This is the first part of a multi-part series on fund formations and investments.
Private equity funds are big business in Canada. According to PitchBook, there are almost 500 private equity funds in Canada, and that does not include the significant number of foreign funds that count Canadian individuals, companies and institutions as investors. Per the Canadian Venture Capital & Private Equity Association, investments by Canadian private equity funds totalled C$3.6-billion across 316 deals in the first half of 2023.
While structures can vary, private equity funds (Funds) in Canada are typically structured as limited partnerships to allow flow-through tax treatment for investors and to limit liability for investors as limited partners. Generally, the “sponsor” of the Fund will act as the general partner and manager of the Fund, and will seek different investors to act as limited partners. It will also normally be expected to have some “skin in the game” and invest as a limited partner alongside the other investors.
A limited partnership agreement will set out the rights and obligations of the general partner and the limited partners. It will usually be negotiated between the general partner and one or two “anchor” limited partners, who are normally making the largest financial commitments to the Fund, before being circulated more broadly to the other limited partners. This initial negotiation serves two primary purposes:
It ensures the Fund’s key investors are in agreement with the terms governing the limited partnership.
It allows the general partner to circulate a largely final form agreement to the other, often smaller, limited partners.
There are many factors and issues to consider when forming a Fund, and different funds will have different issues based on (i) how they are structured, (ii) the sponsor’s track record with previous funds, (iii) the target investment type and industry, and (iv) the past experience of investors and their counsel. In this multi-part Fund Formation 101 series, we will set out some key structuring and commercial considerations for Funds, and then consider some trends we are seeing in the Fund formation space.
First, we have set forth below some key structuring considerations to keep in mind when forming a Fund.
Structuring. One of the first decisions a Fund needs to make is whether it will be an “open-ended” or a “closed-end” fund. In an open-ended fund, there is no set termination date and new investors can be continually brought in to add fresh capital. A closed-end fund usually has a set timeline (seven to nine years is quite typical), and capital is raised from investors for a period of time before the Fund is closed and no new capital can be accepted. Most private equity funds, in our experience, are closed-end funds, as they allow the sponsors and the investors the certainty of a defined period of time for capital investments and disposition of assets. However, there are a number of larger, well-established funds that are open-ended.
Investor Class. A Fund sponsor will need to determine whether it will seek to allow foreign investors into the Fund. While the increased pool of potential investors can be attractive to sponsors, foreign investors come with their own structuring issues, and often require a parallel fund structure (or special purpose limited partnership that pools the foreign investors into one limited partner), which can have its own complications and costs. A Fund will also need to determine whether it will allow for tax-exempt entities to invest (for example, pension funds). Again, while a very attractive class of investors, pension funds are subject to specific investment rules. For example, pension funds can be restricted from investing in related entities and from holding more than 30% of the votes of an entity to which the right to elect directors is attached. These limits can provide uncertainly as to capital availability, especially where the tax-exempt entity has other investments with the sponsor group.
Carried Interest / Management Fee.
The general partner is usually entitled to share in the success of the Fund through a “carried interest.” Generally, a carried interest is a special distribution payable to the general partner, or a related “special” limited partner, once the limited partners have received back their invested capital and realized a defined rate of return on such capital (often between 8% to 12% per annum). The intent of the carried interest is to align the interests of the general partner with that of the limited partners in maximizing the Fund’s return on investment. Put more simply, a carried interest structure ensures that the sponsor does not get compensated until the limited partners earn a threshold level of return. While the amount of the carried interest is normally around 20%, some sponsors are able to negotiate a higher “tiered” carry structure (with the amount of the carry escalating as the Fund’s ROI increases) depending on their past history with similar investments or investors.
Generally, management fees are payable by a Fund to an asset manager (Manager), who is usually a related party of the general partner. Management fees are normally up to 2% of the Fund’s committed capital during the investment period, and often have a step-down following the investment period or are calculated on net invested capital as opposed to committed capital. The Manager uses the management fees to pay its costs in operating and administering the Fund, including overhead, paying staff salaries, and performing its other duties as the Manager. In some Funds, Managers are also entitled to certain other fees, such as acquisition fees, monitoring fees or development fees, although these are often Fund-specific and dependent on the type of assets managed by the Fund. If the general partner or the Manager receive other fees such as break-up fees or advisory fees in connection with the Fund’s investments, those are often deducted from the management fee. As mentioned above, larger limited partners can sometimes negotiate a smaller management fee or Funds will offer a larger carried interest to the general partner in exchange for reduced management fees.
Investment Period. The investment period for most Funds is fairly standard — three to four years from closing. The general partner and limited partners often need to negotiate what, if any, extension periods are permitted and who has the right to exercise them. There is an inherent tension in the general partner’s desire to have access to capital and the need to extend that access in certain situations (extended negotiations for certain assets being a prime example) and a limited partner’s desire for certainty as to how long its capital needs to remain committed for capital calls. Increasingly, in our experience, it is common for the general partner to have a unilateral right to extend for a specific period, and then require the consent of a majority of limited partners or the limited partner advisory committee for further specified extension.
Liquidity Rights. An important area of focus for limited partners, especially in open-ended funds where there is no fixed timeline for Fund termination, is liquidity rights. Many open-ended funds will allow for redemptions by its limited partners, although they are normally limited, both as to the number of units an individual limited partner can redeem and the aggregate number available for redemption to all limited partners. Often, there will also be a discount (often between 1% to 5%) applied on units tendered for redemption by limited partners, although it may decrease the longer the units are held.
The ability for a limited partner to assign its units is also usually addressed in a limited partnership agreement. Here, the desire for limited partners to have an ability to exit their investment has to be weighed against the general partner’s desire to control who the limited partners are. Often, limited partners will have a right to assign their units to a limited subset of other investors without the general partner’s prior consent. These other investors may include affiliates, other existing limited partners or investors under the same advisory control. General partner consent is required for all other assignments.
Governance. As a limited partnership, the limited partners generally cannot participate in the operations or management of the Fund without losing their limited liability status. That means limited partners have a very limited right to vote on matters affecting the Fund. Normally, these decisions include the removal of the general partner or Manager, dissolution of the Fund and amendments to related-party documents (such as a management agreement) and require a high threshold of approval (from 66% to 80% is common in our experience). However, the majority of Funds form an “advisory committee” of nominees from select limited partners that have the power to approve and/or opine on certain matters, including conflict of interest transactions, fees payable to the Manager, and changes to the Fund’s financial policies and investment guidelines. The right to participate in the advisory committee is generally granted to anchor investors, as well as other investors with large commitments or strategic importance to the sponsor.
Your legal advisors can assist you with understanding the various factors that should be considered when forming or investing in a private equity fund so you can determine how best to address those factors in your own Fund or Fund investment.
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