Deal-By-Deal and Pledge Fund Models by Geoffrey Kittredge and John W

Legal & Regulatory Bulletin

— SPECIAL FEATURE: ALTERNATIVE FUND STRUCTURES —

Deal-By-Deal and Pledge Fund Models By Geoffrey Kittredge and John W. Rife III, Debevoise & Plimpton LLP

A manager seeking to deepen its track record or build a costs may be recouped when the deal-by-deal fund closes, relationship with a prospective investor may seek to raise or sometimes earlier through a “cost sharing” agreement capital on a deal-by-deal basis or by offering investors a with prospective investors. In a pledge fund model, these pledge fund structure. preliminary costs can be paid by the fund itself or, if neces- sary, partially covered by the manager out of a management In a deal-by-deal fund, a dedicated vehicle will be created for fee charged on subscribed capital. purposes of making an investment in a single target opportunity (or single portfolio of target opportunities). Unlike a Economic Terms traditional private equity fund model, where investors commit capital to the fund on a blind-pool basis and depend on In general, there is a less well defined set of “market terms” the fund’s investment team to identify and execute invest- for deal-by-deal and pledge funds than there is for tradi- ment opportunities going forward, investors considering an tional private equity funds, so investors’ expectations about investment in a deal-by-deal fund have full transparency on market-standard terms are less fixed, with the result that the underlying investments that will be made by the deal-by- terms for these alternative structures tend to show a greater deal fund and are able to perform “M&A-style” diligence on degree of variability than traditional fund models. such investments (in addition to the traditional fund investment diligence on the fund manager’s investment team) prior Some deal-by-deal funds do not pay a management fee to deciding whether to commit to the deal-by-deal fund. at all, though the manager may charge a one-off transac- tion fee from investors upon successful completion of the By contrast, in a pledge fund, investors make “soft commit- underlying investment. To the extent that a management ments” to the pledge fund prior to its investments being fee is charged, that fee tends to be based purely on invested identified. Unlike a traditional private equity fund, however, capital and to be a lower percentage than the 2% typical for investors are given the right to “opt out” of (or “opt in” to) traditional small and mid-sized private equity funds. Pledge each investment opportunity that the manager of the pledge funds, on the other hand, are likely to charge a low man- fund presents to investors. In this way, each of the investors agement fee on subscribed capital (whether or not drawn) is able to make its own decision whether or not to participate during a pledge fund’s investment period plus a higher fee in each investment opportunity instead of being required on deployed capital. to participate in each investment (subject to narrow excuse rights) as is the case in traditional private equity funds. Sponsors of both deal-by-deal and pledge funds typically receive some carried interest on the profits of the fund. When managers are choosing between a deal-by-deal fund While the carried interest rates for pledge funds tend to be model or a pledge fund model, there are a number of con- close to (though lower than) full carry charged by traditional siderations that they should bear in mind. funds, deal-by-deal funds tend to be subject to lower carried interest rates. Deal Execution Uncertainty & Costs As a result of the need for investors to diligence and approve an investment opportunity prior to participating in such an investment, both deal-by-deal funds and pledge funds can Unlike a traditional private face a degree of deal execution uncertainty (and delay). This equity fund, however, investors can place such funds at a disadvantage in a competitive are given the right to “opt acquisition process, as a seller may be reluctant to engage out” of (or “opt in” to) each and progress the sale process with a buyer that has limited “ control over its ultimate ability to fund the acquisition. investment opportunity that the manager of the pledge fund In addition, a deal-by-deal model requires the manager to front the costs of identifying, investigating and negotiating presents to investors. the investment opportunity prior to consideration by prospective investors in the deal-by-deal fund, although these — SPECIAL FEATURE: ALTERNATIVE FUND STRUCTURES —

Sponsors of both deal-by-deal Conclusion and pledge funds typically Deal-by-deal and pledge fund models provide alternative receive some carried interest on fundraising possibilities to the traditional private equity the profits of the fund. While the fund model. While these alternatives can be useful for a “ manager developing its track record or seeking to build carried interest rates for pledge relationships with one or more prospective investors, they funds tend to be close to (though are generally used as stepping stones toward the sponsor- ship of a traditional private equity fund rather than as a lower than) full carry charged long term product line. While an investor that is getting to by traditional funds, deal-by- know a manager is likely to appreciate the degree of control deal funds tend to be subject to these alternative models provide over the deployment of its capital in the short term, many institutional investors are lower carried interest rates. not staffed or equipped to participate in the enhanced level of investor involvement required from these structures over the longer term (or across many regions and investment Complexity strategies) and, as a result, continue to seek discretionary Unlike deal-by-deal funds (and traditional private equity blind pool products as a core part of their private equity funds), the management, administration and documen- investment allocation. tation associated with a pledge fund is generally more complicated because the exercise of opt-out/opt-in rights by different investors changes the composition of the inves- About the Authors tor group for each portfolio investment. As a result, there are multiple “pools” of investment portfolio within a pledge fund organized as a single vehicle, which raises issues Geoff Kittredge is a Partner in the London regarding the tracking and allocation of expenses (e.g., bro- office of Debevoise & Plimpton LLP. ken deal expenses) and other liabilities, and the potential cross-collateralization of the different pools. Alternatively, establishing a new fund vehicle for each portfolio investment made by the pledge fund can simplify some of the internal complexity by eliminating the need for multiple John W. Rife III is an Associate in the London pools within a single pledge fund vehicle, but substantially office of Debevoise & Plimpton LLP. increases the administrative burden of the overall structure. By the same token, a sponsor considering raising a number of deal-by-deal funds will face a greater administrative burden than if those investment vehicles were housed in a single private equity fund structure.

Investor Protections Investors in deal-by-deal funds are more likely than investors in a pledge fund to view their participation as that of an active co-investor rather than a passive fund investor. As a result, it is not uncommon for investors in deal-by-deal funds to seek a range of investor protections, including exit condi- tions, anti-dilution rights (including pre-emption rights in connection with the funding of any follow-on investments), consent rights over certain key decisions (a.k.a. “reserved matters”) taken with respect to the underlying investment and the ability to appoint a representative to the board of directors of the relevant company.