Structural Distinctions Between Private Equity and Hedge
Funds
Closed-end investment funds (private equity, buy-out, venture capital, real estate, natural resources
and energy) differ structurally from the traditional open-end (e.g., hedge fund) model in a number of
significant ways. These differences are the direct result of the type of portfolio securities held by the
respective types of fund. The open-end fund structure is generally appropriate for any investment
vehicle focused on assets with an established trading market and which are predominantly free from
restrictions on the transfer thereof, i.e., the assets can be readily marked to market and the portfolio
re-balanced regularly to accommodate investor contributions and redemptions. In contrast, the closedend fund structure is advisable for investment vehicles focused on investments that are not capable of
being marked to market and are generally subject to substantial restrictions on transferability for a
period of time. The portfolio investments held by these funds are generally carried at cost until a
realization
event
occurs.
These differing characteristics are the cause of the following structural distinctions:
1. Term. Open-end funds typically have no specific term (subject to the laws of the jurisdiction of
formation: while most states, including Delaware, no longer require entities such as limited
partnerships to have a finite term, some states may still retain this requirement). In contrast, closedend funds have a specific term which is typically 10-12 years, and which may be extended for 1-2 year
terms in the discretion of the manager/GP entity and/or with the consent of investors (LPs) or an LP
advisory committee.
a. Commitment Period While open-end funds typically require an investors capital be
contributed upon admission (and thereafter, investors may make additional contributions from
time to time), closed-end funds require investors to make a capital commitment that is drawn
down from time to time upon a specified period of notice by the GP (typically, 5-10 business days).
At the closing at which investors are admitted to the fund, they may not (and typically do not)
fund any portion of their investment amount at that time. Commitment periods for closed-end
funds typically range from 3-5 years from the final closing date.
b. Investment Period While open end funds make investments and re-balance their portfolios on
an on-going basis, closed-end funds usually have a limited period of time during which new
investments may be made. There may also be a separate time limitation on making additional
investments in existing portfolio companies. Although the investment period may conceivably
mirror the commitment period discussed above, many closed-end funds have an investment period
that endures for an extra 1-2 years following the termination of the commitment period in order
to permit the recycling of capital, i.e., reinvestment of realized capital.
2. Liquidity Due to the ability to mark to market the portfolio securities held by open-end funds, the
typical hedge fund structure permits admission of investors and redemption of capital at regular
intervals (monthly, quarterly or semi-annually), possibly following some fixed lock-up period. In
contrast, closed-end funds display different features regarding the acceptance of investments and
redemptions of investor capital.
a. Closings The typical closed-end fund will hold an initial closing admitting an initial set of 3rd
party investors once the manager/GP has obtained sufficient indications of interest through its
marketing efforts to have a level of assurance that a specified threshold of capital will be
committed to the vehicle. Thereafter, the GP will have the right to hold additional closings to
both accept new investors and permit additional commitments from previously admitted investors
at such times as it determined, but only within a specified time-frame (typically between 6 and 12
months from the initial closing date).
b. Capital Call Defaults As mentioned above, investments in closed-end funds are typically drawn
down incrementally pursuant to capital calls from the manager during a specified commitment
period. Because investors have a contractual obligation to contribute the agreed upon amounts
but do not initially fund these investments, closed-end fund documents typically contain onerous
penalties on investors who default on this obligation. The provisions typically provide for a limited
forgiveness period, where an investor who missed the initial due date may correct the mistake and
pay an interest penalty. After the forgiveness period expires, the GP typically retains the right to
terminate the investors right to contribute subsequent capital, to buy out the defaulting investor
for a fraction of the amount previously contributed and/or to actively locate a buyer for the
defaulting investors interest (which can be other investors who have not defaulted, or 3rd parties
who have not invested in the fund previously).
c. Catch-Up Contributions (and Cost of Carry) Because closed-end funds may have an offering
period of up to 1 year (and possibly longer), it is possible that the GP/manager may have called
capital from earlier investors at the time a subsequent closing occurs. Because of the illiquid
nature of closed-end fund portfolio securities, they cannot be marked to market and subsequent
investors admitted at NAV, as with the open-end structure. Thus, most closed-end funds will
require that investors coming into the fund subsequent to one or more capital calls to catch up on
their pro rata share of the amount of capital previously drawn down (as if all investors had been
admitted at a single initial closing) and also pay an interest charge on such amount (typically,
prime + 2%) that is referred to as a cost of carry contribution, in order to compensate initial
investors for having funded earlier investments in which the new investors will participate
(effectively, they have lent funds to the investors admitted at subsequent closings). Further, the
GP/manager typically has the discretion to keep these funds on hand or return them to the initial
investors. If returned to investors, the catch-up contributions are credited against the amount
contributed by initial investors such that the amount of capital they are required to subsequently
contribute will increase as if the amount returned had never been contributed (this calculation
will typically exclude the cost of carry interest charge so that the earlier investors receive the
cost of carry as an actual return on their contributed capital).
d. Redemptions Closed-end funds do not typically permit redemptions of capital at any time
prior to the expiration of the funds specified term, except in extraordinary circumstances (such as
ERISA violations or for other regulatory reasons). To offset this possible hardship, the
documentation for many closed-end funds provide broader language on the ability of an investor
to transfer its interest than is found in open-end funds, and also may contain language providing
that the GP/manager will cooperate with an investor seeking to transfer its interest to a third
party and possibly will assist the investor in locating a buyer to succeed to its interest in the fund.
e. Tax Distributions Due to the inability to effect regular redemptions of capital, closed-end
funds typically provide for the annual payment of distributions (to the extent there is available
cash) to investors in an amount necessary to satisfy investors tax obligations with respect to
undistributed taxable income.
3. Fee Base and Transaction Fees Open-end funds typically charge the management fee based on
either the funds NAV or an investors capital account balance (each of which is marked to market). In
contrast, closed-end funds tend to feature a tiered management fee, where the management fee
during the commitment period is a specified percentage of total capital commitments and following
the commitment period is a specified percentage of total capital contributions. Moreover, most closedend funds charge management fees whereby the actual fee percentage rate declines during the postcommitment period as most, if not all, investments have been identified and many are likely to be
nearing the exit stage. A related feature is that most closed-end funds will offset the management fee
to be charged to the fund by transaction fees received from portfolio companies (such as advisory fees,
break-up fees for unconsummated deals, investment banking fees, directors fees for serving on the
board of a portfolio company, etc.) so that the total amount of fee income to the GP/manager arising
out of its relationship to the fund is capped and investors receive the benefit when the GP/manager
and
its
affiliates
receive
these
kinds
of
fees.
4. Performance Compensation In contrast to the performance allocation/fee charged by open-end
funds based on the increase in the market value of the funds portfolio securities, closed-end funds pay
the GP/manager a carried interest based on the profits realized from the disposition of fund
investments.
a. Basic PE structure The carried interest is generally characterized as a distribution waterfall of
the funds capital. The typical structure is as follows: (i) investors first receive a return of
contributed capital from realized investments (including fund expenses and any investments that
are written down and/or written off) on a pro rata basis, (ii) investors then receive an annual
preferred return computed like simple interest on their contributed capital, typically in an
amount between 5-6% per year, (iii) the GP/manager then receives catch up distributions to
ensure that it receives its carried interest percentage on the preferred return to investors in step
(ii), and (iv) all profits in excess of these amounts are split between investors and the
GP/manager based on its carried interest percentage, typically 20-25% of fund profits.
b. Cumulative vs. Deal-specific The distribution waterfall in the closed-end fund structure is
computed in one of two ways: (1) the first option is the cumulative waterfall, whereby the return
of capital, the preferred return, the GP catch up and the profit split is measured over the life of
the fund on a cumulative basis, or (2) the second option is the deal-specific waterfall, whereby
the computations of returns and profits above is measured based on the performance of each
investment in isolation from the others. The deal-specific waterfall has become the industry
standard (especially for LBO and VC funds) over the past decade, and is less investor friendly than
the cumulative waterfall. This enables the GP to receive a carried interest on profitable
investments even when investors may have lost money in the aggregate, whereas the cumulative
waterfall ensures the GP does not receive its carried interest unless investors are earning
aggregate profits on their investments in the fund.
c. Clawback & Several Guarantee Because the GP/manager of a closed-end fund may receive
interim distributions of profits if the fund is profitable (under either the cumulative or dealspecific waterfall), but subsequent realized losses cause these profits to have been overdistributed to the GP on a look back basis, the documents for closed-end funds typically provide
for a clawback mechanism whereby, upon liquidation of the fund, the GP/manager must restore
any excess profits received to the investors. Moreover, in order to ensure that this clawback
provision is actually effective (because the principals of the GP can dispose of their shares of the
carried interest paid to them), many funds require that the principals of the GP/manager and any
other person who may share in the carried interest sign a personal guarantee obligating them to
restore their personal pro rata share of the clawback amount (i.e., it is a several, not joint,
liability).
d. Escrow Because of the potential clawback obligation of the GP/manager, a large minority of
closed-end funds have escrow provisions whereby a specified portion of the potential carried
interest is required to be held in escrow for a specified period of time, and the amount required
to be segregated may fluctuate based on the fair value of the funds unrealized investments or the
total amount of unrealized capital.
5. Restrictions on Investments While most open-end funds typically have broad investment mandates
and the flexibility to invest in most asset classes, closed-end funds typically have more detailed and
stricter restrictions on the funds investment program and the portfolio securities in which the fund is
permitted to invest.
a. Fixed Income Closed-end funds typically contain substantial restrictions on the making of
temporary investments for cash management purposes, which generally must be money market
instruments, cash equivalents and highly-rated commercial paper. The making of these
investments is generally only intended to be for cash management purposes (for the payment of
fees and expenses and the nimble deployment of investment capital) and ensuring the funds idle
cash is both secure but also earning some minimal amount of return.
b. Publicly Traded Securities Closed-end funds, where permitted to invest in publicly traded
equity securities, typically include restrictions permitting them to do so only in circumstances
where it is done with a view to acquiring a controlling block of securities (e.g., 25% of the public
float) or otherwise with the intent to influence the management of the issuer, subject to
exception for limited investments (such as 5% of the funds invested capital).
c. Diversification/Concentration Limits Most closed-end funds are subject to greater restrictions
than open-end funds with respect to the (i) geographic regions in which the funds portfolio
companies are headquartered or from which they derive the bulk of their revenues, (ii) amount
that may be invested in portfolio companies focused on any single market sector, and (iii)
amounts that may be invested in a single portfolio company. Moreover, closed-end funds focused
on a particular asset class will generally be prohibited or restricted from investing in other asset
classes (e.g., PE funds prohibited from investing in real estate, energy funds being limited in their
ability to invest in real estate, real estate funds prohibited from investing in equity securities, VC
funds being prohibited from investments in portfolio companies with a certain revenue threshold,
etc.).
d. Maximum Fund Size and Invested Capital While some open-end funds may have a cap on the
amount of subscriptions the fund will accept, this kind of limitation is almost invariably
incorporated into the constituent documentation for closed-end funds and typically appears in 2
forms (usually both of them): (1) a maximum total amount of committed capital that will be
accepted, and (2) a maximum amount of total capital that will be invested in portfolio companies.
Committed capital is limited to a set amount in order to ensure the GP only pursues attractive
deals and can effectively manage the funds investments. Because closed-end funds typically have
a limited right to re-invest realized capital, the total amount of invested capital is usually capped
at between 110-120% of committed capital.
6. Valuation; LP Committees Closed-end funds typically appoint an advisory committee composed of
investor representatives selected by the GP/manager, although the members are all unaffiliated with
management. The purpose of the committee is to meet with management on a somewhat regular basis
to discuss developments with respect to portfolio investments, valuation matters and annual
performance. The committee also frequently is empowered to approve affiliated transactions that may
present a conflict of interest for the GP/manager, as well as to approve certain material changes, such
as extensions of the funds term or investment period and recycling the proceeds from realized
investments.
7. Investor Clawback Because closed-end funds typically are activist investors that are expected to
participate in the management of portfolio companies, liability and indemnification provisions in favor
of portfolio companies are of much greater importance in the closed-end fund context. Similar to the
GP clawback discussed above, the investors in closed-end funds are also typically subject to certain
clawback obligations pursuant to which investors are required to return distributions of investment
proceeds to the fund (and the GP is authorized to withhold capital from investor distributions for the
purpose of establishing reserves for liabilities) in the event of contingent liabilities and indemnification
obligations. This potential clawback obligation is typically limited in both amount and duration (e.g.,
up to 25% of distributions received during the preceding 2-year period are subject to recall).
8. Conflicts of Interest Unlike the documentation for the typical open-end fund, which permits the
manager to engage in a wide array of outside business activities as long as the fund is treated fairly,
the documentation of closed-end funds typically contains substantial restrictions and/or prohibitions on
the GP/managers ability to (i) manage funds or accounts with a similar investment mandate, (ii) offer
co-investment opportunities to specific LPs or the principals and affiliates of the GP/manager
(including its personnel and other investment vehicles or managed accounts), (iii) engage in other
investment activities similar to those of the fund, and (iv) cause the fund to engage in transactions
with principals and affiliates of the GP/manager. The first and third restrictions typically only apply
during the funds investment period or until the funds capital has been sufficiently drawn down and
invested (typically 75%). The second and fourth restrictions usually apply over the term of the fund,
but are also subject to review and/or approval by the LP advisory committee.
9. ERISA/VCOC Closed-end funds are subject to the same general set of rules under ERISA as are open-
end funds and their managers. However, there is one additional tool available to closed-end fund
managers in order to avoid potential ERISA duties and liability. Even if participation by benefit plan
investors in a closed-end fund is deemed significant (i.e., 25% or more of a class of the funds equity
securities are held by benefit plan investors subject to ERISA), a funds manager can avoid being
deemed an ERISA fiduciary as long as the fund qualifies as a venture capital operating company (VCOC).
A VCOC must have at least 50% of its assets held for investment purposes invested in operating
companies with respect to which the fund has and exercises management rights. This test is applied
from the making of the funds first long-term investment and therefore the funds first investment
generally must be in an operating company.