Fund forecast: Healthy for emerging managers

Thinking of starting a private equity or venture capital fund? Now is the time to get into the alternative investment game. While launching a first or even a second fund can be exciting, yet challenging at the same time, the recent swell in would-be managers is proof that the fund forecast is healthy. Improving market conditions and favorable performance in 2017 thus far, coupled with a higher investor risk tolerance, have sparked tremendous interest and activity.

Historically, alternative investment funds are one of the most successful asset classes, consistently outperforming their S&P 500 counterparts over the past decade. While the big names garner the most press coverage, the highest concentration of players are small-to-midsized shops – the ideal category into which emerging managers fall.

Many industry insiders and outsiders cite mediocre returns in 2016 and high fees as the catalyst for a defection from the bellwether funds. The likes of the California Public Employees’ Retirement System and New York City Employees’ Retirement System, along with their Texas, Kentucky and Rhode Island counterparts, are taking a cue from smaller pension funds. They are locking in on emerging manager platforms as a means to achieve diversification and tap into new talent.

The definition of an emerging manager typically varies, depending on who you talk to, but all have one common objective: to achieve investment goals. For state institutional investors, each takes the lead in articulating which alternative investment funds qualify. Typically, there is one common theme: the business must be majority owned by minorities, women, individuals with disabilities and/or veterans. Another area of common ground: today’s emerging managers are generating strong returns and positive results. In many cases, they also are outperforming their large-fund counterparts.

Of course, emerging manager start-ups require a multi-year commitment at minimum. The significance of defining and refining strategy, recruiting and building the right team and fortifying a niche presence for the most profitable operation should not and cannot be approached with any level of nonchalance. Other than a vision and determination, what else should emerging managers consider when fashioning the fund framework?

The need for expert advice

The highest priority is to consult with an attorney and tackle all legal and tax considerations up front. It should go without saying that nothing short of qualified, experienced legal counsel is acceptable at this governing-document phase. Unfortunately, many emerging managers engage counsel with little-to-no-experience in alternative investment fund start-ups, which ultimately results in additional fees and penalties – or worse – during the fund’s lifetime and beyond.

Although it may seem obvious, a fund’s structure is influenced by the types of investments and its anticipated capital flow. That being said, private equity and venture capital funds are always close-ended in structure. As a result, investors are committed through liquidation.

Next up: the Limited Partnership Agreement, also known as the Operating Agreement for a Limited Liability Company. LPAs define what can and cannot be done, as well as the role and responsibilities of the general partner or managing member. Furthermore, it outlines capital contribution and withdrawal terms and fund and investor fee arrangements.

Actual formation of the fund encompasses filing of the proper paperwork. This can be done anywhere, so the most favorable jurisdiction that will yield the best active return on investment is typically the address of choice. In the US, Delaware is the state of choice. Despite its relatively small population and geographic size, Delaware consistently ranks as the nation’s top state for incorporating businesses. This is due in large part to its flexible, clear and efficient corporate and partnership laws. For funds, the principle drivers are the “First State’s” freedom of contract and enforceability of LPA and/or LLC agreements.

Rounding out the legal “boxes” that need to be checked by emerging managers is the one that pertains to offering materials. It is at this stage a Private Placement Memorandum (PPM), an in-depth, detailed offering overview, and the LPA information related to fund management are finalized. These materials also incorporate vital protections against litigation should the fund NOT be successful. And even when it is.

There is no doubt tax implications are plentiful for emerging managers. Once again, a third-party service provider well-versed in this highly specialized area of expertise is the best solution. Among the issues impacting tax liability are the fund structure, type of entity, manager compensation, deductibility of benefits, state and local tax implications and income/loss allocation.

In and of itself, the type of entity and its structure are complex matters. The LP (the most common) and LLC are the most common investment vehicles for private equity and venture capital funds. Adding further layers are the two different types of structures: onshore versus offshore. Taking it one step further, both structures can take the form of a standalone, master feeder or side-by-side format.

While this is simply the tip of the iceberg, which is “melted down” in WithumSmith+Brown’s newly amended and released Emerging Manager Desk Reference (Second Edition), there are a multitude of other important areas upon which to focus. These include the custody rule, estate planning, insurance, office space, outsourcing, registration, retirement benefits, service provider selection, staffing and valuation. However, there is one area that warrants special attention: cybersecurity.

It is imperative, in this era of mass hacking and identity theft, to ascertain each fund’s legal obligations in terms of preventing, detecting and responding to cyberattacks – no matter how minimal. Like many other industries, alternative investing is faced with heightened penalties if cyber breaches go unreported.

In short, a lack of due care will most certainly yield exponential financial damages and a tarnished reputation, both of which can translate into an expensive failed alternative investment fund. The best advice: work with a third-party, certified ethical hacker to validate any and all cyber defenses. Protect your investors, protect your assets, protect your fund. Enough said.

While institutional investment in alternative funds has been a matter of practice for the past 10 years or so, adding emerging managers into the mix is a fairly recent phenomenon that has gained traction – fast. Emerging manager programs are no longer focused solely on social justice or corporate responsibility initiatives to attract underrepresented groups. Emerging managers embody the term “diversity” in a different sense: they employ an entrepreneurial approach to fund investments and innovative thinking that yield a powerful return-on-investment. Emerging managers bring something new to the table and the alternative investment industry is the better for it. 

What not to do

For all the “dos,” there are just as many “do nots.” Always, always, always avoid:

Partnering with an inexperienced attorney at fund formation, particularly during the structure and tax set-up stages

An inability to justify results published in marketing materials

Self-performing back-office accounting, which may seem like a good idea at the time to reduce fees – investors’ comfort levels are heightened with the engagement of a third-party provider

Uncontrolled costs that are easily remedied by engaging a third-party service provider

Unrealistic capital projections for launching and funding the business

Tom Angell, CPA, is a practice leader in Withum’s financial and investment services group where he serves a diverse roster of private equity and venture capital clients, including domestic funds, offshore funds and fund of funds. He is a co-author/editor of WithumSmith+Brown’s “Emerging Manager Desk Reference Manual” and is also an expert in raising financing, deal origination plus organizational structure and operational issues.