Navigating Growth -- Considerations for Fund Managers
November 19, 2020
By Caitlin Cotter
The year 2020 has proven to be a challenging year for all. Fund managers have been faced with new hurdles when it comes to fundraising, particularly in this virtual environment. During a live webinar moderated by Bonnie Sussman, Partner at EisnerAmper, panelists Nicole Belmont, Managing Director, Far Hills Group; Beth Mueller, Co-Founder and COO, Socium Fund Services, and Amanda Nussbaum, Partner, Proskauer Rose, reflected on lessons learned in 2020 and shared insights on how fund managers should navigate growth going forward.
Infrastructure and Operations
When it comes to attracting institutional investors, the importance of infrastructure and operations are key. The expectation is for there to be robust processes and controls in place surrounding due diligence, reporting and cybersecurity. Investors may have their own templates for reporting, which could prove to be onerous. Investors will also expect managers to know how they will comply with anti-money laundering (AML) procedures; SEC regulations; and environmental, social and corporate governance (ESG) considerations. Growing managers should explore their options and evaluate whether or not outsourcing these tasks would be the best fit. Often the organizations providing outsourced CFO, CCO, and middle/back office functions have reliable and effective infrastructures that are well respected by investors. Having quality service providers in place before going out to the market can show managers’ readiness and ability to launch. Managers should be prepared for where they are going, not where they are.
Not only do institutional investors bring with them increased due diligence and reporting standards, they often require more complex fund structures. If potential investors are foreign and/or tax-exempt they will want to minimize their exposure to tax filing obligations through offshore blocker entities. For example, a previously single-fund private equity vehicle may be faced with having to set up parallel funds or feeder entities. Offshore domiciles such as the Cayman Islands have their own due diligence process and set of AML and countering the financing of terrorism (CFT) regulations that require a look-through for each investor who comes into the fund as an entity versus an individual. There are also additional fees to be paid to regulators, auditors, directors, and attorneys, to name a few. Fund managers should have a clear idea of what their investment strategy is and what investors they are targeting. Knowing this could prevent unnecessarily complicated structures.
Upon the onset of the pandemic fundraising all but shut down. After the initial panic investors began responding to opportunities from their existing managers, managers already in their pipeline, or large established managers. Family offices and high net worth individuals were able to adapt fairly quickly -- but for institutions, there is less flexibility.
As capital continues to flow, managers are encouraged to prepare a strong pitch deck and practice it ahead of time. Free flowing conversations used to be the preferred method, but in this new virtual environment, staying on message ensures managers hit all the key points. Investors want to know what sets one manager apart from the others and how they are going to implement their investment strategy. Having data to support one’s strategy is important, but even more so is the ability to demonstrate how it’s repeatable. Investors want to see that the strategy can be replicated at a larger scale.
In terms of increasing exposure, hiring a third-party marketer and attending quality conferences can help grow a manager’s investor pool. Quality investors are attending these capital introduction events and they can be a great way to meet investors managers may have not been able to get in front of before. Participating in webinars or speaking to hedge fund and private equity publications is another way to gain recognition.
Do not underestimate the value of developing an investor portfolio and having respectable references. In the past, managers may have waited to bring forward references but in this new environment they should be made known early on in the process. Having a stable investor base will not only alleviate some of the burden of investor due diligence; it will show outside investors the faith these existing partners have in managers. Investors want to see that managers are capable of fully operating in a remote environment and at the forefront of their mind is how managers are keeping up with controls, protecting data and managing cash. These can be communicated through webinars, virtual office visits, and video interviews with key personnel. The key takeaways for fundraising are: Stay in front of investors, be transparent and communicate often.
Tax considerations both emerging and existing managers should keep in mind primarily relate to carried interest and management company structure. In light of the 2017 tax changes, carried interest is now subject to a three-year holding period, changed from the general one-year holding period for long-term capital gain. This creates various issues from the legal side in terms of potential conflicts between investor needs and the holding period for investments. However, there is an opportunity to plan. This holding period particularly impacts hedge fund managers, given the historically short-term nature of their investments. Managers should consider whether or not the carried interest should be structured as an allocation versus a fee in light of the reform. There could still be potential benefit from an allocation even if the underlying income ends up being all short-term gain, because the potential deferral depends on how quickly the portfolio turns over assets. Alternatively, if managers structure the carried interest as a fee, as long as the fee is being taken on an annual basis, certain deferred compensation rules may not apply and there also may be an opportunity for Medicare tax savings. There are also concerns for private equity managers, depending on the fund strategy. Managers may want to waive gains from investments that are held less than three years depending on the fund strategy and whether this scenario is an outlier. There is also planning to be done at the portfolio company level. Managers may want to finance investments in a way that does not restart a holding period.
In terms of management company structuring, it is still advised to use a limited partnership versus a limited liability company. This is to give managers the opportunity to take advantage of a tax loophole that still exists where partners may be able to benefit from an exemption from Medicare tax on their distributed share of partnership income above their base salary and bonus. However, this loophole has come close to being shut down in the past and there is increased IRS audit activity in this area.
An important caveat: The strategies mentioned above are likely to be impacted by the change in the new administration. In general, people are expecting tax rate increases, whether to ordinary income rates or as part of the removal of capital gains rates for high-income earners, which would instead be taxed as ordinary income rates. Additionally, there may no longer be a cap on what base the social security tax applies to. In light of this, managers may want to think about opportunities to sell investments this year to accelerate the gain and take advantage of a potentially lower tax rate. However, these are speculations and it is not known when, or if, these reforms will come into play.
Lastly, the impact of COVID-19 and the resulting new work-from-home environment is a big question on people’s minds. Employees are now working in multiple jurisdictions and managers are wondering how this is being viewed by the individual states and what effect it has on withholdings and whether or not a company has nexus in a particular state. Although the guidance from states is lacking, managers should monitor the situation closely for potential tax implications for their people and organization.
The entire webcast can be viewed here.