The Art of the Deal-By-Deal
Having worked with clients in so many different parts of the world over the years, I have always found it interesting to see certain practices in some markets that are not commonly undertaken in others.
One recent example of this is the use in Asia of segregated portfolio company (SPC) structures to create private equity funds that allow investors to participate entirely on a deal-by-deal basis.
This is a different approach to structuring private equity funds than is typically seen in other markets, where general partners typically form limited partnership structures and investors invest on a blind pool basis. In such blind pool funds, investors do not have visibility at the time they make their investment of any of the underlying assets that the fund will ultimately acquire. Rather, they are placing their trust in the ability of the fund manager to source and execute unknown deals on terms that will lead to attractive returns over time.
In addition, the more traditional approach to structuring private equity funds is to utilize a commitment-and-drawdown model, where investors do not actually invest all their capital at the time of becoming an investor in the fund. Rather, they make a contractual commitment up to a certain amount, with that amount then being available for drawdown when called from time to time by the general partner or fund manager as required for completing underlying purchase transactions.
The prevalence in Asia of using SPC structures to allow investors to participate on a deal-by-deal basis is driven by a lower level of willingness by many investors in this region to invest on a blind pool basis. In addition, general partners or fund managers in the Asia region are often less interested in a commitment-and-drawdown approach and often prefer that investors simply invest all their capital at the time of their becoming an investor.
An SPC is a company able to create one or more segregated portfolios (Portfolios) in order to segregate the assets and liabilities of each Portfolio from the assets and liabilities of any other Portfolio.
By creating a new Portfolio each time that a particular underlying deal is proposed, a separate offering of shares in that particular Portfolio can be undertaken, usually pursuant to a supplement to an existing private placement memorandum, and managers are able to pitch a specific underlying portfolio investment opportunity to investors.
The low cost of rolling out new Portfolios make an SPC a potentially preferable structure to creating entirely separate companies each time that a particular underlying deal is proposed.
Obviously, catering to this investor appetite for a deal-by-deal approach creates some additional considerations or difficulties for fund managers, and these need to be managed in utilizing these types of SPC structures.
Firstly, with such an SPC structure the fund manager will not have existing contractual commitments from investors, or “dry powder”, that can be called down at very short notice, and this can affect the ability of the manager to commit to underlying transactions in a timely manner. Clearly, entering into a binding underlying purchase contract cannot be finalized until the necessary capital has been raised, as this would give rise to a risk of a breach of contract if the funding cannot ultimately be obtained.
If the fund manager is competing against another potential purchaser for an asset, and such other purchaser already has guaranteed funding in place, the vendor may prefer to deal with such other purchaser (even potentially on slightly less favorable terms) due to a perceived greater degree of certainty of closing the transaction.
If potential investors require access to key investment personnel as part of their investment decision-making process, whilst such personnel are also trying to focus on negotiating and agreeing terms on an underlying transaction (and possibly also any related debt-financing) at the same time, this constitutes an additional time burden on such personnel.
As all of the capital raised by a new Portfolio will often be invested in the single underlying investment for which the Portfolio has been formed, the Portfolio will not have access to cash to make monthly or quarterly management fee payments. This often results in several years of management fees being charged up-front at the time of the Portfolio’s launch.
Notwithstanding some of these additional considerations and difficulties for fund managers in utilizing these types of deal-by-deal SPC structures, managers will always seek to provide investment opportunities and structures that meet the demands of investors. For this reason, the use of deal-by-deal structures is likely to continue in the Asia region for some time yet.