Invest with confidence: Private equity funds for family offices

Investment lifecycle: Commitment, capital calls, recycling, harvesting, and extensions

• Capital commitments/calls. Unlike (usually) an investor in a hedge fund, a private equity fund investor makes a “capital commitment” that is called in over a fixed “commitment period” (or “investment period”) as investment opportunities are identified by the sponsor. Although family offices are often more nimble than other institutional investors, a reasonable period of notice should be expected (10 business days is common). Further, given the potentially drastic consequences of missing a capital call, investors may wish to seek enhanced notice and cure rights before default remedies are exercised by the sponsor.
• Recycling and reinvestment. Investors should focus upon what, if any, investment proceeds can be recycled and reinvested during the commitment period. And can the sponsor return unused capital without paying the investor the preferred return in respect of the amount that was initially called?
• Extensions. It is common for the commitment period and the term of the fund to be subject to extension. Investors should note all unilateral extension rights of the sponsor and consider whether consent of an independent body (e.g., a limited partner advisory committee (LPAC)) or a supermajority of investors is required for extensions beyond stated periods. In certain cases, management fee step-downs could be triggered by extensions to the fund’s term.

Key consideration

Consider whether extension rights are reasonable. Is it possible to tie any extension of the fund term to a reduced management fee, or require that a near-term exit plan for remaining assets be delivered to investors if the fund’s term drags on?
 

Waterfalls and carry: “European” versus “American,” catch-ups, givebacks

• Waterfalls. A key distinction among private equity funds is whether carried interest, or “carry,” is paid on the basis of a “European” or “whole fund” waterfall, where the sponsor earns carry only after all contributed capital is returned and a preferred return (often 6% to 8%) is paid to the investor, or on the basis of an “American” or “deal-by-deal” waterfall, where carry is determined on a deal-by-deal basis and thus paid earlier. In each case, attention should also be paid to the sponsor’s giveback obligations, with interim giveback testing (i.e., not only upon fund dissolution) particularly desirable in the case of a deal-by-deal waterfall.
• Catch-ups. In a private equity fund, after the preferred return is paid, a “general partner (GP) catch-up” in respect of that preferred return is common. Modified catch-ups (less than 100%, e.g., 50:50) are seen relatively often and are beneficial to investors.
• Givebacks. Receipt should be assured by way of guarantees provided by carry recipients (sometimes an escrow regime is included). Unless supported in this way, the investor’s exposure may be to a limited liability entity without assets.

Key consideration

If the fund is deal-by-deal, check for interim giveback calculations, with appropriate credit support.
 

Fees and expenses: Offsets, caps, and other key terms

• Offsets. Private equity fund sponsors often earn income through monitoring, transaction, and similar fee streams, in additional to management fees and carry. Investors should seek to ensure that monitoring, transaction, and other similar fees are offset against and reduce the fund’s management fees – this remains an important economic protection.
• Organizational expenses. Organizational expenses are often very significant for private equity funds, given the extensive investor comments and requests that they attract during the formation phase. The portion borne by investors will usually be capped, but often at a relatively high level, and the sponsor is often able to use the fund’s assets to meet the excess over the cap, with a corresponding management fee offset to follow. Investors should consider requesting an organizational expense estimate, even if a cap is included.
• Broken-deal expense allocation. Many private equity funds co-invest alongside other products with the same sponsor, and sponsors typically reserve the ability to allocate opportunities away from the fund to co-investors. Investors should pay attention to the manner in which shared expenses are apportioned; often, investors in a fund will bear a disproportionate share of broken-deal expenses if an expected co-investor does not complete its investment.
• Other fund expenses. Often, an extensive litany of permitted expenses is disclosed. Although digesting these disclosures can be challenging, investors should consider whether expense categories seem reasonable in light of the given strategy and program.

Conflicts management

The private equity business model can present a number of potential conflicts of interest:

• Affiliated servicers. If affiliates of the sponsor provide consulting, financing, administration, or other services to the fund, investors should seek to ensure arm’s-length terms, third-party fee benchmarking, and LPAC preapproval for arrangements that are not easily benchmarked.
• Cross-fund transactions. Generally, some form of independent valuation/fairness opinion and LPAC consent is required before a private equity fund sells its position to another of the sponsor’s products. Investors should consider what process is described in the fund documents and what exceptions apply.
• Co-investment allocations. As noted earlier, private equity fund sponsors typically reserve to themselves the ability to allocate opportunities away from the fund to co-investors. Investors will want the documents to set forth as objective an allocation policy as practicable (e.g., pro-rata to commitments, subject to speed and strategic fit).

Key consideration

Understand the scope and extent of the sponsor’s use of affiliated servicers and ensure that the related costs will be appropriately reported to investors.
 

Governance

In private equity funds, LPAC rights often include consent rights with respect to material conflicts, valuation policy changes, continuation fund deals, and term extensions, to name a few. But LPAC members serve the interests of the investor that nominates them, rather than the interests of all investors. And a family office that will be represented on an LPAC should look carefully at the express roles and responsibilities of the LPAC, the rights of members to convene meetings, the exculpation and indemnification rights of members (and their appointors), and the right of the LPAC to engage counsel and other experts as and when required (at the fund’s expense).
 

Key consideration

If you will not sit on the LPAC, consider seeking observer rights and/or access to LPAC materials.
 

Continuation funds

“Continuation funds” – vehicles that let a sponsor allow its thesis to play out longer by moving a position from an older fund into a new home, while giving investors the choice to cash out or stay invested – are now mainstream. Faced with continuation elections, investors often take the cash-out option, sometimes purely in an effort to avoid the burden of reviewing an entirely new fund offering, but factors worthy of consideration include:

• Independent valuation/fairness and LPAC approval. Investors should carefully review the materials provided and resist compressed decision windows.
• Fee/carry-related conflicts. Investors should consider the inherent conflicts of interest, which will usually be addressed by the sponsor in detail in the election materials.

Key consideration

New private equity funds are launched by established sponsors on a regular basis and (where applicable) usually strongly resemble their immediate predecessor. If the terms of a predecessor fund are available, family offices should use a “redline” to consider the extent to which the expense practices of the sponsor are changing over time, among other things.
 

In investing in private equity funds, a family office’s priorities and side letter concerns are likely to be more extensive than they are in the context of a hedge fund investment. Side letters may address fee and expense allocations, the use of alternative investment vehicles, co-investment opportunities, limits on recycling or reinvestment of proceeds, distributions in-kind, reporting and LPAC participation, conflicts, and transfer restrictions, to name a few. Further guidance on side letter protections can be found in The family office playbook for investing in private funds.