What Are Fund Agreements?
A fund agreement is an integral part of any financial venture, be it a private equity fund, a hedge fund, or in any sort of investment joint venture structure. As the name infers, a fund agreement will govern a particular fund. Even though a fund agreement governs a fund, typically a fund agreement will not act as a stand-alone document. Instead, a fund agreement will reference and integrate into operating agreements, by-laws, partnership agreements, etc. Essentially, a fund agreement is a contract that describes the details of how the fund will be run, what assets are included in the fund, when distributions will occur, how taxes will be paid, etc. Even though the terms contained within a fund agreement will vary and depend on the type of fund (e.g. private equity, hedge, real estate, etc.), generally speaking , a fund agreement will include elements such as: types of securities the fund can issue and on what terms; how investors are notified of distributions; how distributions are allocated; procedures for valuing assets in which the fund invests; details as to how plans for the liquidation of fund assets and how any remaining assets will be distributed to investors; how and when parties are admitted and/or removed as investors; how the funds are managed, including details as to who can transact on behalf of the fund and how those rights are delegated; and any other matters fundamental to the operation/management of the fund. Parties involved in a fund agreement will usually include: the fund manager and the fund’s investors (which could be other funds, high net worth individuals, large institutional investors, etc.). It is key for all parties to a fund agreement to be represented by independent counsel because the terms of a fund agreement will usually be ‘non-negotiable’ and any amendments would require full compliance with the express terms of the agreement.
Elements of a Fund Agreement
A fund agreement, sometimes called a partnership agreement, is a document that governs the relationship and contractual obligations of a fund and its respective fund investors. However, the specific items that will be addressed in the fund agreement significantly depend on the nature of the fund. For example, a private equity fund will generally have different key terms than a hedge fund because of the way those funds invest and the type of investors they have. With that said, there are key terms that are generally included in all fund agreements these are, but not limited to, capital commitments, investment strategy, capital calls, drawdown periods, recycling, permitted investments and follow-on investments.
Investment strategy. This term addresses what kinds of investments the fund will make. For example, most fund investors expect the fund to address in detail the investment strategy that the fund will use in making decisions. Funds typically address what industries, regions and the timeframe for making those investments.
Capital calls. This term addresses how the fund will make calls on limited partners for capital contributions. Limited partners who are investing in limited partner commitments to a fund typically agree to provide the general partner or investment manager with the power to make capital calls on the limited partners, which will be legally binding obligations to meet.
Drawdown periods. This term addresses the period in which the fund can make a call for capital contributions and when limited partners must meet those commitments. Typically, fund investors want to address how often the capital calls will occur, for example annually or quarterly. Fund investors also want to address how much is held back by the fund for contingent reserves. Finally, fund investors will want to address both the minimum and maximum amount of the investment that can be committed to the fund and when that amount would be permanently invested by the fund.
Recycling. This term addresses whether and under what circumstances a fund can recycle capital in the case of a partial or full return of a previous investment. This lets the fund make further investments without having to meet the return requirements for existing limited partner commitments.
Permitted investments. This term addresses the kind of investments allowed under the fund agreement, such as equity, debt and other types of securities. For example, certain funds do not like to invest in non-cash items whereas other funds do.
Also, some funds do not invest in publicly or privately traded securities or financial instruments. Funds need to have the flexibility they need to make such investments available to them.
Follow-on investments. This term addresses whether and under what circumstances the fund is allowed to make follow-on or subsequent investments. In other words, in the case of an investment already made, can the fund make additional investments and under what circumstances. This allows the fund to protect itself from the dilution of shares and allows it to take advantage of further opportunities of future offerings when making an investment.
Fund Agreement Types
Different Types of Fund Agreements
The term "fund agreement" can refer to a multitude of different types of agreements, and the purpose of the agreement as well as its terms will vary depending on the type of fund. For example:
Venture capital funds are typically organized as limited partnerships. While the terms of the funds vary, generally the PPM and partnership agreements outline the fund’s investment strategy, management team and the use of leverage. Investors are typically passive limited partners, with a very small management fee.
Private equity funds are also typically organized as limited partnerships. However, these funds may have a single investor, or several "anchor" investors, who usually participate in the fund’s investment decisions and have the ability to invest larger sums of money. Private equity funds often focus on a particular sector of the market, and require higher management fees and an investment commitment from the investor.
Hedge funds are structurally similar to private equity funds. The difference is that hedge funds implement complex trading strategies, often using leverage, in order to achieve high returns for their investors. Hedge fund investors are often able to redeem their shares at any time, for a relatively high cost.
Legal Aspects of Fund Agreements
Legal considerations must underpin the success of fund agreements. There is a wide range of regulatory requirements which set out the obligations for the establishment and operation of funds. Drafting these requirements in a fund agreement is of fundamental importance and there are various market practices which help to incorporate such requirements into fund agreements.
The FCA handbooks require that a disclosure document is issued for an offer of regulated securities (such as unit trusts, contractual schemes or shares in a company) in the UK, including an offering document containing detailed information about the structure and strategy for the fund, its fees and the potential risks to investors. The suitability of investors must be considered and appropriately addressed in the fund documentation. In order to comply with the FCA’s Conduct of Business rules, the fund must be suitable for the investor’s individual circumstances, allowing for the fact that most investments are high risk. Where there is a lack of liquidity in a fund, and therefore the timing of withdrawal requests could be restricted, investors would likely be considered a "high net worth investor" by the FCA Conduct of Business rules, and may be considered "not basic advice clients". These investor classification terms have been widely understood across the industry for over a decade. However, the recent introduction of the FCA’s new definition of a "retail client" has caused some confusion and it will be critical to consider which category of investor a fund may be promoted to.
A careful assessment of the fund structure and strategy will help to identify the regulatory approach which will be taken to each fund, the corresponding authorisations required, and any on-going regulatory obligations and requirements. Once this is done, appropriate fund documentation will then need to be drafted and established. This will include the investment management agreements, which will set out the regulatory and operational requirements; the fund agreements (unit trust scheme documentation, contractual scheme and/or corporate documents); and the offering document (specified information rule (SIRs) agreement), among other documents.
Where funds fall within the FCA’s definition for investment (includes collective investments such as unit trusts and mutual funds), units/shares in the fund may not be marketed or sold to people other than authorised persons and certified high net worth investors. Similarly, shares in a body corporate may only be marketed to certain categories of investor under the existing regulations, including sophisticated or high net worth investors, or to those who commit €100,000 or more. These rules were enforced to protect investors against high-risk offerings. Again, these wording conventions are fairly standard in fund agreements.
Negotiating a Fund Agreement
The negotiation of a fund agreement is central to the relationship between a fund and its investors. It is, after all, the "rules of the game" governing how the fund and its investors will act and interact. These rules govern: what fees will be charged, how compensation will be calculated and paid, when and on what terms investors may redeem their capital contributions, management decisions requiring investor approval, performance targets, and, perhaps most importantly, how information will be shared so that investors may correctly assess the scope of their investment risk. As with any negotiation, seeking common ground is the most productive approach. Investor demands arise out of genuine concern for the fund’s successful performance and the ability to make informed investment decisions. Similarly, there is no financial or governance advantage for a fund manager in agreeing to unfettered redeemability, overly demanding investor information rights, or a fee structure that discourages investors from participating in upside. Finding the silver lining offered by each of these investor concerns will go a long way toward fostering a sustainable and mutually beneficial relationship between a fund and its investors. A number of points quickly become central to the negotiation of a fund agreement, and these are discussed below. Knowledge of these issues and their significance will help investors focus their negotiating efforts, and give fund managers the tools to discuss the real reasons behind an investor’s proposed changes in a compelling fashion.
Sourcing Investment Targets The typical private equity fund gathers investment targets from a variety of sources which include the following: inbound investor and advisor inquiries, referrals from fund insiders, and the fund manager’s active outreach efforts. Investors should focus on the types of sourcing that each fund manager will pursue and the manner in which it will be pursued to gain a better understanding of the fund’s ability to meet its performance targets. Specifically, investors can gain insight into a fund’s potential for success (compared to other funds) based on how much investor, insider or manager-generated deal flow is converted into closed transactions. The more such deals a fund manager sources, the more likely it is that the fund will be able to achieve its financial objectives, and the more likely it will be able to do so sustainably on a long-term basis.
Preferred Return A fund’s preferred return policy can significantly drive the proceeds paid to investors and thus warrants negotiation . A fund commonly pays a preferred return to investors on their unpaid capital contributions, which are commonly subject to a call period of up to two years. After the call period elapses, a fund may pay a preferred return that is less than what would have been payable during the call period if it has not invested the capital contributions it has called. To simplify the monetary effects to the investor of a fund’s preferred return policies, a fund should only apply such a reduced preferred return to capital contributions prior to investment, rather than to capital contributions toward investments. Investors should negotiate for this in order to avoid the situation where the fund invests at redrawn capital contributions, and pays a preferential return on raised but undistributed capital in a given period. Though such treatment of capital would be permitted under most fund agreements, it would have the effect of permanently reducing the economics of investors whose capital contributions are used in this way. An investor may insist that a fund manager pay a higher preferred return rate. Even if it does not seem likely that a fund will regularly pay above-market preferred returns, there may be justification in a given case to agree to it. For example, if the fund manager is organizing its first fund, low preferred return maintenance fees may mean that the fund’s performance will be compared against the performance of funds that are already well established. Thus, the fund manager may want to project high preferred return rates to help improve its internal rate of return. In such cases, an investor may want to use a "weighted" approach that compares upper, middle and lower preferred return scenarios to minimize extrapolating a preferable outcome from an atypical assumption where lower ones are equally likely.
Investment Period The investment period is another fundamental issue that shapes the partnership between a fund and its investors. Investors generally seek a longer investment period to ensure that they are able to commit capital to, at least, a given percentage of the investments offered by the fund manager. Conversely, early investor investment periods are generally preferred by fund managers because the fund will then be able to invest that capital contribution sooner in a new deal. An ideal solution seems to be to allow investors to extend their commitment period with, for example, a 1 – 2% penalty on fees, however, a shorter investor commitment period, as for the fund manager, can entice earlier investor capital contributions.
Common Mistakes Found in Fund Agreements and How to Avoid Them
There are a number of common pitfalls to be found when negotiating or drafting fund agreements. During negotiations, funds or investors may, on occasion, overestimate the influence of their requirements in the negotiation process. The result is that a fund may draft a resolution denying an investor’s proposal that would actually be beneficial for the fund (in fact, it could be when considering other areas of law such as tax).
By way of example, a fund that is reluctant to have its investment proposals discussed and ratified by investors may declare its intention to do so: "Disputes relating to the investment strategy should not be determined by other investors". This may dissuade investors from proposing their investment strategies, many of which may helpfully contribute to furthering the fund’s investment strategy.
In addition to drafting a resolution that will not be beneficial in the long term, funds may undermine their preferred exit structure or key man provisions by writing resolutions that limit the scope of key person departure.
Many of these seemingly harmless resolutions are also contrary to the principle of providing clear and express rights. If fund agreements can be used to avoid the lengthy negotiations needed to establish express rights, they can be used to unilaterally reverse progress. This could, in turn, create disputes that would not otherwise occur, for instance, if the investor was made aware at the outset of the specific rights he is entitled to.
Investors should therefore always carefully consider their drafted resolutions to ensure that they are not detrimental in the long term. It is especially important to remember that such resolutions can be proposed by almost anyone, not just general partners. In any case, they should always check that the final fund agreement is consistent with the general principles, since jargon or surplus language can create ambiguity that could have a negative impact.
Future Trends in Fund Agreements
As technology continues to advance, it’s likely that fund agreements will incorporate more automated and standardized elements. This could help reduce the time and resources required for legal drafting and negotiation. For example, smart contracts have gained traction in other areas of law but may also find a place in private equity fund agreements. Such contracts can automate certain fund agreement provisions and make it easier to track compliance.
Emerging jurisdictions and regulatory changes could also impact the evolution of fund agreements. For example, fund managers looking to raise capital for a new fund in a jurisdiction that has different legal requirements from their home jurisdiction may need to adapt their standard fund agreements to meet these local needs. New regulations in certain jurisdictions might require more extensive disclosure in a fund agreement, or new rules could require provisions that were previously optional. This could open opportunities for law firms that specialize in assisting clients with navigating cross-border or country-specific differences in fund agreement compliance.
Another future trend could involve greater standardization of fund agreements within a specific practice or industry. As industries mature, standardized contractual terms become more common because they help ensure fair competition. In some industries, aligned contractual terms between competing funds can create an assumption that investors have been treated equally by all funds. This could reduce the amount of time spent negotiating the specific terms of a fund agreement on each deal. However, a more standardized approach also has potential downsides if funds want to negotiate bespoke terms in order to attract a particular type of investor.
Final Thoughts
As we have seen, fund agreements play a critical role in ensuring the responsible operation of any real estate investment fund. The structure, organization and manner in which such an entity operates can have far-reaching tax and operational implications. As such, it is imperative that fund managers and investors alike understand the practical operation of the document. In this regard, fund agreements should clearly define:
Distributions of other amounts;
Restrictions on certain actions undertaken by fund management;
Operational partnership obligations;
Fund management decision making;
The distribution of profits of the fund;
The process and extent for determining and allocating fund losses;
Fund management compensation;
The manner through which a capital account will be determined for each partner;
The process through which an investor may reduce its contribution and/or exit the fund;
The extent to which distributions made pursuant to a "waterfall" provision may be challenged;
The considerations to be undertaken in the event the value of properties held by the fund reaches an agreed upon percentage relative to total assets held; and
Other operational matters and obligations between the fund manager and the fund investors .
Understanding the terms and conditions of fund agreements is imperative for fund managers and investors alike. At the same time, the foregoing should not be construed to constitute the entirety of essential fund agreement provisions. There are innumerable other issues that must be consulted when drafting such documents. In the modern commercial real estate landscape, however, it is difficult to overstate the importance of accurately and precisely defining the investment parameters of a fund.
In a broader sense, fund agreements are but one piece of an overall investment puzzle. In this regard, fund managers and investors must develop a thorough understanding of all aspects regarding the formation and operational integrity of funds. Only by committing to this level of understanding may managers and investors alike ensure the success of the vehicles they undertake to create.