Funds Of One Craze

By Benjamin Horney

Law360 (May 14, 2018, 3:13 PM EDT) — Private equity limited partners have shown increasing interest in a form of nontraditional investment vehicles known as separately managed accounts, or funds of one, meaning attorneys with expertise in the intricacies that come with negotiating and crafting such agreements will be in high demand.

Separately managed accounts, which are called SMAs for short and are also referred to as funds of one, are customized arrangements PE firms enter into with a single investor or a small group of investors. While the general makeup of such agreements may look somewhat similar to the fund documents tied to standard private equity funds, SMAs are far more exclusive than traditional PE vehicles and can offer benefits to the participating LP or LPs, including more control over investment terms and lower fees.

“It really is the future,” said Peter Gilman, a partner with Simpson Thacher & Bartlett LLP. “If it’s done right, both the sponsor and investors are better off.”

The surge in popularity of SMAs is illustrated by the fact that the average number of such funds that close annually has gone up significantly in recent years, according to data provided by research firm Preqin. From 2010 through 2013, about 63 SMAs closed each year on average. From 2014 through 2017, meanwhile, the mean number skyrocketed to 118, and there have already been 25 such fund closings this year, according to Preqin.

Attorneys hoping to capitalize on the craze by landing work on such investment vehicles would be wise to begin educating themselves on why exactly funds of one have become more popular in the private equity world. The uptick in demand for funds of one is part of a larger trend toward customization in the realm of private equity, as institutional investors have become more interested in constructing portfolios that match their unique investment needs or terms, according to Miguel Gonzalo, a partner at private markets investment firm Adams Street Partners.

“Many times, investors are looking to develop a unique portfolio that targets a certain geographic exposure, or a specific cash-flow profile, or a certain level of diversification, all of which can be accomplished with an SMA vehicle,” said Gonzalo, who is also head of investment strategy and risk management at Adams Street.

Meanwhile, funds of one are often used to help private equity investment vehicles that might be nearing the end of their life cycle but need additional cash to fund more deals, according to Neil Townsend, a partner in the corporate and financial services department of Willkie Farr & Gallagher LLP and co-chair of the firm’s private equity group.

“We’re seeing a lot of managers out there who have funds that are expiring but still want to do deals,” Townsend told Law360. “These funds of one help fund managers generate more of a track record before they go out and raise money again.”

The other main rationale behind investors’ seeking to enter into funds-of-one arrangements with PE fund managers is the potential to get more attractive terms. LPs often have a leg up when it comes to negotiating the terms of these types of vehicles, because funds of one typically involve a single investor or a select few investors that provide a sizable capital commitment, as opposed to standard PE funds that feature many investors all contributing varying amounts of capital.

Once attorneys feel confident in their understanding of why PE investors are increasingly trending toward customized terms via funds of one, their next move should be to study the specific differences that can exist between such arrangements and standard PE funds. Funds of one often offer the participating investor things like favorable carry structures and certain investor rights; in some cases, investors are aggressive and seek the right to take over a portfolio company’s board or desire to play a more active role in the operations of a particular company.

Depending on the way a given private equity firm has structured its funds-of-one program, consideration should be given as to whether any of the favorable terms being provided to one investor must be disclosed and even offered to other investors in parallel funds, according to Phyllis A. Schwartz, an investment management partner at Schulte Roth & Zabel LLP.

“If not intended to be so offered, such favorable terms should be carved out from ‘most favored nations’ provisions granted to other investors,” Schwartz added, referring to a type of clause that is regularly included in side letters permitting an LP to receive certain benefits that have been negotiated and granted to other LPs via side letters of their own.

Different fund managers have different ways of structuring their funds-of-one programs, and some choose to have individual terms for every different LP they enter into an SMA arrangement with. However, many PE fund managers run their various separately managed accounts as an overall investment program, and while the funds can still have certain differences when it comes to some of the particulars, there should be symmetry on some key terms, Gilman explained.

“For example, it would be difficult to give a particular LP investor approval rights over a deal if it would have an adverse effect on other accounts,” Gilman said. “There are certain things that have to be harmonized across a program.”

Attorneys can draw upon their legal expertise to help ensure that one SMA doesn’t negatively impact any other funds of one in a program, something fund managers tend to find extremely helpful considering the grouping together of a sponsor’s funds of one can make things easier for both sides.

Take, for instance, the Blackstone Tactical Opportunities Program, which is a series of SMAs that invest alongside a traditional commingled fund as part of an integrated investment program.

“The Blackstone Tactical Opportunities Program didn’t exist five years ago,” Gilman said. “Now it’s worth $17 billion, and most of these are funds of one that invest together as part of an opportunistic strategy.”

In programs like the one Blackstone has grown over the past few years, the sponsor serves as the general partner and controls the fund the same way it does all its other funds, only investors see benefits such as carried interest that is charged at lower capital gains rates relative to ordinary income that would be generated by a contractual arrangement, Gilman explained.

“Sponsors are looking to be more creative in how they deploy capital, and having these complementary, customized vehicles that can invest where flagship funds don’t typically is beneficial for both the sponsor and the investors,” Gilman said.

–Editing by Rebecca Flanagan and Edrienne Su.