Private equity funds have become increasingly popular in recent years among those asset managers looking to offer a differentiated product to their clients and to increase their earning potential. Nonetheless, navigating the complexities of launching a private equity fund requires careful planning in order to navigate the numerous regulatory and legal landmines that can create risk for new fund managers. In this article, we provide a basic roadmap for those interested in forming a private equity fund and discuss, among other things, what is a private equity fund, how private equity funds are structured, who manages a private equity fund and how they are paid, the key terms governing investments in private equity funds, the regulations that govern the offer and sale of private equity fund interests, who can invest in a private equity fund, what vendors are typically retained to provide services to a private equity fund, the documents that are typically drafted to form a private equity fund, and how much it costs to launch and operate a private equity fund.


What Is a Private Equity Fund?

In short, a private equity fund is a pool of assets gathered from one or more investors whose capital is invested in various investments that are acquired and disposed of by a private equity fund manager (who we will also refer to as a “sponsor” in this article) during the life of the fund. Private equity funds come in all shapes and sizes. Some raise as little as $500,000 before launching operations while others can raise $10 billion in assets at launch. Private equity funds can invest in almost any kind of assets, although there may be restrictions in certain circumstances. Most private equity funds invest in privately-offered companies and funds. A subset of private equity funds is the venture capital fund, which typically invests in start-up companies or early-stage companies. Typically, the investments that characterize private equity investments are illiquid in nature, meaning they cannot be easily disposed of at the discretion of the fund. Therefore, private equity funds are classified as “closed-end” funds because investors are prohibited from voluntarily withdrawing their investments in the fund and only receive distributions once fund investments have been sold or income is otherwise received in connection with fund investments.   


Typically, the investors participate in the profits from the private equity fund based on their ownership interest in the private equity fund. Unlike hedge funds, private equity fund investors typically do not contribute all of their invested funds at the time of investment, but only commit to contribute capital (a so-called “capital commitment”) when they initially invest in the fund. The investor only transfers money to the fund once it is “called” by the fund manager when the fund is ready to make an investment. Typically, investors are only admitted to the fund at the initial closing of the fund and, in certain circumstances, up to one year after the initial closing. Private equity funds typically have a finite investment period, typically lasting anywhere from two to seven years, during which initial portfolio investments can be made. After the termination of the investment period, fund managers can only make follow-on investments in existing portfolio investments and harvest existing investments. Private equity funds typically have a finite lifespan, typically from seven to ten years, with the right for the fund manager to extend the life of the fund for a few years, depending on the circumstances.  


How Are Private Equity Funds Structured?

Where a fund sponsor’s prospective investors are all U.S. residents, typically the fund sponsor will organize a single stand-alone domestic fund that will typically be organized in Delaware as a limited partnership or limited liability company. The investors typically participate in the limited liability company or limited partnership by purchasing “interests” in the fund. However, if the fund sponsor has non-U.S. investors and/or tax-exempt investors, the fund sponsor may want to organize an offshore fund (typically set up in a tax-friendly jurisdiction) where the non-U.S. investors and/or tax-exempt investors can invest. Therefore, the fund sponsor can run the domestic and offshore funds “side-by-side” making investments pro-rata among the funds. However, for administrative or tax reasons, the fund sponsor may choose to organize the funds in a “master-feeder” structure whereby the assets of the onshore and offshore funds “feed” into a master fund (typically organized in the tax-friendly jurisdiction) where all of the investments are held.


Who Manages the Private Equity Fund and How Are They Paid?

Typically, the individuals that are launching the private equity fund will organize separate entities which they will own and manage that are responsible for managing the investments and operations of the private equity fund. Typically, one of these entities will serve as the managing member of the private equity fund if it is organized as a limited liability company or the general partner if the private equity fund is organized as a limited partnership. This entity will typically be responsible for overseeing all of the private equity fund’s corporate and financial affairs. However, in many circumstances, the private equity fund will arrange for its investments to be managed by a separate management company entity organized by the individuals launching the fund.


Typically, the private equity fund will pay the management company entity that manages its investments a management fee which, initially, is typically based on the amount of capital commitments of the fund investors and, later on, based on the amount of capital actually invested on behalf of fund investors. The entity that serves as the general partner or managing member of the private equity fund will also receive a fee based on the profits realized as a result of the private equity fund’s investments which is often called the “carried interest”. There are many types of arrangements that are utilized for calculation of the sponsor’s carried interest, but in general, the sponsor does not receive a performance fee until after the investors have received a return of their capital contributions plus a “preferred return” which is typically a percentage of profit based on the amount they have invested. 

What Are the Key Terms Related to an Investment in a Private Equity Fund?

The private equity fund sponsor and investors typically agree to certain terms in connection with the investments to be made by the investors and the services to be provided by the fund sponsor. These terms are typically spelled out in the contractual agreement that governs the affairs of the private equity fund. For private equity funds organized as limited liability companies, typically this document is called the “operating agreement,” and for private equity funds organized as limited partnerships, this document is typically called the “limited partnership agreement.”


The first set of terms dictate how the investors will be admitted to and participate in the profits of the fund. Such terms will often dictate how much capital investors must commit in order to be admitted as an investor and when and how the fund sponsor will call for capital contributions to be made to the fund. Such terms will also cover how the fund will allocate and distribute fund profits among investors (often fund investors will receive a proportionate share of profits based on how much capital they have contributed).   


The second set of terms deals with the fees to be received by the fund manager, which we have described in more detail above.


The third set of terms deal with how the expenses associated with the private equity fund’s operations will be allocated among the fund investors and the fund sponsor. Typically, the fund sponsor will be responsible for its own overhead expenses including any office, rent, utilities, and employee salaries in connection with managing the fund’s affairs. The investors will typically be responsible for all costs associated with organizing the fund (including attorney’s fees and fees paid to third parties to raise capital for the fund), fees in connection with the fund’s investment activities (which could include research and due diligence costs, costs of acquiring and disposing of investments, and fees for services rendered by the sponsor or other third party in connection with managing the portfolio companies’ affairs), expenses in connection with the private equity fund’s ongoing operations (including any fees paid to service providers), and fees for the liabilities incurred by the private equity fund in connection with its activities.


What Regulations Govern the Offer and Sale of Private Equity Fund Interests?

Numerous securities laws impact how private equity funds can offer and sell interests in the private equity fund to prospective investors. For starters, because private equity funds typically seek to avoid having to register the securities with the U.S. Securities and Exchange Commission (SEC) or any states (because registration of securities is a time-consuming and expensive process), they typically rely on exemptions from having to register such securities that do not require registration if the securities are “privately” offered. There are various private offering exemptions available, but the most widely-used exemption, for various reasons, is that offered through Rule 506 through Regulation D under the Securities Act of 1933. Among other things, Rule 506 requires that (a) securities only be offered and sold to “accredited investors” (which we will discuss below) and up to 35 non-accredited investors in some circumstances, (b) that the fund file a notice of sale of securities on Form D, which is filed publicly with the SEC, and update the filing as necessary; and (c) that certain key persons associated with the fund sponsor, significant investors, and certain persons who raise capital for the fund may not have been subject to certain “disqualifying events” including certain criminal convictions, regulatory sanctions, and other “bad acts”. Additionally, other restrictions apply depending on whether the fund wishes to engage in “general solicitation or advertising” to promote the fund. If the fund does not wish to engage in general solicitation or advertising, it cannot publicly market the fund and generally must only provide offering materials to those persons with whom the fund sponsor has a substantive, pre-existing business or social relationship. If the fund wishes to market the fund through general solicitation or advertising, the fund cannot admit any non-accredited investors, and the fund sponsor must undertake additional steps to verify that all investors are in fact accredited including reviewing bank or brokerage statements, tax returns, or other documents that verify that the prospective investor is accredited.


Second, private equity funds also typically seek to avoid having to register the private equity fund as an investment company because the registration process is time-consuming and costly. Most funds that invest in securities (such as mutual funds and exchange-traded funds) are, by default, required to register as investment companies. However, there are certain exemptions that allow private equity funds to avoid having to register as an investment company. For instance, private equity funds can rely on an exemption found in Section 3(c)(1) under the Investment Company Act of 1940 to avoid registering as an investment company as long as they privately offer their securities and have no more than one hundred investors. Alternatively, private equity funds can rely on an exemption from having to register the fund as an investment company found in Section 3(c)(7) if they privately offer their securities and only offer their securities to “qualified purchasers” (which we will discuss below in more detail).


Although these are the regulations that govern the offer and sale of the private equity fund’s securities, they are hardly the only regulations that govern operation of the private equity funds. For instance, the private equity fund manager may need to register with and be regulated as an investment adviser with the SEC or one or more states, depending on various factors. For an article discussing when private equity fund managers must be registered with and regulated by the SEC or one or more states, please click here.    


Who Can Invest in a Private Equity Fund?

The determination as to who can invest in a private equity fund is dictated by, among other things, the exemptions from registration relied on by the private equity fund, which we have described above in more detail.


As noted above, those private equity funds that rely on Rule 506 under Regulation D to offer their private equity funds must limit offers and sales of interests in the fund to accredited investors, and, in certain circumstances, up to 35 non-accredited investors. Nonetheless, for a variety of reasons, most private equity funds do not admit non-accredited investors to the fund. Accredited investors, as defined in Rule 501(a) under the Securities Act of 1933, include (a) individuals that have earned at least $200,000 (or $300,000 when combined with a spouse) over the last two years and have a reasonable expectation of earning such compensation in the current year or (b) have a net worth (individually or with a spouse) of at least $1 million (excluding the value of a principal residence). Accredited investors also include certain entities that are not formed for the purpose of investing in the fund and that have at least $5 million in assets. Certain entities whose owners are all accredited investors can also qualify as an accredited investor, regardless of whether the entity has $5 million in assets.


If the fund relies on Section 3(c)(7) of the Investment Company Act of 1940, it must also limit its investors to “qualified purchasers” which, as defined in Section 2a(51)(A) of the Investment Company Act of 1940, include individuals with at least $5 million in qualifying investments and entities with at least $25 million in qualifying investments not formed for the purpose of investing in the fund. An entity whose owners are all “qualified purchasers” will also qualify as a qualified purchaser, regardless of the amount of its investments.


Funds may also be required to ensure that their investors are “qualified clients” if the private equity fund charges investors performance-based fees and the fund manager is registered as an investment adviser with the SEC or certain states. A “qualified client”, as defined in Rule 205-3 under the Investment Advisers Act of 1940, includes (a) an individual or entity who, immediately after becoming a fund investor, has at least $1.1 million invested with the fund sponsor; (b) a natural person who, or a company that the fund sponsor reasonably believes, immediately before becoming an investor, has a net worth (either individually or with a spouse) of at least $2.2 million (excluding the value of a principal residence); or (c) a qualified purchaser.


In addition to the above, private equity funds typically also prohibit or restrict investments by those investing through retirement accounts such as 401(k) accounts or individual retirement accounts because the fund manager aims to avoid having the Employee Retirement Income Security Act of 1974 (ERISA), which governs advice to retirement plan accounts, govern the activities of the fund. ERISA imposes restrictions on fund management that are, in most instances, prohibitively restrictive for most fund managers.


What Vendors Are Typically Utilized to Provide Services to a Private Equity Fund?

Although there may be some variation, there are certain vendors that typically provide key services to a fund. First, private equity fund managers typically retain an attorney to provide advice with respect to the structuring of the fund and preparation of the fund offering documents. Lawyers also provide ongoing advice to the private equity fund and its sponsor. Second, many private equity funds retain a third-party fund administrator to provide a variety of operational, financial accounting and payment, and reporting services on behalf of the private equity fund. Among other things, fund administrators can help review and process subscriptions, process bill payments on behalf of the fund, perform accounting services and prepare financial statements on behalf of the fund, and prepare and distribute reports to fund investors. Third, fund managers, particularly those that register as investment advisers with the SEC, retain an auditor to review and audit the financial statements of the private equity fund to ensure compliance with the SEC’s Custody Rule.    


What Documents Are Typically Drafted to Form a Private Equity Fund?

There are several key documents that are typically drafted to form private equity funds. First, as noted above, the operating agreement or partnership agreement (discussed above) is the contract that governs the activities of the fund and spells out the key rights and obligations of fund investors and the fund sponsor. Second, the private placement memorandum or offering memorandum typically provides information about the private equity fund’s investment program (including information about the fund’s investment objectives and investment strategies) and key personnel, the risks and conflicts of interest associated with an investment in the fund, information about the fund’s service providers, and the steps involved in subscribing for interests in the fund. Third, the subscription documents typically include certain terms agreed upon by fund investors as a condition of making an investment in the fund as well as a detailed questionnaire designed to ensure that the investor is eligible to invest in the fund. Fourth, an investment management agreement may be entered into between the fund and the management company entity that outlines the rights and obligations of the fund and the management company entity with respect to the management of the fund’s investments.


How Much Does It Cost to Start a Private Equity Fund?

Unfortunately, there is no easy answer to this question as the cost depends on a variety of factors including, among other things, the complexity of the fund and its investments, the preparedness of the fund sponsor, the amount of negotiation that takes place with investors, and the number and quality of service providers retained to provide services for the private equity fund. Fund sponsors should allot, at a minimum, somewhere between $40,000 and $70,000 for the initial costs associated with launching a domestic private equity fund. However, costs can increase from there if the private equity fund manager requires formation of an offshore fund. Costs of ongoing management of a private equity fund after the first year should decline (because the organizational costs are often one-time costs), but again, this will depend on the factors listed above.


As evident from the above, preparing to launch a private equity fund requires careful planning and advice from experienced counsel. However, the process has been undertaken many, who have realized the benefits of launching their own fund.


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