Alternative Private Equity Funds: Pledge Funds, Managed Accounts, Deal-By-Deal Co-Investments and Other Hybrids

Presenting a live 90-minute webinar with interactive Q&A Alternative Private Equity Funds: Pledge Funds, Managed Accounts, Deal-by-Deal Co-Investments and Other Hybrids Structuring and Negotiating Alternative Funds for Investment Managers and Investors

TUESDAY, MARCH 29, 2016 1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific

Today’s faculty features:

Mark Proctor, Partner, Vinson & Elkins, New York

Robert Seber, Partner, Vinson & Elkins, New York

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MARCH 29, 2016

ALTERNATIVE PRIVATE EQUITY FUNDS

Robert Seber Mark Proctor

www.velaw.com AGENDA

1. Pledge Funds 2. Combo Funds

3. Co-Investments 4. Separately Managed Accounts

• It’s getting tougher for new GPs to raise capital…

– In 2015, 689 PE vehicles raised $288bn

– Just 8% of capital went to new GPs

– 54% of investors would not consider investing in first-time funds over the next 12 months

• What is a pledge fund?

– Investors decide whether to participate in investments on deal by deal basis

– Limited due diligence

– Prearranged terms if participate

• Basic elements of a pledge fund

– Agreement to give investors a first look at deals, often in exchange for a fee

– A set process / timeline by which investors decide to participate in each deal

– Prearranged structure and terms for deals that get executed

• Advantages

– Gives GP a preferred source of capital

– Enables an investment team to establish a track record without raising a blind pool

– Enables manager to have some ongoing fee stream

– Allay investor concerns about committing capital to managers with lack of track record or tarnished track record

• Disadvantages

– Manager takes on risk that capital will not be available for any given deal

– Fees are lower than with a blind pool; manager must operate leanly

– Sometimes perceived by potential target companies as “tire kickers” and not “serious investors” – could be a disadvantage in an auction process

• Structural Approaches – Multiple SPVs

– IMA signed initially; includes ROFO, “capital commitments” and option or management fee provisions

– Separate SPV (can be LP or LLC) for each deal; each SPV has its own waterfall and governance terms

– LPA negotiated upfront at same time as IMA

• Structural Alternatives – Single Vehicle

– Single LP or LLC that issues multiple classes

– Lets investors opt into or out of each deal – all deals within the same vehicle

– Vehicle issues a separate class of interest for each deal with a discrete set of investors

• Pledge Fund Mechanics

– Each investor subscribes for a specific amount

– Investment manager is obligated to present opportunities to fund up to the aggregate amount

– Manager presents investors with a due diligence memorandum describing each investment opportunity. Investors are permitted to opt into (or out of) each investment – typically have 5 to 10 days

– Each investor may opt into a deal for up to its maximum allotment to the deal

– Any unsubscribed capacity may either be offered to other pledge fund investors or third parties

• Expense Allocation Provisions

– Expenses for deals shared by investors who opt in pro rata based on deal sharing percentages

– Broken deal expenses allocated depending on when the deal “breaks”:

• If breaks before expiration of the opt-in period: allocated in accordance with “commitments” to pledge fund

• If breaks after expiration of opt-in period: allocated in accordance with deal sharing percentages

• Fees

– “Option” fee on commitments – investors pay a small fee (e.g., 50bps) for the right to a first look at deals

– Management fee – investors pay a management fee on invested capital in each partnership

– Carried interest – investors pay carry on a deal by deal basis

• Deal point: whether deals are cross collateralized

• Key Issues

– Track record: question as to whether returns completely driven by GP’s investment discretion (since investors can opt out of deals); each investor has its own returns

– Serial non-participation: how to deal with LPs who don’t fund their share of deals?

• Three strikes rule with penalty, which can be structured as penalty for each opt-out, or increase in “option” fee

• Manager should ask for right to terminate investment period if there is significant lack of participation in deals

• Key Issues (cont’d)

– Credit for rejected deals

• Manager has incentive to show as many deals as quickly as possible to get through ROFO obligation

• To keep manager from showing deals that are trash LPs may seek to have manager receive reduced (or no) credit for deals rejected by a majority of investors

– Winding Up – it is important for the Manager to be able to terminate the pledge fund if LPs reject too many deals

– Conversion to Blind Pool – Managers may seek to include mechanism to convert the pledge fund to a blind pool

• Investment Advisers Act

– Assets invested in deals count as RAUM

– If pledge fund has nominal commitments (as most do), do nominal commitments count as RAUM?

• Non-discretionary IMA

– If pledge fund does not state nominal commitments, what result?

• Overview

– Combination between a pledge fund and a blind pool

– Investors make a capital commitment to the “hub” or blind pool fund and separate “commitment” to the “spoke” or pledge fund

– Each deal may be allocated to the blind pool fund and, potentially, the pledge fund

• Principal issues

– Allocation of capital between blind pool and pledge fund

– Allocation of deals between blind pool and pledge fund

• Based on investment restrictions in blind pool

• Set allocation

• Unsubscribed investment allocation

– Netting of carried interest

– Management Fee

• Not a clearly defined category

 Our focus is on LPs investing in deals alongside the PE fund based on their own investment decision

• How do LPs and GPs view co-investments?

• How have co-investments evolved?

• How are co-investments structured?

• What are the key economic terms of co-investments?

• What are some regulatory issues?

“The past year saw continued growth in the successful Principal Investments Program, which seeks to take advantage of TRS’s competitive advantages as a large, long-term investor by initiating high-transparency, low-fee, alpha-producing investment arrangements with select investment partners. Since the beginning of the program in 2009, the fund has committed $6 billion in more than 50 principal investments across Private Equity, Real Assets, Energy and Natural Resources, Special Opportunities, and Internal Public Markets. In addition, the Investment Management Division (IMD) has committed another $1.2 billion across nearly 70 smaller principal investments in separate dedicated vehicles managed by select general partners, as well as an even greater volume of principal investments in side-car vehicles. …

To date, this effort has been highly accretive to the Trust’s returns and it should continue to be in the future.”

TRS - 2015 Comprehensive Annual Financial Report

62% Existing LPs  PE Fund of Funds 20% Public Pension Funds 10% 18% Referrals from LPs Family Offices 10% 10% LPs from prior funds Insurance Companies 7% 6% Prospective LPs Asset Managers 6% Private Pension Funds 5%

North America – Based 47% Europe – Based 22%

Sources: Mergerstat; Prequin 24

Co-Investment IRR Co-Investment MOIC Year Investments - Fund IRR - Fund MOIC 1994 1 11.99% -0.44 … … … … 2005 10 2.79% -0.03 2006 18 -10.51% -0.31 2007 33 -16.08% -0.37 2008 9 -25.54% -0.63 2010 8 -1.27% -0.15 2011 6 -13.22% -0.51 Total 103 -8.98% -0.22

Data from investments by seven large institutional investors.

Source: Fang/Ivashina/Lerner, “The Disintermediation of Financial Markets: Direct Investing in Private Equity” (2014)

Legal Effect Concept Frequency

Binding GP is obligated to offer co- Low investments Preferential Certain LPs may have Medium; can be preferential rights over other turned into a LPs, based on: marketing advantage  early closing by GP  size of commitment  other factors

Voluntary Side letters may express High interest by LPs, but co- investment is in GP’s discretion

• GP’s need for prompt decision-making v. LPs’ frequent lack of decision-making capability

• One counsel for all co-investors v. separate counsel for each co- investor

• Independent evaluation of all due diligence materials (access to data room) v. reliance reports on prepared by GP or advisors

• Full disclosure and access to information v. limitations set by confidentiality agreement

Principal Governing Document: Shareholders’ Agreement

Principal Governing Document: LLC Agreement

Principal Governing Document: LP (or LLC) Agreement for SPV

• Drag-Along: Requires the co-investors to sell alongside the GP in the event of a sale of control

• Tag-Along: Requires the GP to allow the co-investors to participate in sales by the GP

• Preemptive Rights: Permit the co-investors to maintain their ownership percentage

• Transfer Restrictions: Limit or prohibit transfers by the co-investors

• Veto Rights: Prohibit or restrict limited types of decisions by the GP

• Governance: – Representation by co-investor(s) on portfolio company board – Board or advisory committee at co-investment vehicle – Observer and other information rights • Separate audit of co-investment vehicle • Asymmetric exit rights (e.g., upon portfolio company IPO)

• Allocation of investment opportunities between fund and LPs

 Policies for decision-making; disclosure

• Preferential co-investment opportunities to certain LPs

 Only if provided in LPA or set out in disclosed policy

• Allocation of deal expenses, including broken deal expenses, between fund and potential co-investors

 Policies governing expense allocations in completed and broken deals

Washington D.C., June 29, 2015 — The Securities and Exchange Commission today charged Kohlberg Kravis Roberts & Co. (KKR) with misallocating more than $17 million in so-called “broken deal” expenses to its flagship private equity funds in breach of its fiduciary duty. KKR agreed to pay nearly $30 million to settle the charges, including a $10 million penalty. An SEC investigation found that during a six-year period ending in 2011, KKR incurred $338 million in broken deal or diligence expenses related to unsuccessful buyout opportunities and similar expenses. Even though KKR’s co-investors, including KKR executives, participated in the firm’s private equity transactions and benefited from the firm’s deal sourcing efforts, KKR did not allocate any portion of these broken deal expenses to any of them for years. KKR did not expressly disclose in its fund limited partnership agreements or related offering materials that it did not allocate broken deal expenses to the co-investors. The SEC’s order instituting a settled administrative proceeding also finds that KKR failed to implement a written compliance policy governing its fund expense allocation practices until the end of the six-year period in 2011.

Separately managed accounts are partnerships that:

• have only the fund manager and the investor as partners within them

• mimic the main fund vehicle but include customized terms on management fees, carried interest and term

• typically co-invest alongside other funds managed by the fund manager, but the investor may also retain some discretionary investment power

• are being increasingly used by investors with significant amounts of capital, but are still more common at the fund-of-funds level

The California Public Employees’ Retirement System, the biggest U.S. pension, will pursue separately managed accounts for its future investments with private equity. “It’s our preference to use these structures moving forward,” spokesman Joe DeAnda said Thursday in an e-mail. The managed accounts, where a customer’s capital is invested separately rather than mixed with that of other clients in a traditional fund, offer cheaper fees and more control for investors. Clients known as limited partners in turn agree to commit large sums for longer. The $303 billion pension fund is working on plans to reduce costs … To lower fees it pays out, Sacramento, California-based Calpers said on Monday it will cull the number of external managers it hires to about 100 from 212 over the next five years. The number of private equity managers will fall to about 30 from 100. BloombergBusiness, June 12, 2015 42

• Control or influence over investment decisions

• Management fee and carried interest

• Investment horizon

• Liquidity rights

• Environmental, social and governance policies

Robert Seber [email protected]

Mark Proctor [email protected]

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