Bridget Barker
Chair of the Board, Mainspring Fund Services
An investment fund is an arrangement, usually managed by a third party, which allows participants to invest in one or more assets and share the returns and the risks of the underlying investments.
A fund structure is typically used so that each investor can take a small share of a number of assets, which an investor might not be able to access individually. It is also often cheaper for an investor to share in the costs of a fund with others, rather than create its own individual holding structure. Another advantage is that once assets are within a fund, the fund interests can be transferred without moving the underlying assets, which can be tax efficient.
Funds are usually structured to ensure that the investors are no worse off than if they had invested in the underlying assets directly. Consequently, funds tend to be established in jurisdictions which offer a tax-exempt company or a fiscally transparent limited partnership, which means that there will be either no, or very little, tax leakage at the fund level. Onshore investors typically elect to use an onshore structure. For example, UK investors may use an English or Scottish limited partnership and US investors may go through Delaware. However, alternative funds for international investors are usually set up in Cayman, Jersey, Guernsey, Luxembourg or Dublin. The choice of jurisdiction and vehicle used is often led by the requirements of the potential investors.
Funds can be “open ended” which means that an investor can require his interests to be redeemed or “closed ended” when the fund will have a fixed life and the investor will be tied in until certain events occur. Most hedge funds, which trade the underlying (usually liquid) assets, are open ended, whereas most private equity funds which hold illiquid investments, are closed ended.
A private equity or venture capital fund is usually established using a limited partnership under the limited partnership law of the relevant jurisdiction. A limited partnership is created by executing a limited partnership agreement (“LPA”) and, in order to obtain limited liability for the limited partners, will usually need to be registered with a public body, although the level of required disclosure can vary. The statutory provisions and regulations which govern a limited partnership tend to be far less extensive than those applicable to limited companies, where fairly detailed statutory provisions and regulations automatically apply unless they are specifically removed. The LPA will set out all the contractual terms and governance procedures, for example: profit shares, termination rights and keyman provisions, which have been agreed between the partners.
The LPA is usually negotiated by the fund promoter (and its lawyers) with investors and their lawyers. This means that each private equity fund document will be different, depending on which investors go into the fund and which particular terms they require. A limited partnership can be established under the laws of the relevant jurisdiction by at least one general partner and at least one limited partner. A general partner is liable for the debts and obligations of the partnership, whereas a limited partner is usually only liable for the amount of capital contributed to the partnership.
A limited partner can however be held liable for the debts and obligations of the partnership, as if it were a general partner, if it takes part in the “management” of the partnership. The definition of what constitutes “management” varies between jurisdictions but often certain “safe harbours” are provided, so that a limited partner can undertake some activities, without incurring liability as a general partner.
Since a general partner of a fund has unlimited liability, a promoter will typically establish an additional entity, usually a limited liability company, which has few assets, to act as a general partner and have another related entity, with more assets, appointed to act as the manager and be the day to day operator of the fund, which might affect its regulatory capital requirements. As the manager will usually require to be regulated, this avoids the risk of the authorised entity having unlimited liability as a general partner of the fund, which might affect its regulatory capital requirements. This results in a number of entities being part of the fund structure, an example of which is set out in Diagram 1.
The manager of the fund will usually be involved with marketing the fund, will source deals and make the buy/sell decisions. Depending on the size of the fund and the number of investors, the fund and/or the manager may have to seek prior approval from the relevant regulatory body. Consequently, the manager may be required to comply with certain principles for the conduct of business, plus detailed regulatory rules.
Most managers will choose to appoint an administrator to run the back office of the fund and keep detailed records of the interests of each investor. It may also be necessary to appoint a depositary to hold the assets of the fund, as well as a firm of accountants to audit the fund’s financial statements.
It is usual to prepare a Private Placing Memorandum (“PPM”) which will set out full details of the fund structure, the various parties involved, the proposed assets and how the arrangements will be structured. The PPM is a key selling document on which potential investors will rely so it must be true, accurate and not misleading. It may be necessary for the PPM to be approved by and/or registered with a regulatory authority.
It is important for any fund promoter to obtain good guidance early on in the fund formation process. No two funds are the same and the level of detail involved may trip up the unwary.
For further information on the regulatory position and the formalities required for setting up a new private equity or venture capital fund please see the insight article: https://www.mainspringfs.com/set-up-pe-venture-fund-permissions/
The information set out in this note is for information purposes only. It does not constitute formal advice. If a recipient of this note wishes to take any further steps in relation to the matters referred to above, it is recommended that such recipient takes formal legal and taxation advice in the appropriate jurisdiction.
