It seems like everybody wants to start their own fund some day. Here’s a high-level overview of the legal landscape for private equity formation.
What is Private Equity? Private funds are types of investment systems that are created by investment managers, known as sponsors. These managers raise capital to make multiple investments in a particular industry or geographic region. Typically, private equity groups (PEGs) acquire controlling interests in private companies or occasionally, a PEG will buyout a public company thereby taking the corporation private. PEG capital comes mostly from institutional investors and ultra-high net worth investors who have the means to invest substantial sums of money for an extended amount of time.
Types of Funds. PEGs are typically formed as limited partnerships (LPs) or limited liability companies (LLCs). The distinction between types of funds comes from the differences in their investment strategy.
In a traditional private equity fund, a PEG will raise committed capital for a fund from outside investors. PEGs typically invest in proven companies with experienced management teams and predictable, recurring revenue. Venture capital funds (VC), provide growth capital financing to startup companies and emerging companies perceived to have significant growth potential. VC financing typically comes in the form of convertible debt (i.e., promissory notes that can be converted to stock). Compared to PEGS, VC’s typically are less risk averse; while, PEGs typically expect a return on every investment. VCs make riskier investments and can offset occasional lost causes if they find a rare unicorn.
An increasingly common type of investment fund is known as a fundless sponsor or a search fund. Other than family offices, most private equity funds involve investing “other people’s money.” But, a fundless sponsor doesn’t really ever have other people’s money under management. Instead, a fundless sponsor has commitments from potential investors who agree to contribute capital to the sponsor if the sponsor identifies qualified investments. Sometimes the fundless sponsor is called a search fund because the sponsor and their investors are looking for one or two companies to acquire and manage.
A hedge fund, unlike other PEGs, manages investors’ capital by investing in publicly traded securities.
Financial Terms. PEG sponsors typically receive an annual management fee of 2% of the committed capital from investors. However this fee structure is not universal and fees ranging from 1.5% to 2.5% are not uncommon depending on the overall size of the fund. In addition, the sponsor usually receives a carried interest, which is typically 20% above the expected rate of return. A carried interest is a share of the profits of an investment that is paid to the investment manager in excess of the amount that the manager contributes to the partnership. A carried interest is a partnership interest. It is called a “carry” because the sponsor is allocated a greater percentage of partnership interest than their investment would otherwise equal. In other words, the limited partners are “carrying” the sponsor’s interest.
Expenses. Private equity expenses include: (1) establishing and organizing the fund, (2) the operation of the fund, and (3) the sponsor’s management company. Organizational expenses generally include the out-of-pocket expenses of the sponsor incurred in forming the fund, such as printing, travel, legal, accounting, filing, and other organizational expenses. Organizational expenses are to be paid by the fund’s investors out of their capital commitments. Operating expenses include, but are not limited to, management fees, third-party service providers to the fund, insurance, indemnity and litigation expenses, and taxes and any other governmental fees or charges levied against the fund. The fund’s manager pays the cost of their own administrative and overhead expenses incurred in managing the fund.
Fund Raising Regulations; Regulation D. There would be no private equity without fundraising. Every offer or sale of a security must be registered with the Securities Exchange Commission and appropriate state and agency unless the offering is subject to an exemption from registration. Offerings of interests in private equity funds can avoid SEC registration by satisfying the safe harbor exemptions under Regulation D. When a sponsor relies on exemptions under Regulation D, it is required to file Form D notice with the SEC within 15 days of the first sale. Form D requires certain basic information such as: (1) the offering price of the interests, (2) the number and location of purchasers, (3) details of offering expenses (including sales commissions), and (4) a description of the use of proceeds raised from the sale of the interests.
Private Securities Offerings. The private placement memorandum (PPM) is a prospectus that explains why the investor is investing in a company or fund. The PPM discloses crucial information to the investor so that the investor can make an informed decision before investing in the fund. The PPM details the investment opportunity, disclaims certain legal liabilities, and explains the risk of losses. PPMs are designed as a stand-alone document which means no other information has to be presented to the investor for them to make a careful investment decision.
Registered Investment Advisers. Generally, a sponsor with more than $100 million of assets under management must register with the SEC as a Registered Investment Adviser. The adviser’s registration covers its employees and other persons under its control, provided that their advisory activities are undertaken on the adviser’s behalf. Lastly, if an investment adviser exceeds $100 million asset management and is required to register under the SEC without exemption, parts 1 and 2 of the Form ADV must be submitted to the SEC with a description of the business, its clients, ownership, feeds, and other various issues deemed material to the SEC and to investors. A federally registered investment adviser is subject to the Advisers Act and its rules as well as increased oversight by the SEC, primarily through its inspection and enforcement powers. A registered investment adviser is responsible for implementing policies and procedures to ensure that it has a compliance program that is reasonably designed to prevent violations of the Advisers Act. Regardless of being registered with the SEC or the state level, RIAs are required to have a set of written compliance policies and procedures, including a code of ethics, and to appoint a chief compliance officer to oversee the firm’s compliance program.