Private equity fundraising is tough in the current economic climate. In mid-2010 buy-out firms had on average just three years to invest about $400 billion (€323 billion), over one-third of their total 'dry powder', or return it to their limited partners. With this reserve of dry powder still uninvested and the number of secondary transactions rising, one might wonder where all the attractive targets to justify another generation of private equity funds will come from. Limited partners are becoming increasingly sensitive with regard to (in their eyes) voluminous management fees, and general partners are therefore looking for alternative arrangements to sweeten sought-after fund commitments.
On the other hand, empirical wisdom shows that exit returns tend to be higher where the portfolio company was initially acquired in a down phase and at a bargain price. Therefore, it should be worth the effort to think about fund structures that give limited partners an extra amount of comfort. A pledge fund might be such a structure.
Pledge funds are limited partnerships in the form of a soft-commited fund where investors have a high degree of discretion regarding whether to invest finally on a deal-by-deal basis. The idea utilises the model of the club deal and business angel camp, where the one opportunistic investment idea trumps a structured and long-term investment process. For general partners, particularly first-time sponsors, this alternative structure makes it potentially easier to raise a fund in the current environment. Limited partners might feel more comfortable without having to commit a huge amount of money over a defined investment period.
With regard to the economics of a pledge fund vehicle, a management fee can, to a certain extent, be based on the pledge commitment at a lower percentage rate plus an additional fee on the invested capital, for example. This allows the general partner to source and monitor potential targets actively. Alternatively, a membership fee can be charged for the period in which the limited partner actively screens the general partner's offers. A third model includes seed investors that make certain initial payments to cover operational costs.
The classic carried-interest model also applies to the pledge fund. The main question is the extent to which the performance can be aggregated across all of the fund's investments. There are a number of structures in place that aim to reward those investors which participate in a high number of transactions.
Time is of the essence for pledge funds. Limited partners need time to screen potential investments with a higher amount of diligence than the usual 'passive' fund investor, taking into account their potential cluster risk. The general partner still needs to bid effectively and potentially solicit third-party co-investors. Delays in getting consent (and money) from limited partners could materially disadvantage the general partner's investments.
Another disadvantage for pledge funds can be a negative perception among the sellers or the management of the target company. A lack of committed equity financing might be a problem for stakeholders of larger targets that could tend to prefer those investors which potentially would close the deal immediately. Another disadvantage might be the lack of diversification for those limited partners who participate in only one or two of the pledge funds transactions. Taken together, the pledge fund continues to be a viable alternative for general partners looking at small and mid-market transactions. Large leveraged buy-outs are likely to continue to be undertaken under a classic fund regime. Even there, it is possible to address many limited partner concerns in a traditional fund structure, such as:
reducing the standard management fee over the fund term;
switching from committed capital to invested capital as a carry basis;
deducting transaction and/or monitoring fees; or
applying a higher hurdle rate.
Finally, there is the question of those funds already raised and still left with a substantial amount of dry powder. One solution would be a renegotiation of the fund terms to achieve an extension of the investment period. Taking into account that the scarcity of targets drove up the prices for potential target companies at least at the beginning of 2010, such an extension would make sense for successful private equity firms which felt that they would not want to pay such an ambitious price. In addition, with syndicated and visible debt financings slowly but surely becoming available again, an additional number of players will become active in the coming quarters, so that having more time to invest would be reasonable.
With some effort on the structural and legal issues, new funds have the option of either fundraising at terms more favourable to the limited partners or trying out the pledge fund model. Existing funds may want to consider whether they see a need to renegotiate their investments terms or periods – or just to proceed with new investments, provided that debt becomes more available, operative improvements harvest higher earnings again and exit options become more realistic.
This article was first published by the International Law Office, a premium online legal update service for major companies and law firms worldwide. Register for a free subscription.