In light of a few conversations that I have had with various people who are interested in this space, I thought it would be good to write a brief overview of the categories of investors that a fund sponsor will typically seek to be LPs in their fund. It will serve as a primer to some of the considerations—including some legal considerations arising from the Investment Advisers Act of 1940 (the “AA”) and the Investment Company Act of 1940 (the “ICA”)—that anyone involved in the industry ought to consider when dealing with fundraising for a PE/VC fund that is subject to U.S. securities laws and regulations.

Who are the limited partners?

The fund sponsor’s perspective

Let us first look at the choice of limited partners from the perspective of the fund sponsor, since it is the fund sponsor that decides to whom the fund should be marketed. In general, the fund sponsor will take into account—without limitation—three key legal and regulatory considerations when determining what kind of investors to approach:

  • Avoid registration of the limited partnership interests of the fund with the U.S. SEC.
  • Avoid registration of the fund as an investment company under the ICA.
  • Qualify for an exemption to the AA restriction on performance fees.

First, limited partnership interests in a PE/VC fund are “securities”, as such term is broadly defined in the Securities Act of 1933 (the “SA”). Such limited partnership interest, as a “security”, must be registered with the SEC unless it falls within an exemption. A fund sponsor will want to avoid registering the limited partnership interests of the fund with the SEC because registration is costly, public disclosures can compromise the fund’s ability to execute its investment strategy, and ongoing compliance obligations are onerous. Accordingly, most fund sponsors will try to conduct a private placement of their fund’s limited partnership interests pursuant to section 4(2) of the SA, typically by complying with the safe harbor guidelines of Regulation D. As a general rule, fund sponsors rely on Rule 506(b) of Regulation D, which allow a fund sponsor to sell its limited partnership interests to an unlimited number1 of “accredited investors” (a term defined in Regulation D that we will come back to in a moment) and up to 35 non-accredited but sophisticated investors.

Who qualify as accredited investors? That’s defined in Rule 501 of Regulation D, and includes:

  • Natural persons with net worth2 (individually or with their spouse) in excess of $1 million;
  • Natural persons that have individual income in excess of $200,000 or joint income with their spouses of $300,000 in each of the two most recent years and a reasonable expectation of the same income in the current year;
  • Corporations, partnerships, buinesses trusts, tax-exempt 501(c)(3) organizations (also known as “charitable organizations”) with total assets in excess of $5 million and which were not formed for specific purpose of acquiring the securities offered;
  • Banks, brokers or dealers registered under the Securities Exchange Act of 1934;
  • Investment companies registered under the ICA;
  • Pension plans with total assets in excess of $5 million established and maintained by a state or one of its agencies or political subdivisions for its employees, i.e. public pension funds;
  • Employee benefit plans within the meaning of the Employee Retirement Income Security Act of 1974 (“ERISA”) if the investment decisions are made by a plan fiduciary that is a bank, savings and loan association, insurance company, or registered investment adviser, or if the plan has total assets in excess of $5 million;
  • A private business development company;
  • A trust with total assets in excess of $5 million and the investment decisions of which are directed by a sophisticated person (i.e. a person with such knowledge of financial and business matters as to be able to evaluate the merits and risks of a prospective investors); or
  • Any entity in which all equity owners are accredited investors (i.e. falling within one of the above categories).

Regulation D limits the pool of prospective U.S. based investors, but there are still additional limitations that most fund sponsors will have to observe. A fund sponsor will also want to avoid registration of the fund as an investment company under the ICA. Fund sponsors do this for much the same reasons that they avoid registering their fund interests as securities under the SA: it imposes considerable up-front and on-going expenses, requires public disclosures, and imposes additional compliance obligations.

A fund sponsor can avoid registering its fund as an investment company through one of two principal exemptions: the section 3(c)(1) of the ICA “private fund exemption” for funds with no more than 100 beneficial owners, and the section 3(c)(7) “qualified purchaser fund” exemption for funds where all the investors are qualified purchasers. The private fund exemption is deceptively simple—and a minefield for the inexperience fund sponsor—because there are a tangled web of rules for calculating how many beneficial owners a fund has.3 It has been my experience that most fund sponsors tend to rely primarily on the qualified purchaser fund exemption rather than the private fund exemption, firstly because this avoids the labyrinthine rules for calculating the number of beneficial owners of the fund, and secondly, because it allows the fund to charge performance fees, as shown below.

So let us now turn to the qualified purchaser fund exemption. To qualify for this exemption, the fund sponsor must ensure that all its investors are qualified purchasers, as defined in section 2(a)(51)(A) of the ICA:

  • Natural persons owning not less than $5 million in investments (individually or jointly with their spouses);4
  • A company with not less than $5 million in investments that is owned directly or indirectly by natural persons who are related as siblings, spouses, former spouses, or direct lineal descendants of one of the owners, i.e. a family-owned investment vehicle;
  • A trust, foundation, or charitable organization established by or for the benefit of natural persons who are siblings, spouses, former spouses, or direct lineal descendants of the settlor;
  • Any person not falling into any of the above categories that in aggregate owns and invests on a discretionary basis not less than $25 million in investments; or
  • A trust where the trustee or other persons authorized to make decisions for the trust, and each settlor of the trust falls into one of the above categories.

So, from the fairly generous pool of prospective limited partners offered by the definition of accredited investor, the fund sponsor is further restricted to a pool of prospective limited partners that meet the higher standards of a qualified purchaser. (Unfortunately, due to some areas where there is no overlap, one cannot simply think of qualified purchasers as a fully nested subset of accredited investors, much to my annoyance: such nesting would be conceptually more elegant and parsimonious.)

A fund sponsor will want to charge performance fees, better known in PE/VC as “carried interest”. For a fund sponsor to do so, the fund must either be a qualified purchaser fund under section 3(c)(7) of the ICA, or the investors in the fund must be “qualified clients”. Again, these terms are defined in U.S. securities law and SEC regulations. As we have already discussed the qualified purchaser fund, I will limit this discussion to the question of who are qualified clients.

The term qualified client is defined by Rule 205-3 under the AA:

  • A natural person that immediately after entering into an investment advisory relationship with the fund sponsor has at least $1 million in assets under management with that fund sponsor;
  • A natural person (individually or jointly with his or her spouse) or company that has a net worth of at least $2 million;
  • A qualified purchaser as defined in section 2(a)(51)(A) of the ICA;
  • A natural person who is a director, executive officer, general partner, or trustee of the investment adviser; or
  • A natural person who is an employee of the investment adviser and who as part of his or her employment duties regularly participates in the investment activities of such investment adviser and who has performed such duties for at least 12 months.

From the above, we can see that the choice of who to approach as prospective limited partners is to a great degree determined by legal considerations. A U.S. fund sponsor (or a non-U.S. fund sponsor seeking to offer fund interests to U.S. persons) must be cognizant of the securities laws and SEC regulations relating to private placements. If the fund sponsor seeks to offer fund interests to investors in other countries, it will have to ensure that its offer is in compliance with the laws of those countries. It has been my experience that ensuring compliance with the securities laws of diverse countries can be an extremely complex and fraught process, and one that requires a fairly competent in-house lawyer and expert advice from law firms local to the countries where the fund sponsor is offering its fund interests.5

In practice, I would focus my energy on investors that fall within the intersection of the sets of “accredited investors” and “qualified purchasers”. This fulfills the requirement that the placement comply with the safe harbor of Rule 506 of Regulation D to avoid registration of the fund interests under the SA, as well as the qualified purchaser fund exemption from registration as an investment company under the ICA, and the exemption from the restriction on the charging of performance fees of section 205(b)(4) of the AA. We will consider, briefly, who these investors might be in my general observations about fundraising from limited partners.

Finally, after ensuring that the legal requirements have been met, the fund sponsor will want to consider other characteristics it might find suitable for screening its prospective limited partners. These could include (without limitation):

  • The fit between the investment philosophy of the prospective limited partner and the fund sponsor. This can be of particular importance to fund sponsors with investment philosophies that differ from the mainstream, e.g. a fund like the Founders Fund. It can also be a crucial consideration when one is dealing with investors from the Middle East and other Islamic countries, which have additional investment restrictions deriving from their religious beliefs.
  • The reputation of the prospective limited partner. For a fund sponsor raising its first fund, it can often be crucial to secure a commitment from a credible limited partner with a good track record of investing in the asset class. This acts as a signal to other prospective limited partners that the fund sponsor has been vetted by a respected source and found to be credible.6
  • In our post-2008 world, the financial strength of the prospective limited partner is of vital importance. Certain classes of investors in PE/VC have proven to be somewhat less than reliable in meeting their capital calls. A shrewd fund sponsor will consider the counterparty risk under different states of the world when deciding whether to offer fund interests to a prospective limited partner.
  • The demands of the prospective limited partner. Some limited partners, it must be said, demand more hand-holding than others. Sometimes this comes with a commitment to the fund large enough to offset the additional hand-holding. Sometimes it does not.
  • The operational and reporting burden the fund sponsor or its delegated third-party administrator is able to handle. The more limited partners a fund has, the greater the burden.

Now let us turn our attention to some general observations about limited partners.

A taxonomy of limited partners

First, let us quickly identify the categories of investors that invest in PE and VC. They include:

  • Public pension funds: These include U.S. based public pension funds established by and administered by a state, its political subdivisions, or agencies, as well as pension funds of foreign countries or their political subdivisions. Some of the most notable public pension funds investing in PE/VC funds include CalPERS, CalSTRS, the Washington State Investment Board, South Korea’s National Pension Service and the CPP Investment Board.
  • Private pension funds: These include pension funds established by corporations for the benefit of their employees, pension funds established by religious organizations for their employees or clergy, and other pension or benefit schemes established by non-governmental actors, such as workers associations or unions. In Australia, these can include what are termed “superannuation” funds, which are compulsory private retirement savings. Some examples of such funds include The Western Conference of Teamsters Pension Plan and the Nestlé Pension Plan.
  • University endowments: University endowments have become an increasingly important investor in many PE/VC funds, especially after the interesting work by David Swensen and Dean Takahashi at Yale University.
  • Insurance companies: Insurance companies, with their access to “float”, have long found it prudent to invest that float in stocks and bonds to earn the returns they need to pay out future claims. They have also invested a—very small—portion of their float in PE and VC funds. (It should be fairly obvious why only a small portion of the float can be invested in illiquid assets.) That being said, given the total assets under management among insurance companies worldwide is in the range of at least $16 trillion, even a 2% allocation to PE and VC funds adds up to a lot, in dollar terms.
  • Family offices: Family offices have long been investors in PE/VC funds. While they no longer represent the majority of commitments to PE/VC funds, they are still a crucial source of capital, particularly for small fund sponsors or new fund sponsors that lack the established track record and ability to obtain investments from pension funds and university endowments.
  • High net worth individuals (HNWI): Like family offices, HNWIs have long been a source of funds for PE and VC fund sponsors. They are also, very often, one of the few sources available to new or small fund sponsors.
  • Corporate treasuries: Some corporations with more cash than they know what to do with have been fairly active investors in PE funds, VC funds, and hedge funds. In my opinion these corporate treasuries are an uncertain source of funding as the corporations are sensitive to adverse economic conditions.8

Recent developments

It would be remiss of me to conclude this survey without mentioning a few recent—circa 2015—developments that I have observed:

  • Disintermediation: Certain large and sophisticated limited partners, notably some sovereign wealth funds and national pension plans, have established direct investment programs to invest directly in private equity and venture capital transactions. Others have sought and obtained co-investment rights from fund sponsors as a condition for investing in a sponsor’s new fund. It remains, of course, to be seen how effective the direct investment programs at these institutional investors will be. Certainly skeptics have questions the ability of such limited partners to pursue such programs without deep changes in their investment approach. My view is slightly more nuanced: I think that properly executed disintermediation offers such investors, with a different investment time horizon, the opportunity to invest in assets that traditional PE and VC fund sponsors cannot easily invest in.
  • Consolidation: Large and sophisticated limited partners are reducing the number of fund sponsors that they will invest in. This consolidation has two key effects on fund sponsors. First, it puts pressure on incumbent, undifferentiated fund sponsors that cannot identify a unique edge that delivers better than average returns to limited partners. Second, it reduces the likelihood that new fund sponsors will be able to obtain investments from such limited partners, greatly increasing the difficulty for new fund sponsors to raise their first time fund.
  • Preference for specialist fund sponsors: Large and sophisticated limited partners are increasingly preferring to invest in specialist fund sponsors that have geographic or sector expertise that allow them to better identify promising targets. At the same time, many of these limited partners are consolidating their fund sponsor relationships, often selecting large global fund sponsors with long track records. One can say that this strategy appears to be a barbell strategy, with one end dominated by large global generalist fund sponsors with long track records, and the other end dominated by small, local specialist fund sponsors with differentiated investment strategies.
  • Resistance to sponsor friendly terms: While some fund sponsors with exemplary performance even in the post-2008 economic downturns have been able to retain sponsor friendly terms in their most recent funds, quite a few fund sponsors have found themselves faced with substantial resistance to such terms and have been forced to compromise on these terms.

Summation

The fundraising landscape for fund sponsors is changing. A thorough understanding of the legal considerations relating to fundraising is essential to understand who fund sponsors can approach as prospective limited partners. This understanding must then be complemented by a solid understanding of the shifting landscape of fund sponsor and limited partner relations.