Separate Accounts Vs. Commingled Funds: Similarities and Differences in the Context of Credit Facilities

Article Separate Accounts vs. Commingled Funds: Similarities and Differences in the Context of Credit Facilities By Todd N. Bundrant and Wendy Dodson Gallegos1 The use of managed accounts as an investment efficiency associated with consolidating the vehicle has been widely publicized of late with number of capital calls made upon limited institutional investors such as the California State partners. These benefits would equally apply to Teachers’ Retirement System and the New York institutional investors establishing separate State Common Retirement Fund (referring to accounts with private equity firms and, despite such vehicles as “separate accounts”), and the fundamental differences between separate Teacher Retirement System of Texas and the New accounts and Funds, a separate account may be Jersey Division of Investment (referring to such structured to take advantage of the flexibility vehicles as “strategic partnerships”) making afforded by a similar credit facility. sizeable investments with high-profile private equity firms such as Apollo Global Management, Definition of “Separate Account” LLC, Kohlberg Kravis Roberts & Co. and the The term “separate account” has been used 2 Blackstone Group. generically to describe an arrangement whereby a Regardless of name, these tailored investment single investor provides virtually all of the vehicles represent a significant trend, with 32% of necessary equity capital for accomplishing a surveyed fund managers indicating they were specified investment objective. It is important, intending to invest more from separate accounts however, to distinguish a “separate account” from during 2013.3 And although structurally divergent a joint venture or partnership in which there is an from commingled real estate or private equity additional party (frequently the investment funds (“Funds”), these separate accounts share a manager) with an equity interest in the owner of common objective with Funds: to produce strong the investment. The equity provided (or earned) returns with respect to invested capital in the by the investment manager may be slight in most efficient manner possible. comparison to the equity capital provided by the institutional investor. However, despite the In many situations, accessing a credit facility can imbalance of economic interests, these joint facilitate achieving investment objectives. This is ventures and partnerships involve two or more quite clear in the context of Funds establishing equity stakeholders and generally require careful subscription credit facilities, also frequently consideration with respect to many of the same referred to as a capital call facility (a “Facility”). issues which arise in the context of Funds These Facilities are popular for Funds because of (whether such Fund includes just a few, or a few the flexibility they provide to the general partner hundred, investors). And confusion arises when of the Fund in terms of liquidity and the these joint ventures and partnerships are termination), while termination of a Fund incorrectly referred to as a “separate account.” Manager ordinarily requires the consent of a majority or supermajority of the other limited In fact, a separate account (“Separate Account”) partners, and oftentimes must be supported by is an investment vehicle with only one (1) “cause” attributable to the action (or inaction) of commonly institutional investor (“Investor”) the Manager. However, there are also significant willing to commit significant capital to a manager costs and trade-offs associated with this (which may also simultaneously manage a Fund flexibility, including that the Investor must or Funds (“Manager”)) subject to the terms set identify and agree upon terms with a suitable forth in a two (2) party agreement (commonly Manager, and the time commitment and referred to as an Investment Management expertise required by the Investor to be actively Agreement or the “IMA”). The IMA is structured involved in analyzing and approving investment to meet specific goals of the Investor, which may recommendations made by the Manager. be strategic, tax-driven or relate to specific needs Likewise, the Manager will require a sizeable (such as excluding investments in a particular commitment to the Separate Account to type of asset or market). As a result, it is not overcome the inefficiency of a Separate Account atypical for a Separate Account to be non- as compared to operating a Fund with a larger discretionary in terms of investment decisions pool of committed capital, more beneficial fee made by the Manager (with Investor approval structures, and discretion over investment being required on a deal-by-deal basis). Separate decisions. Accounts can also be tailored to match the specific investment policies and reporting Benefits of Credit Facilities for Separate requirements of the Investor. Accounts Separate Accounts vs. Commingled Funds Notwithstanding the differences between Aside from fundamental differences such as the Separate Accounts and Funds, Investors and Managers alike would benefit from access to a number of investors and the potential lack of credit facility in connection with a Separate Manager discretion in making investment decisions (described above), several key Account. To begin with, credit facilities provide a ready source of capital so that investment distinctions exist between Separate Accounts and opportunities (once approved) can be quickly Funds. Notably, fees paid to the Manager under Separate Account arrangements are typically closed. Timing considerations are critical in a competitive environment for quality investments, lower than those paid to a Manager operating a particularly if internal Investor approvals are Fund (in part because of the leverage maintained by an Investor willing to commit significant difficult to obtain quickly. The liquidity offered by a credit facility can decrease Investor burden and capital to a Separate Account), and any shorten the overall investment process by performance fees must be carefully structured to ensure they do not violate applicable law relating eliminating the need for simultaneous arrangement of funding by the Investor. The to conflicts of interest. closing of an investment through a credit facility The popularity of Separate Accounts may be minimizes administration by both the Investor attributable to the greater flexibility they provide and Manager, as funding of the obligations to the to the Investor. In addition to Investor input Separate Account can be consolidated into a related to investment decisions, IMAs are routine call for capital (instead of multiple draws sometimes structured to be terminable at will taxing the human capital of both the Manager upon advance notice to the Manager (although and Investor executing the objectives of the IMA). there may be penalties associated with early 2 Mayer Brown | Structuring a Subscription Credit Facility for Open-End Funds And, perhaps most importantly from the to request and receive the related Account Investor’s perspective, a credit facility may Contribution when called by the Manager (a eliminate the need to continually maintain “Capital Call”), to the Creditor. If so, the Investor liquidity for the capital required to fund retains discretion with respect to both investment investments contemplated by the Separate selection and Facility utilization and, when drawn Account. upon the Facility, would be supported by a pledge of: (a) the Required Commitment; (b) the right of Although alternatives exist (including asset-level the Manager to make a Capital Call upon the financing arrangements), many Funds have Required Commitment after an event of default established Facilities for purposes of obtaining under the Facility (and the right of the Creditor to liquidity, flexibility and efficiency in connection enforce payment thereof); and (c) the account with portfolio management. The most common into which the Investor is required to fund form of Facility is a loan by a bank or other credit Account Contributions in response to a Capital institution (the “Creditor”) to a Fund, with the Call. Creditors may also require investor letters loan obligations being secured by the unfunded from the Investor acknowledging the rights and capital commitments (the “Unfunded obligations associated with this structure from Commitments”) of the limited partners of the time to time. As mentioned above, most Investors Fund. Under a Facility, the Creditor’s primary and Managers are familiar with these terms and and intended source of repayment is the funding recognize the benefits afforded by establishing a of capital contributions by such limited partners, Facility for purposes of flexibility, efficient instead of collateral support being derived from execution, and administration of private equity the actual investments made by the Fund. The investments. proven track record of Unfunded Commitments as collateral has generally enabled Creditors to Conclusion provide favorable Facility pricing as compared to asset-level financing, although many Funds The number of Funds seeking a Facility is steadily utilize both forms of credit in order to increase increasing due to the benefits these loans provide overall leverage of the investment portfolio. to Investors and Managers in terms of liquidity and facilitating investment execution, while Assuming the Investor is a creditworthy simultaneously decreasing the administrative institution, the IMA can be drafted to take burden associated with numerous and/or advantage of the

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