Considerations for Launching a Fund with Friends and Family Investors

There are numerous considerations investment managers must take into account for best practices when launching a fund with commitments from their friends and family. EisnerAmper recently discussed the topic and current trends at a webinar titled “Considerations for Launching a Fund with Friends and Family Investors,” moderated by EisnerAmper David Goldstein, Director, Business Development in the Financial Services Group, with insights from the following panelists:

• Ron Geffner, Partner, Sadis & Goldberg
• Jorge Hendrickson, Senior Vice President/ Head of Sales and Marketing, Opus Fund Services
• Peter Tarrant, Managing Director, Head of Business Development & Capital Introduction, BTIG
• Katie Brandtjen, Partner, EisnerAmper

Current Trends for New Launches with Backing from Friends and Family:

Investment managers launching with capital from friends and family should determine their vision and business plan in order to select the appropriate investment strategy and growth potential for a new fund launch. It is important to do this correctly the first time, no matter the size, strategy or type of investors in the fund.  The manager should work closely with legal counsel in order to structure the fund in the best way to optimize its objective.

Things to consider include:

• How the fund should be structured and where should it be domiciled.
  • Are there tax-exempt investors?
  • Should corporate blockers be put in place to avoid taxation related to Unrelated Business Taxable Income (UBTI)?
• Does the investment manager want to offer initial investors a discount on fees to invest early?
  • Funds can offer reduced or waived fees, at the manager’s discretion.
  • Funds can offer investors a founders’ class or side letter arrangements.
• Does a manager want to consider outsourcing the C-suite as opposed to hiring in house?
  • A manager may decide to put in place an institutional-quality infrastructure from the start.
  • Outsourcing reduces operational risk and counterparty risk.
  • Outsourcing may allow for the manager to focus on the investment side of operations and raising money rather than the day-to day-operations
• Managers also need to document the policies and procedures with their service providers to reduce counterparty risk.

Best Practices for Choosing the “Right” Service Provider:

When choosing the right service providers for the fund, the manager should consider:

• Infrastructure type.
• Employee bandwidth.
• Cost relevant to assets under management (AUM) appropriate for the fund.
• How the management company and fund interrelate:
  • How much should the fund’s AUM be?
    • The fees generated from AUM are considered income to the management company.
  • Which expenses are considered fund expenses versus management company expenses?

The key is putting together a solid infrastructure from day one that the fund can scale into without outgrowing. Changes to the infrastructure during the life of the fund may cause investors to ask questions and could prohibit new investors from allocating.

Investors will want to perform their own due diligence; good practice dictates that the manager be able to explain policy, procedure and infrastructure choices (i.e., service provider selection) that were implemented and why. Managers have many options and it’s important that the focus be on doing it right the first time.

Best Practices to Capital Raise after a Friends and Family Launch:

The manager’s pitch should be consistent, no matter who they are trying to capital raise from.

Every fund should have:

• A completed DDQ; completing your questionnaire early on may be beneficial in helping raise capital.
• A professional pitch book.
• A monthly tear sheet that includes:
  • The fund’s gross and net performance.
  • AUM tracked by current and future investors.
• Key Items in quarterly performance letters including:
  • What makes the fund different?
  • New ideas related to the fund and risk management.
  • Infrastructure changes.
  • Opportunities in today’s market.
  • The fund’s AUM.
  • Any other relevant areas related to the fund’s growth.
• A new launch letter including:
  • Journey of the fund -- the story of the fund from the planning phase to the execution phase.
  • Current infrastructure.
• A CRM or excel document which tracks all the investors the manager is working or speaking with should be used and the manager may hire a marketer to streamline the process.

The fund’s prime brokers (PBs) should have the fund’s current marketing material and work with the manager since the PB typically has a lot of visibility into the marketplace and can potentially offer capital introduction services. A manager should be able to relate and connect to potential investors.

Tax Considerations for a New Fund Launch:

Manager must make an annual determination if the fund will be taxed as:

• Trader fund
  • Short holding period – 30 days or less.
  • Trades frequently.
  • A strategy that aims to gain from short-term market swings.
• Investor fund
  • A strategy that aims to profit from dividends, interest and capital appreciation.

Depending on the filing determination, there are different treatments for certain tax considerations.

• Fund expenses
  • Trader fund - fully deductible.
  • Investor fund - non-deductible as of January 2018.
• Business interest expense limitations
  • Potential limitations on the interest expense that can be deducted by trader funds.
  • There are modifications to the limitations highlighted in the March 2020 CARES Act.
• Excess business loss limitation for non-corporate tax payers
  • For a trader fund, married filing joint taxpayers can offset their net business losses by investment income, if there are losses in excess of $500k ($250k for single taxpayers).
    • Business losses in excess of that $500k would be carried forward to future years as a net operating loss.

*The March 2020 CARES Act suspends all of the rules noted until 2021.

New tax implications for carried interest:

• The holding period required for long-term capital gain treatment increased from more than one year to more than three years.
• If the underlying asset that generated the gains has not been held for more than three years, a general partner’s share of the gain will be reclassified from long-term to short-term capital gain.
• No impact on limited partners; allocation of income is based on contributed capital.

Considerations of fund of funds investments or funds that invest in other partnerships:

• What is the expected timing of K1 availability?
• Will tax estimates be available?
• Are there other state tax implications if the fund is investing in other funds?

Considerations for tax exempt investors:

• Possible tax implications if the fund is generating UBTI. UBTI can be generated by:
  • Investment in partnerships that are operating businesses.
  • A fund that uses leverage or trades on margin.
• Subscription through a corporate blocker may be used in order to mitigate UBTI.

Extended first year audits:

For a new launch not yet registered with the U.S. Securities and Exchange Commission (SEC): While it is not required, the fund may still chose to have an audit for the stub period rather than doing an extended first-year audit.  For registered investment advisors (RIAs), the Custody Rule requires financial statements be issued within 120 days of year-end. Audited financial statements may be used to assist fund raising and marketing efforts.