When East Meets West: Ten Considerations for VC Managers Launching "Evergreen" Funds and Hedge Fund Managers Launching PE Funds
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pelawreport.com
August 3, 2021
FUND FORMATION
When East Meets West: Ten Considerations for
VC Managers Launching “Evergreen” Funds and
Hedge Fund Managers Launching PE Funds
By Udi Grofman and Lindsey L. Wiersma, Paul Weiss
The Fourth Industrial Revolution – i.e., delineates ten unique areas (e.g., professional
innovation in areas such as artificial compensation, handling of recycling
intelligence, machine learning, quantum provisions, etc.) that require extra
computing, robotics, the Internet of Things, considerations by managers that are deviating
genetic engineering and other technologies – from their traditional approaches to offer new
has affected, and will continue to impact, types of fund products.
people’s lives in ways that were once
unimaginable. As that revolution reshapes the See “Structural and Operational
U.S. economy, the continent that once seemed Considerations for Hybrid Funds” (Feb. 23,
to separate the “West Coast” world of venture 2021); and “Fund Managers Turn to Hybrid
capital (VC) and growth equity investing and Fund Structures to Reconcile Fund Liquidity
the “East Coast” world of hedge fund investing Terms and the Duration of Assets” (Feb. 4,
has shrunk. 2009).
The result is the current landscape where Background: Impetus for
managers from each coast are deviating from
their traditional fund products, either to Evolution of Traditional
launch counterpart products or those with
hybrid characteristics. As that practice
Fund Structures
becomes more pervasive, it is valuable for fund West Coast asset managers who historically
managers to consider how the innate invested with deep, specialized expertise in
differences in the products necessitate certain niche markets – e.g., software or biotechnology
practical modifications to manager’s start-ups – find themselves with traditional VC
operations, compliance practices, fund assets that transition quickly into expansion or
structuring and other efforts. growth-stage investments, then to traditional
PE targets and into public companies –
This article identifies the prevailing trend sometimes even appearing to skip stages
within the private funds industry in which the altogether. Those managers’ expertise to
East and West Coast worlds are melding. In evaluate the technologies of Fourth Industrial
light of that development, the article then Revolution companies can be used to identify
©2021 Private Equity Law Report. All rights reserved. 1pelawreport.com
opportunities and create value in investments Ten Important Pre-
well outside the typical VC or expansion
phases. Taking advantage of those Considerations
opportunities at the public stage of the
corporate lifecycle, however, requires a fund Although there are many issues and intricacies
that can invest in public equities, which to be worked out in any fundraise, when
traditional closed-end VC-style funds are not contemplating raising a fund “of the other
designed to do. kind” asset managers should give special
consideration to the following ten factors from
Similarly, traditional East Coast managers early in the fund formation process.
specializing in understanding undervalued
public companies – and in particular those 1) Voluntary Liquidity Is Real in
focusing on the technology; media and Hedge Funds; End-of-Life Is Real
telecom; artificial intelligence; or healthcare
industries – often have the knowledge and in VC Funds
expertise to guide a would-be public company
through the expansion and growth stages of Investors in hedge funds expect to have
the process (or avoid or delay the public phase voluntary liquidity rights that can be exercised
by attracting private institutional capital at the as agreed upon in the fund documents. That
“pre-IPO” stage). That type of private-stage might require the manager to:
investment requires a fund with the capacity
to manage the lack of liquidity and readily • sell a position prematurely to satisfy
ascertainable market value, which a typical withdrawal requests;
hedge fund lacks. • get comfortable with certain positions
(including those with outsized organic
As the worlds in which those managers operate growth) representing a significant portion
increasingly overlap, traditionally West Coast of the fund’s value;
managers are increasingly going to the market • incur more leverage than initially
with evergreen products more akin to those of expected to finance the satisfaction of
East Coast managers than to traditional VC or withdrawal requests;
growth equity funds. Similarly, traditionally • suspend liquidity requests;
East Coast managers are increasingly going to • perform in-kind distributions of positions
market with closed-end products more akin to into liquidating vehicles;
traditional VC or growth equity funds than to • perform in-kind distribution of actual
traditional hedge funds. Launching those new securities; or
types of products exposes each type of • install “spillover” liquidating vehicles.
manager to both the benefits and the
limitations of “the other kind” of fund and can Whereas investors in evergreen funds can
require managers to rethink deeply engrained express dissatisfaction with a fund by “voting
aspects of how they run their businesses. with their feet” and demanding liquidity,
closed-end investors are locked into their
See “Panel Discusses Operational and Tax investments and can only express
Challenges of Hybrid Funds” (Nov. 5, 2019). dissatisfaction with a manager by refusing to
commit to a successor fund. They do expect,
©2021 Private Equity Law Report. All rights reserved. 2pelawreport.com
however, that once the fund has reached the investment suffers subsequent losses; that is
end of its life, they will recoup their capital the price investors are willing to pay for a
within a reasonable time frame. product with voluntary liquidity.
Due to increasing instances when assets at the Closed-end funds pay the manager its “carried
life of the fund still have “room to grow,” a interest” upon the disposition of investments.
whole industry of “end-of-life” solutions and Some funds may utilize a “European” waterfall
“GP-led secondaries” has rapidly developed, where all contributions have to be returned
including continuation funds, LP-tender offers before the carried interest is taken, while
and cross-fund sales funds. Although older others would use a “deal-by-deal” waterfall
funds are unlikely to have many “end-of-life” requiring only capital relating to realized
mechanics in their documents, sponsors investments be returned before the carried
raising new closed-end funds should consider interest is taken. In this model, the general
incorporating them into their fund documents. partner (and therefore the investment
professionals) receive compensation only when
See “Evolution and Future of GP-Led investments are disposed of, no matter how
Restructurings: Transaction Structuring much unrealized appreciation has accumulated
Trends and Conflicts of Interest Management in the portfolio.
(Part One of Two)” (Jun. 2, 2020).
It may take many years for realizations by
Each of those dynamics is anathema to closed-end funds to start occurring, and in a
managers of the “other kind” of funds, but to European waterfall, it may be many more years
investors they are fundamental expectations after the first realizations before carried
for investments in the asset class that need to interest is actually received. Further, when a
be addressed. A product that tries to skirt realization is actually received, it is generally
around either of those expectations will face subject to clawback if the remaining
an uphill climb in its fundraising. investments in the portfolio do not perform.
2) Compensation-Wise, See “How Carried Interest Clawbacks Preserve
Satisfaction Is Quicker in Hedge Investor Returns and Affect Taxation (Part Two
of Two)” (Jun. 11, 2019).
Funds
3) Differences Remain in How
Hedge funds are “mark-to-market” products in Borrowing and Leverage Is
which realized and unrealized gains are
calculated at certain predetermined times (e.g., Obtained and Deployed
at the end of each year and when capital is
withdrawn). If those gains exceed any past Borrowing and leverage are among the
losses (i.e., the “high watermark”), then an bedrocks of the alternative asset management
incentive allocation is taken by the manager at industry. Borrowing is used to obtain levered
that time. That incentive allocation is not exposure, but also to smooth out fund
subject to a clawback if the investor’s operations, to manage cash flows and to bridge
©2021 Private Equity Law Report. All rights reserved. 3pelawreport.com
financing when equity financing has not been 4) Recycling Is Automatic in
obtained in a timely manner. Leverage is used Hedge Funds, and That Might Be a
differently, however, in the open-end and
closed-end parts of the industry. Problem
In the closed-end context, borrowing – Closed-end funds have limited durations and
whether creating leverage or not – is typically typically impose limitations on how proceeds
obtained through “subscription line” facilities, from liquidated investments can be reused (or
using the undrawn commitment of investors as recycled) for investment purposes. Closed-end
collateral, or by applying leverage on the sponsors, therefore, often carefully consider
individual portfolio company (i.e., putting the whether they have sufficient capital to pursue
“leveraged” in “leveraged buyout”). More new investment opportunities later in their
recently, certain lenders have expressed an funds’ lives, while also not wanting to leave
increased appetite to extend credit at the capital unused unnecessarily.
fund-level with recourse to certain, or
sometimes all, of the fund’s illiquid positions. The same issue does not exist in open-end
funds, however. Notwithstanding the
See “Five Obstacles When Negotiating NAV withdrawals permitted by open-end funds,
Facilities and Potential Ways to Overcome they are typically operated as “closed systems”
Them (Part Two of Two)” (Mar. 24, 2020); and where the proceeds from liquidated
“Trends in the Use of Subscription Credit investments are retained as cash on the fund’s
Facilities: Structuring Considerations balance sheet. If the cash is not promptly
Negotiated With Lenders and Important LPA deployed into new investments, it will become
and Side Letter Provisions (Part Two of Two)” a burden by creating a drag on the fund’s
(Feb. 7, 2019). returns.
Investments in the hedge fund context can be Each type of fund has its own concerns as it
valued reliably because the assets, upon the relates to an efficient use of capital. Those
lender’s request, can be liquidated rather concerns are very different, however, and an
quickly. Therefore, leverage and borrowing investment team accustomed to one set of
manifest as asset-based borrowing, usually considerations needs to acclimate itself to
using the fund’s entire balance sheet as those of the other.
collateral. Fluctuations in market prices of
underlying positions – which can be tracked
on a “real time” basis – can lead lenders to
margin calls that may require the fund to sell
assets at inopportune times.
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5) Compliance Is Critical, but the around market manipulation and allocation of
Focus and Possible Landmines new issues. Those concerns place additional
pressure on personal trading policies;
Vary management of restricted lists; information
sharing practices; and other policies and
A robust compliance infrastructure is an procedures that may be less high risk in the
intelligent, risk-focused system that closed-end context.
categorizes relevant risks and probabilities and
correlates the approach taken accordingly. See our two-part series on mitigating insider
Those efforts have become a “must have” for trading risks: “Relevant Laws and Regulations;
private fund managers of all varieties as they Internal Controls; Restricted Lists;
seek to reduce the possibility of SEC Confidentiality Agreements; Personal Trading;
enforcement actions, shorten the time of Testing; and Training” (Sep. 27, 2016); and
routine exams by the Division of Examination “Expert Networks, Political Intelligence,
and secure investments from institutional Meetings With Management, Data Rooms,
investors. Information Barriers and Office Sharing” (Oct.
11, 2018).
Closed-end and open-end funds share many
similar areas of risk and probabilities, In light of those differences, any expansion or
including: evolution of an asset manager’s business
requires a review of its compliance policies and
• presentation of performance results; procedures to ensure they appropriately cover
• description of investment program; and those changes and, potentially, significant
• fair assessment of the risks involved. revisions to address those differences.
Differences between the fund structures and 6) Upper-Tier Arrangements
asset classes also lend themselves to bespoke Need to Be Reevaluated to Keep
types of risk and probabilities, however. On the
closed-end side: Professionals Happy
• capacity constraints make allocations of In the typical closed-end vehicle “upper-tier”
opportunities more challenging; arrangement, investment professionals vest
• the possibility of board service, consulting into the carried interest of a particular deal or
or similar relationships with portfolio fund over a period of time (typically 4-7 years).
companies requires a greater focus on fee That system works well with the fund
offset mechanisms; and compensation model and incentivizes
• the prevalence of co-investments professionals to stick around to monitor
warrants a closer look at expense investments they originated. It also requires a
allocations, particularly as to broken deal significant amount of patience, however, as
expenses. professionals must wait until carried interest is
actually paid by the fund to receive their
As for open-end funds, trading in public performance compensation – which often
companies increases the risk of insider trading remains subject to clawback.
inquiries and liability, as well as concerns
©2021 Private Equity Law Report. All rights reserved. 5pelawreport.com
That starkly contrasts against performance receive long-term capital gains treatment. As
compensation in the hedge fund context, as current laws require a longer holding period
incentive allocations are usually crystalized at for a fund’s GP to receive long-term capital
the end of every year if the firm performs well gains treatment for carried interest, closed-
and professionals expect to be compensated end fund managers have certain considerations
similarly. Yet, to maintain longevity and in structuring their funds and their
minimize the probability of professionals investments that are not present in hedge
exercising “the trader’s option,” it is not funds. In addition, early-stage VC funds may
unusual for a portion of the compensation to have qualified small business stock
vest over time or to be required to be considerations that are not generally on the
reinvested into the fund. radar of trading firms.
A fund sponsor moving from one type of fund See our two-part series: “Techniques for
to another must carefully consider its Preserving Qualified Small Business Stock
compensation and retention programs to Benefits for Early‑Stage Investments” (Jan. 19,
ensure alignment with the characteristics of 2021); and “Tips for Realizing Qualified Small
the new fund and to manage the expectation of Business Stock Benefits for Fund Investments
professionals who may now be getting part of and Certain Convertible Instruments” (Jan. 26,
their compensation on significantly different 2021).
timetables and terms.
Making tax results more efficient for the
See “Structuring Compensation Vehicles and manager and the fund investors requires not
Profits Interests to Optimize Tax Treatment only deep understanding of the various
When Forming a PE Firm (Part Two of Two)” strategies but also significant experience in
(Dec. 1, 2020). navigating tax nuances.
7) Tax Considerations Vary With 8) Different Approaches Are
the Asset Features and Investment Required to Achieve the Same
Durations ERISA Status
The same tax laws and regulations apply to all Although both types of funds endeavor to
fund structures and investment strategies. manage themselves in a manner that does not
Different economic terms, however, make make their funds “plan assets” under the
management fee waiver programs more Employee Retirement Income Security Act of
prevalent in closed-end structures; effectively 1974 (ERISA), they arrive at that goal via
connected income concerns more relevant for different approaches.
certain debt-focused strategies; and
deductibility concerns around management Closed-end funds that invest in private
fees more common in trading funds. companies may avail themselves of the VC
operating company (VCOC) exemption, which
In the closed-end context, the longer holding allows ERISA investors to constitute greater
period of investments may allow them to than 25 percent of each equity class.
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The VCOC exemption is only available, the investor may be different. Therefore, the
however, if VC investments constitute more manager will need to build a new relationship
than 50 percent of the portfolio and if the fund with a new team of professionals with a
exercises certain “management rights” over the different set of preferences and incentives,
underlying portfolio investments. VC, speaking the language of that particular team.
expansion and growth equity funds tend to
meet the VCOC exemption rather ordinarily. Understanding the different needs of those
investors, and being able to articulate how the
See “Tips for Avoiding ERISA Prohibited product addresses their needs, requires a deep
Transactions and for Satisfying Plan Asset understanding of the products sold and its
Exemptions (Part Two of Two)” (Nov. 10, 2020). features.
Conversely, hedge funds tend to be passive See “When IR and Compliance Clash: Contexts
investors in public companies and therefore and Reasons for the Strained Relationship and
must ensure the participation by ERISA Potential Ramifications (Part One of Two)”
investors is not significant (i.e., below 25 (Mar. 16, 2021).
percent of each equity class). There are,
however, strict parameters for measuring that
25-percent test and distinct idiosyncrasies 10) Back‑Office Staff Needs to
with respect to how that test is applied in the Walk the Walk
open-end and closed-end contexts.
Behind every successful fund product stands
9) Investor Relations Staff Needs not only a skilled and highly performing
to Talk the Talk portfolio management team and a persuasive
IR department, but also a competent support
Skillful investor relations (IR) personnel are system. Supporting an alternative asset
required to both perform successful manager is both an art and a science. Although
fundraisings and to retain existing capital in motivated back-office teams can learn the
the context of evergreen funds. The tasks are science of new products and operate funds
similar and require comparable skill sets, but with different features, when it comes to the
different type of investors are attracted to art, there is no substitute for the hard-won
different types of vehicles and have different lessons of experience. Therefore, often the
motivations and limitations. Even where a only shortcut on the road to smooth
single institutional investor is investing in both performance is to retain a team of
open-end and closed-end products, the professionals who have experience with both
individual teams managing those portfolios at types of funds.
©2021 Private Equity Law Report. All rights reserved. 7pelawreport.com
Udi Grofman is a partner in the New York office funds, including buyout funds, hedge funds,
of Paul Weiss and the global co-head of the firm’s hybrid funds, distressed funds, credit funds,
private funds group. His practice focuses on structured product funds, co-investment funds
fund formation, strategic advice and crisis and funds of funds. In addition to advising on a
management and spans all asset classes in the wide range of fund formation issues, she also
alternative management space. advises fund managers on regulatory issues,
management company “upper tier”
Lindsey L. Wiersma is a partner in Paul Weiss’s arrangements, investment management M&A
private funds group in its New York office. She transactions, seeding arrangements and
focuses her practice on the organization and secondary transactions.
operation of a variety of private investment
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