How VC Funds Work: Capital Commitments and Closings
Notwithstanding the recent economic climate, investment fund managers are once again actively working to setup new investment funds. The type of funds that we’re helping launch now are admittedly different than those we helped launch during the 2005 to 2008 expansion years. In general, funds are now being formed with less capital and many have a more specialized investment mandate than previously used. I’m now often seeing new fund managers entering the space by differentiating themselves from the norm in terms of the types of investments that they’re going after (e.g., revenue based lending, seed financings, etc.). The opportunities in the marketplace for these new types of funds are bringing in new fund managers with unique skill sets who could be hugely successful in this new landscape. Often, these new investment professionals, being from different markets than traditional VC investing, need to ramp up quickly in understanding the fund formation market.
Recently, I was asked a series of questions about how the capital commitment process works for a fund that anticipates multiple closings. This following summarized that discussion, providing a high-level overview of how to take commitments from investors in multiple closings and then proceed to call money from partners when making investments.
CAPITAL COMMITMENT MECHANICS
Investments in so-called “blind pool” funds (where the money is committed by investors into a fund with a designated purpose but without knowledge of exactly how that money will be invested) typically are structured as “capital commitments” subscribed for by the partners at a closing and then contributed by the partners over time, when and as requested by the fund manager. This allows fund managers to have a pool of capital available without needing to manage short-term investments for a large pool of cash for which they’ve not yet sourced deals. This also helps increase the fund’s ultimate internal rate of return (“IRR”) to partners. IRR is the standard on which most funds are evaluated, and impact the fund manager’s ability to raise capital in subsequent funds. No interest or other fee is charged on the deferred contributions other than as described below relating to interest or fees that may be charged to investors in subsequent closings. Typically, separate minimum commitment levels are set for individual and institutional investors.
2. Capital Calls
Fund managers “call” committed capital on an as-needed basis to make fund investments or to fund management fees or fund expenses. Contributions are required to be contributed within a prescribed period (usually 10 days) to avoid default under the fund agreement. In some instances, capital contributions for any period may be limited (e.g., no more than 25% of the committed capital in any 12 month period) or specifically prescribed (e.g., 10% at closing).
If capital is required to make a fund investment, timing of capital calls and the closing of investments can become a science in itself. To avoid the risk of failing to have capital available at closing, funds may consider borrowing money on a short-term basis to make the investments or pay expenses and using the later contributed capital to satisfy the borrowings. Although these allowances are common, they may cause the fund to recognize “unrelated business taxable income” and have adverse tax consequences to tax-exempt partners. Accordingly, such borrowings may be prohibited by the fund agreement, depending on the type of partners in the fund.
3. Multiple Closings
If the fund has multiple closings, investors admitted in later closings typically will fund their proportionate share of any amounts contributed at prior closings (i.e. if 10% of the fund was called previously, they will fund 10% of their commitment) and often will be charged interest on initial capital contributions in order to compensate the initial partners for the time value of money on their initial investments. In all other cases, investors generally treated similarly, as if they all invested in the original closing. Specifically:
• Investors share pro-rata in all fund investments, including those made prior to an investor’s commitment (typically, a fund will not make any distributions during its fundraising period, to avoid complexity in that regard).
• Organizational expenses in setting up the fund and partnership expenses charged to the investors, including management fees, typically are allocated proportionately among all partners regardless of the closing in which they may have made an investment.
• Management fees typically are calculated based on the aggregate capital commitments as of the final closing, as if all such funds were committed at the initial closing.
Funds generally are restricted from having closings after a prescribed period (e.g., 6 to 18 months) after the initial closing.
4. Fund Manager Commitment
The fund manager’s capital commitment typically is at least 1% of total capital commitments. This standard originated in early tax ruling guidelines and survives today due to industry standards and tax adviser’s insistence on maintaining some significant level of contribution to ensure favored partner tax treatment on allocations of carried interest. The fund manager participates proportionately with all partners on all economic rights associated with its capital contribution.
CONTRIBUTION DEFAULT RULES
In the event a partner fails to make its capital contribution when required, the partner may be subject to one one more prescribed penalties, along with general common law damages, under the fund’s governing agreement. These penalties can include one or more of the following: (1) canceling any further capital commitment of the partner and capping its participation based on amounts contributed; (2) limiting the partner from participating in all or a substantial portion of future profits and distributions of the fund; (3) charging interest on all delinquent capital contributions; (4) forcing the sale of the partner’s interest to existing partners or third parties on prescribed terms; and (5) actions brought against the partner for specific performance and consequential damages resulting from the failure to contribute.
Generally, these provisions are enforceable against the defaulting partner(s) but it is important to recognize that a fund manager may want to apply different provisions to different partners depending on the particular facts that lead to the default. Such different treatment should be done with care, to avoid the perception of favortism or special treatment. Similarly, the fund manager must be cognizant of its fiduciary duties to nondefaulting partners to maximize their returns. Stated differently, the more draconian the default provision enforced on the defaulting partner, the more beneficial the treatment to nondefaulting partners. Accordingly, these situations are very challenging for a fund manager, which must weigh a number of critical and potentially conflicting factors when determining the proper path or remedy to take with respect to a defaulting partner.
Check back soon for more installments of How VC Funds Work.