasons, to make pre-formation investments (Pre-Formation Investments), in which an investment in a portfolio company is completed prior to the date the upcoming Fund is ready for its initial closing, the ultimate intent being to transfer the Pre-Formation Investments to the Fund. Pre-Formation Investments prompt many considerations for the Sponsor, investors in the Pre-Formation Investment and investors in the Fund that are not otherwise applicable in the Fund-launching process. This article explains a number of these considerations, including the benefits and detriments of Pre-Formation Investments to Sponsors and investors, the mechanics of making Pre-Formation Investments, the structure of Pre-Formation investments and the ultimate means by which Pre-Formation Investments may be transferred to the Fund.
Why Make Pre-Formation Investments?
Sponsors undertake Pre-Formation Investments for a number of reasons, including (i) remaining continuously in the deal market, (ii) displaying the Fund’s investment strategy, (iii) displaying the Sponsor’s deal sourcing and deal execution capabilities, (iv) capitalising on attractive opportunities, (v) enhancing investment opportunities for investors, (vi) keeping the Fund’s management team together, incentivised and rewarded, and (vii) smoothing out the J-curve by increasing the speed of capital deployment.
Sponsors are often faced with the challenge of completing one Fund’s deployment while fundraising for a subsequent Fund. The ability to continue to execute investments prior to achieving the new Fund’s initial closing will ensure that the management team remains focused during any gap period, that the Fund’s brand recognition continues in the market, and that investors continue to have opportunities to deploy capital.
Sponsors should expect to invest at least the same amount into Pre-Formation Investments as they will into the upcoming Fund. If their commitment to the Fund will be 5 percent, then their participation in the Pre-Formation Investment should be at least 5 percent. It may need to be more.
A fundamental decision point is for whose benefit the Pre-Formation Investments are to be made: the people that put up the money for the Pre-Formation Investments (the ‘Early Investors’) or all of the investors in the upcoming Fund (which may include the Early Investors). This article presupposes that the investment is ultimately to be for the benefit of the investors in the upcoming Fund, but another fundamental consideration is whether all or only part of the Pre-Formation Investments should be in fact transferred to the upcoming Fund.
Early Investors may retain a portion of the Pre-Formation Investments solely for their benefit, while the remaining portion is transferred to the upcoming Fund. The Early Investors are thus ‘rewarded’ – if the Pre-Formation Investment is successful – for having put their capital at risk in a non-diversified investment. Or, if all Pre-Formation Investments are transferred to the Fund, a ‘time use of money’ payment may be made to Early Investors to compensate them for their early capital deployment.
These mechanics must be negotiated in advance, before returns are realised, and set forth in the Pre-Formation Investment documentation. After-the-fact decision-making may result in an appearance of impropriety (e.g. of the Sponsor and Early Investors hoarding successful investments). Further, when there are multiple Pre-Formation Investments, Sponsors should never be allowed to ‘cherry-pick’ which Pre-Formation Investments become Fund investments and which do not.
In addition, splitting a Pre-Formation Investment between Early Investors and the upcoming Fund can lead to conflicts of interests, which the Sponsor should acknowledge in the disclosure documentation for the Fund.
Other preliminary considerations include (i) how the Early Investors will be compensated for their early deployment risk, and (ii) how to ensure the Pre-Formation Investments become Fund investments.
Turning Pre-Formation Investments into Fund Investments
Pre-Formation Investments may be made through either the upcoming Fund or another entity (an ‘SPV’); each strategy gives rise to very different considerations. Either way, Fund investors relying upon the existence of and track record generated by these Pre-Formation Investments will want to see the contractual means by which they become Fund investments, assess the cost they incur due to early investment activity, and evaluate the fairness of any benefit conferred to Early Investors.
Pre-Formation Investments made in the Fund’s name are usually simpler from a valuation standpoint and tend to be used when the Fund’s success is more certain and there is a shorter period of time to the Fund’s initial closing. In these circumstances, it is customary to simply charge a ‘time use of money’ amount to Fund investors (i.e. 5 percent or 6 percent of committed capital – usually the same amount investors are asked to pay pre-existing Fund investors for the privilege of joining after an initial closing). This amount is then distributed to the Early Investors as compensation for the loan they effectively made to subsequent Fund investors.
If the Fund itself makes the Pre-Formation Investment, the investment basically constitutes an ‘early’ initial closing of the Fund. This early closing requires consent of all investors undertaking that closing, which is not hard to obtain since they are funding the Pre-Formation Investment. Early Investors will also negotiate prior to the early funding date: (i) what contributions will be required of subsequent investors when they join the Fund, and (ii) the ramifications of the Fund’s failure to achieve a size satisfactory to Early Investors.
On the first point, Early Investors typically require that the Fund call capital at its initial closing to return funds to the Early Investors. On the second point, the Early Investors may require that if the Fund’s initial size falls short of its target size, the investment period will end earlier than it otherwise would. Early Investors may also obligate the Sponsor to cover all costs associated with early formation of the Fund, notwithstanding that Early Investors will have the sole benefit of the vehicle if subsequent investors never join, and/or that later investors pick up 100 percent of the Fund’s formation costs.
On the other hand, SPVs are more often used when the Fund will not ultimately own 100 percent of the Pre-Formation Investments, when the Fund’s success is uncertain or when there is a long time gap between Funds. Once an SPV is used, there are two ways to transfer the Pre-Formation Investments made in an SPV to the Fund: purchase or contribution. In either scenario, valuation of the Pre-Formation Investment is very important and complicated.
The act of selling a Pre-Formation Investment to the Fund is straightforward; the Pre-Formation Investment’s documentation should allow for the transfer without triggering rights of first refusal or consent obligations. The pricing of the sale is much more complicated. The Sponsor and the Early Investors must determine at the outset, and the Fund offering documents should disclose, whether the sale will be at cost, cost plus an interest factor, or at fair value. Sponsors may be unwilling or think it unfair to require Early Investors (and itself) to part with successful Pre-Formation Investments merely at cost or cost plus an interest factor, and instead may want to transfer such investments to the Fund at fair value (whether by purchase or contribution). In order to verify fair value for Fund investors, such transfers may necessitate a costly and time-consuming appraisal, the costs of which should, in the Sponsor’s view at least, be Fund expenses – further deepening the expense burden on investors in the Fund.
The SPV will incur capital gain or loss, which might be considered long-term if effected after more than a year’s holding, i.e. at the Fund’s final closing. (But caution is warranted regarding related party transaction tax rules.) If effected before the final closing, and if only a portion is being transferred to the Fund, there might need to be multiple transfers. Multiple transfers militate strongly in favour of a cost or cost-plus price to avoid need for multiple visits from the appraiser.
Timing also has a distinct impact on the pricing at which the Pre-Formation Investment is sold to the Fund in another respect. The longer the SPV holds the Pre-Formation Investment, the more likely it is to have appreciated or depreciated. Transferring in depreciated investments at cost or cost plus is immediately dilutive to new investor money and may raise fiduciary or marketing concerns. Transferring in appreciated investments leaves Early Investors feeling diluted. The longer an appreciating investment is held, the less likely either cost or cost plus an interest factor is going to be an acceptable price; but paying an appreciated price late in the game can have the appearance of manipulation to favour Early Investors. In short, much caution is warranted in matching timing and price. To avoid missteps, Sponsors will generally want to sell 100 percent of the Pre-Formation Investments at cost plus an interest factor at the initial closing of the Fund.
Instead of selling to the Fund, Sponsors may contribute Pre-Formation Investments to the Fund in exchange for a membership or other applicable interest in the Fund, resulting in the entity acquiring the Pre-Formation Investment being essentially a feeder fund to the Fund. This scenario may require maintenance of more legal entities than the Sponsor would want, but allows for Early Investors as a group to have easy access (for example, as a ‘special limited partner’) to favourable Fund terms as compensation for their early funding on a basis transparent to subsequent investors. In this case, Fund expenses may include the costs of not only sourcing and investing in Pre-Formation Investments, but also of forming the proper legal entity to make such investments and moving it into the Fund as a feeder entity.
Disclosures and Diligence
In a pure blind pool Fund, the ‘investment strategy’ disclosures in the Fund’s operating documents are the primary and sometimes sole source of investor information regarding how investments will be sourced and deployed. Such disclosures are sometimes very detailed and specific, and other times broad and general. When a Fund holds Pre-Formation Investments, i.e. after its initial closing, the Sponsor has already begun to implement the Fund’s investment strategy, and should have reasonably detailed disclosures about the Pre-Formation Investments in order to satisfy applicable securities laws.
Investors joining a Fund after it holds Pre-Formation Investments will usually take the opportunity to view first-hand the Sponsor’s investment practice in action and will undertake its own, independent review of the Pre-Formation Investments. Enhanced diligence by prospective investors is thus another consequence of the Pre-Formation Investment programme.
Marketing Considerations
Pre-Formation Investments take time and money and may be burdensome for a Sponsor simultaneously trying to raise an upcoming Fund. By deploying its own capital, a Sponsor is indicating to potential investors its own confidence in the Fund’s investment strategy and investors appreciate seeing a Sponsor with this type of ‘skin in the game’. However, a Sponsor will need to ensure that it has adequate support to effectively manage these investments while at the same time marketing the upcoming Fund. Pre-Formation Investments may flounder if Sponsors become too engrossed in the marketing process to the detriment of Pre-Formation Investment management. Should Pre-Formation Investments perform poorly, the Sponsor will need to overcome not only the typical investment process hurdles but also a discouraging and incredibly recent track record.
If, however, Pre-Formation Investments succeed, they will exemplify the Sponsor’s ability to generate investment opportunities and successful returns. Especially for a novice Sponsor without a track record from prior Funds, successful Pre-Formation Investments may prove invaluable throughout the marketing process. For such a Sponsor, if the Fund does not ultimately launch, the Pre-Formation Investments which will have been structured to be part of a Fund will essentially be ‘independent sponsor’ deals and may not have the economics to fly solo.
Timing of Capital Contributions
Closings in typical blind pool funds are often ‘dry,’ meaning investors are not required to contribute their committed capital until it is needed for deployment to investments. While awaiting capital calls, investors will often leave their committed funds in liquid or short-term investments, which produce low returns. Pre-Formation Investments alleviate concerns that funds will idle in low-yield investments. In addition, the Fund will presumably realise returns earlier in its life. Pre-Formation Investments thus get money working faster and can boost IRRs. However, investors must prepare to contribute their capital upon the initial closing, which may impact the time when an investor is willing to make its commitment.
Management and Other Fees
Sponsors will need to determine whether to charge a management fee, and what fee to charge, for their management of Pre-Formation Investments. This is wholly negotiable and there are many permutations. Early Investors may be charged a management fee on Pre-Formation Investment capital from the date the investment is consummated, in which case the Fund’s subsequent investors would likely be charged management fee retroactively to that date as well. Or, there may be no management fee charged to any investor until the Fund’s initial closing. Or, Early Investors may be charged a management fee from the consummation of the Pre-Formation Investment with a subsequent hiatus in management fee burden after the Fund’s initial closing until subsequent investors have borne a proportionate amount of management fee – bringing all to effectively the same place as if management fee were charged to all only from the Fund’s true initial closing, but protecting the Sponsor’s revenue stream in the interim.
In addition to management fees, Sponsors may charge acquisition fees, which would normally be subject to a management fee offset in a Fund, and may have other Fund-type expenses relating to Pre-Formation Investments. All fees and expenses of Pre-Formation Investments should be considered when the investments become Fund investments so that Fund investors fairly and proportionately participate in all of their attributes. A Sponsor may choose not to retroactively charge investors for the costs incurred in evaluating and consummating Pre-Formation Investments, in which case investors who would otherwise have the value of their investment reduced by the transaction expenses would benefit from the ‘free’ pre-closing acquisition. These decisions may affect the price or value at which an SPV’s Pre-Formation Investment is sold or contributed to a Fund.
Carried Interest
Like management fees, Sponsors must decide whether a carried interest will be applicable to a Pre-Formation Investment. For Funds with a net cumulative distribution waterfall, if a portion of a Pre-Formation Investment is to remain with an SPV, not having a carried interest in the SPV helps remove an obvious conflict of interest after the Fund acquires its portion. Having a reduced carry on the Pre-Formation Investment that will apply if the Fund does not get to an initial closing will both preserve the Sponsor’s economics and entice investors to the opportunity. A reduced carry applicable even after Pre-Formation Investments become Fund investments will further entice investors, but may be difficult to administer if it applies only to Pre-Formation Investments and not to the Early Investors’ share of the Fund’s total investment portfolio. The characteristics of the Pre-Formation Investment strategy will determine whether a carried interest should or can be charged for the Sponsor, and, if so, at what level.
Conclusion
Well-established Sponsors with a positive track record from previous funds may not need the additional reinforcement that successful Pre-Formation Investments can provide, but may like or be asked for them for reasons more oriented towards marketing and investor relations. For less well-known or established Sponsors, Pre-Formation Investments are a way to prove to investors the worth of the investment strategies intended to be deployed and offer opportunities that incentivise investors to back the Sponsor. Implementing a strategy involving Pre-Formation Investments is not uncomplicated, but with proper planning, can greatly benefit investor returns.
