As private equity firms continue to succeed and become ever prevalent in the alternative investment space, more aspiring portfolio managers are joining the race to launch their own private equity fund. After refining your business strategy, setting up operations, strategizing a business plan and legal considerations, the next step would be focusing on the structure of your fund. The following summarizes several aspects of setting up your fund structure.
Setting up your fund structure
In the U.S., a fund is typically organized as a limited partnership (LP) or a limited liability company (LLC). As a founder of the fund, you will be a general partner or managing member empowered with the right to decide the investments that make up the fund portfolio. Your investors will be limited partners who will not have the right to make any decisions on behalf of your fund or fund investments. The structure of a private equity fund is dependent on several tax, regulatory and financial considerations, usually driven by the tax needs of the investors. Some private equity fund features and potential structures are discussed briefly below.
Private equity funds are usually closed-end investment vehicles, which means that there is a limited window to raise funds and once this window has closed, no further funds can be raised. Investor capital is typically committed at the onset of the fund and is called by the manager periodically as investments are made. Investors in a closed-end fund are generally not permitted to make withdrawals or additional capital contributions during the life of the fund and after the committed capital period. Some funds may provide for additional contributions for follow on investments in portfolio companies the funds already own. Once funded, an investor’s capital will be returned only upon the sale or restructuring of fund portfolio companies, or if there is positive cash flow from portfolio company operations.
With a closed-end fund, once an investment is sold, the sale proceeds generally cannot be reinvested in that fund. Rather, the fund manager would create another fund to allow investors to reinvest. The cost of launching these successive funds can be significantly less than the initial fund since less legal assistance is required and other administrative costs will be shared across all funds.
Fund structure options
Most private equity funds domiciled in the U.S. are organized as LPs since such a structure generally avoids double taxation of investment returns and grants limited partners (your investors) limited liability protection, thus shielding them from losing more than their investment. An onshore fund is a U.S.-based investment fund structure that typically includes an LP as the fund vehicle, an LLC as the investment manager of the fund (although an LP or an S corporation may be used and could be more favorable for tax purposes), and a general partner of the fund (managing member in the case of an LLC).
An offshore fund, also known as a blocker fund, blocks offshore and tax-exempt U.S. investors from direct U.S. tax exposure. There are a number of ways to structure your offshore fund and the best option for you will depend mainly on the location of the fund manager, types of investors in your fund, and the type of investments that the fund will make. The three most common structures used for offshore funds are briefly described below.
- Offshore Only – An offshore standalone fund is a structure where only one fund is used and that fund is offshore (generally in the Cayman Islands, Bermuda, or the British Virgin Islands). This structure is used by managers who have no U.S. presence and whose fund is solely geared towards non-U.S. investors as well as tax-exempt U.S.-based investors who want to avoid unrelated business taxable income (UBTI).
- Master-Feeder – A master-feeder structure is generally used where there is a U.S. presence and where a manager is looking to raise capital from both U.S. and non-U.S. or tax-exempt U.S. investors. This structure includes a master fund (an offshore fund which is either an LP or a corporate entity, often referred to as an LTD, which makes an election to be treated as a partnership for U.S. tax purposes), which conducts the fund’s trading/investing objectives, and an onshore feeder and offshore feeder that invest all of their assets into the master fund.
- The onshore feeder will generally be structured as a U.S. LP or LLC and is where the U.S. taxable investors will invest. Using an LP or LLC, which is a pass-through entity for U.S. tax purposes, allows the master fund’s profits and losses to be allocated and passed through to the U.S. investors and thus taxed at the investor level. There is no entity tax at the master fund level in the offshore jurisdiction thereby avoiding double taxation.
- The offshore feeder is structured as an offshore fund (see Offshore Only section above) and is where the non-U.S. and U.S. tax-exempt investors will invest. Investment into the offshore feeder means that any U.S. tax exposure arises at the master-feeder fund level and does not affect the offshore feeder investors themselves. Non-U.S. investors who are not generally required to file U.S. tax returns, prefer to invest through an offshore fund to avoid exposure to any U.S. tax or filing obligations. If non-U.S. investors invest directly into a fund structured as a partnership, they could be deemed to be engaged in the business of the fund and, to the extent that this includes any U.S. trades or business, could be required to file a U.S. tax return and be liable to pay U.S. taxes. For similar reasons, U.S. tax-exempt investors invest through the offshore feeder as well. Tax-exempt U.S. investors could be liable for income tax on any income from U.S. trades or businesses which are not substantially related to their tax-exempt purpose, known as UBTI. Therefore, if they invest in a fund that is a partnership, they are treated as participating directly in the activities of the fund, which may include investments in U.S. trades or businesses.
- Side-by-Side – Similar to a master-feeder structure, a side-by-side structure is used when a manager is looking to raise capital from both U.S. investors and non-U.S. or tax-exempt U.S. investors who have differing tax concerns. In this structure, two funds, an offshore and domestic U.S. fund, are formed and both are managed and operated in the same way. The main reason for choosing the side-by-side structure over the master-feeder structure is to enable tax structuring measures for one fund independent of the other. A side-by-side structure generally includes a U.S.-based fund and an offshore-based fund that parallel each other in their trading/investing objectives and have the same investment manager, but that can also maintain separate investment portfolios.
It can be challenging, especially for those who don’t have prior experience, to start their own private equity fund. It requires partnering with experienced accountants and other professionals, and a tremendous effort to refine your business strategy, develop your business plan and build your team. The above information can be helpful in determining the structure of your fund.