Research

A manager seeking to deepen its track record or build a relationship with a prospective investor may seek to raise capital on a deal-by-deal basis or by offering investors a pledge fund structure.

In a deal-by-deal fund, a dedicated vehicle will be created for purposes of making an investment in a single target opportunity (or single portfolio of target opportunities). Unlike a traditional private equity fund model, where investors commit capital to the fund on a blind-pool basis and depend on the fund’s investment team to identify and execute investment opportunities going forward, investors considering an investment in a deal-by-deal fund have full transparency on the underlying investments that will be made by the deal-by-deal fund and are able to perform “M&A-style” diligence on such investments (in addition to the traditional fund investment diligence on the fund manager’s investment team) prior to deciding whether to commit to the deal-by-deal fund.

By contrast, in a pledge fund, investors make “soft commitments” to the pledge fund prior to its investments being identified. Unlike a traditional private equity fund, however, investors are given the right to “opt out” of (or “opt in” to) each investment opportunity that the manager of the pledge fund presents to investors. In this way, each of the investors is able to make its own decision whether or not to participate in each investment opportunity instead of being required to participate in each investment (subject to narrow excuse rights) as is the case in traditional private equity funds.

When managers are choosing between a deal-by-deal fund model or a pledge fund model, there are a number of considerations that they should bear in mind.

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 face a degree of deal execution uncertainty (and delay). This can place such funds at a disadvantage in a competitive acquisition process, as a seller may be reluctant to engage and progress the sale process with a buyer that has limited control over its ultimate ability to fund the acquisition.

In addition, a deal-by-deal model requires the manager to front the costs of identifying, investigating and negotiating the investment opportunity prior to consideration by prospective investors in the deal-by-deal fund, although these costs may be recouped when the deal-by-deal fund closes, or sometimes earlier through a “cost sharing” agreement with prospective investors. In a pledge fund model, these preliminary costs can be paid by the fund itself or, if necessary, partially covered by the manager out of a management fee charged on subscribed capital.

Economic Terms

In general, there is a less well defined set of “market terms” for deal-by-deal and pledge funds than there is for traditional private equity funds, so investors’ expectations about market-standard terms are less fixed, with the result that terms for these alternative structures tend to show a greater degree of variability than traditional fund models.

Some deal-by-deal funds do not pay a management fee at all, though the manager may charge a one-off transaction fee from investors upon successful completion of the underlying investment. To the extent that a management fee is charged, that fee tends to be based purely on invested capital and to be a lower percentage than the 2% typical for traditional small and mid-sized private equity funds. Pledge funds, on the other hand, are likely to charge a low management fee on subscribed capital (whether or not drawn) during a pledge fund’s investment period plus a higher fee on deployed capital.

Sponsors of both deal-by-deal and pledge funds typically receive some carried interest on the profits of the fund. While the carried interest rates for pledge funds tend to be close to (though lower than) full carry charged by traditional funds, deal-by-deal funds tend to be subject to lower carried interest rates.

Complexity

Unlike deal-by-deal funds (and traditional private equity funds), the management, administration and documentation 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 investor 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 regarding the tracking and allocation of expenses (e.g., broken 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 pools within a single pledge fund vehicle, but substantially 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 conditions, 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.

Conclusion

Deal-by-deal and pledge fund models provide alternative fundraising possibilities to the traditional private equity fund model. While these alternatives can be useful for a manager developing its track record or seeking to build relationships with one or more prospective investors, they are generally used as stepping stones toward the sponsorship of a traditional private equity fund rather than as a long term product line. While an investor that is getting to know a manager is likely to appreciate the degree of control these alternative models provide over the deployment of its capital in the short term, many institutional investors are 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 strategies) and, as a result, continue to seek discretionary blind pool products as a core part of their private equity investment allocation.

About the Authors

Geoff Kittredge is a Partner in the London office of Debevoise & Plimpton LLP.

John W. Rife III is an Associate in the London office of Debevoise & Plimpton LLP.