Private Equity Fund Formation: 101

At first blush, the title of this article may seem somewhat fundamental. However, on four separate and recent occasions, a client or prospect asked me to provide an overview of typical fund formation and structure.

Since the subject comes up more often than imagined, an overview of private equity fund formation might be helpful. The following information can serve as a simple reference for industry standards and practices as they relate to private equity fund formation and related infrastructure to support fund activities.

Private equity funds (the “Fund”) are investment entities formed by individuals (i.e., sponsors) interested in raising capital to make investments (i.e., acquire ownership in companies) according to a certain investment strategy. Funds are owned by “accredited investors” who make a pledge to invest a set amount of capital over time (“committed capital”). The individual sponsors who form a Fund are given responsibility to source, acquire, and manage the Fund’s investments over time until an optimal sale opportunity is found to achieve an above-market return on investment.

Based on my industry experience, the prevailing industry standard is to form a management company, an investment fund (private fund), and a general partner (GP) to the private fund when conducting a private equity offering to accredited investors. The following chart illustrates a general fund’s structure.

 In addition, certain legal documents are typically used in private equity fund formation. The industry standard is to compile a subscription package, which consists of at least a private placement memorandum, a copy of the organizational agreement (i.e., LP or LLC), a subscription agreement, and an investor questionnaire.

• The private placement memorandum includes general terms and risk factors as well as biographies of the sponsors, track record, and investment focus.
• The limited partnership agreement defines relationships as well as rights and duties of the general partner and the limited partners, including allocations, distributions, claw-backs, and investment restrictions.
• The subscription agreement includes the investor commitment, closing conditions, and representations.
• The investor questionnaire gathers required information regarding accredited investor, ERISA status, NASD restricted persons, PATRIOT Act compliance, and contact information.

It’s important to remember that private equity funds are regulated by the Securities Act of 1933, the Investment Company Act of 1940, the Investment Advisors Act of 1940, the Securities Exchange Act of 1934, and the Employee Retirement Income Security Act (ERISA). Legal counsel for the Fund should review structure and potential investors before the Fund offering to ensure compliance with U.S. federal regulations. The Fund will typically look to qualify for an exemption from Securities and Exchange (SEC) registration (e.g., no general solicitation, accredited investors, fewer than 100 investors, no commissions to GP for sale of partnership interest, GP will perform substantial duties for the partnership, and so forth.)

Remember, First Things First

Well before soliciting significant contributions from investors or loans from creditors to a private equity fund, the industry standard is to accomplish each of the tasks described above, from entity formation and creation of organizational documents to creation of subscription packages and SEC filing, etc. Experienced investors and lenders expect such documentation and compliance with such legal criteria before they will consider significant investment in a private equity fund, and the pertinent pool of potential investors will not take a private equity fund seriously without such documentation and compliance with legal criteria.

Once such steps are taken, a private equity fund would be well-positioned to solicit further investment from the pertinent pool of potential private investors.