Subsequent Closings for Private Equity Funds
- Jul 19, 2023
- Louis D. Alaimo
Generally speaking, having more investors in a fund is good. Keeping track of all the allocations when investors join at different times can be a bit more challenging. Subsequent closings are extremely common in today’s economic investing climate, as they afford private equity funds the option to launch the fund as soon as they have secured enough soft commitments and allow the general partner (“GP”) to increase the speed of the fund to take advantage of investments in the market.
After the initial close occurs, the GP normally has the option to increase the total level of commitments by way of admitting additional partners (or “new investors”) or allowing current partners to increase their commitments (or “follow-on investors”). This process is commonly known as a subsequent closing, or “sub close”. Any rules or parameters around the treatment of sub closes are outlined in the fund’s limited partnership agreement or private placement memorandum (“LPA” and “PPM”, respectively). The following will explore the common treatment for sub closes.
Each time the GP approves a sub close, the new investors and/or follow-on investors are treated as if they joined the fund on the initial closing date. This is accomplished in three ways:
- rebalancing or equalization,
- partner-to-partner Interest (also known as equalization interest), and
- profit and loss (“P&L”) true-up.
Although each of these items seem straightforward at first glance, the number of factors in these equations can quickly multiply and cause the complexity to rapidly increase.
Rebalancing or Equalization
Rebalancing or equalization occurs each time capital is called after each sub close has occurred and is the process of truing-up all investors as if they had joined the fund during the initial closing. Equalization is achieved by rebalancing the partners’ contributions so that each partner will have contributed an amount equal to their new ownership percentage with respect to the total amount contributed to the fund since inception. Commonly, GPs will call capital simultaneously with a sub close in order to rebalance all the partners when the new commitments are made. However, sometimes GP’s will decide to call capital at a later date, after the sub close has occurred.
Partner-to-partner interest is owed by the new and/or follow-on investors to the existing investors in the fund. The purpose behind this is to account for the period of time from inception through the sub close rebalancing. The existing investors contributed a portion of their commitment at inception, but new and/or follow-on investors are contributing at a later date. Therefore, these investors owe interest to the existing investors for the period of time from the initial closing through the date when the new/follow-on investors make their first contribution. The interest rate to be used should be defined in the LPA or PPM. The fund will collect the interest owed by the new/follow-on investors and distribute it to the existing investors pro-rata based on their ownership percentages prior to the current sub close. Most commonly, this is achieved by netting these amounts alongside the rebalancing when capital is called. However, the GP may decide to collect and distribute the interest apart from the capital call.
Profit and Loss True-Up
The profit and loss true-up is used to reallocate all the profit and loss since inception of the fund, based on the new ownership percentages post sub close. Normally, profit and loss items are allocated pro-rata to each investor based on their ownership percentages, but that is not always the case. Certain investors may have side letters that provide for different allocation methods. The important thing to note is that profit and loss items may be allocated differently. A common example of a non-pro rata allocation would be management fees. Management fees are charged to investors based on a stated rate and not solely on ownership percentage, or not at all. In this instance, management fees do not get reallocated amongst the other partners. Rather, each new investor or follow-on investor will be charged their fees since inception to catch-up with what they would have paid, had they been admitted to the fund on the initial closing date. Any other profit and loss item that is charged on an individual basis or a special allocation will need to be calculated for the period from inception to the current date and charged to each applicable investor. Remaining profit and loss items, which are allocated based on ownership percentage, are to be reallocated among the existing and new/follow-on investors since inception.
A GP may decide to only do a single sub close or multiple sub closes. Each time an additional sub close occurs, all the partners from the initial close and all sub closes prior to the current sub close are the existing partners for the current sub close.
The following is a simple example to illustrate the three components of a sub close.
The LPA states the following:
The Limited Partners agree that the General Partner shall have the right to admit additional Limited Partners to the Partnership or permit an existing Partner to increase its Capital Commitment, in one or more Subsequent Closings in accordance with the terms hereof (any such additional Limited Partner or existing Partner who increases its Capital Commitment, an "Additional Partner").
The amount required from each Additional Partner shall be equal to the sum of:
- (x): the product of (i) a fraction, the numerator of which equals the Additional Partner's new or increased Capital Commitment (as applicable) and the denominator of which equals the Capital Commitments of all Partners (including the Capital Commitments of all Additional Partners); and (ii) all Net Adjusted Capital Contributions (other than the portion thereof drawn to pay the Investment Management Fee); plus
- (y): an amount calculated in a manner equivalent to interest on the average daily balance of the amounts described in clause (x) at a rate equal to 6% per annum; plus
- (z): the Investment Management Fee paid in respect of Capital Commitments attributable to the Additional Partner's new or increased Capital Commitment (as applicable) as if such Capital Commitment had been made on the date of the Initial Closing.
Before proceeding with a sub close, be sure to read and familiarize yourself with the fund’s governing documents in order to gain a complete understanding of the fund’s treatment around calculations for rebalancing, partner-to-partner interest and profit and loss true-up. These calculations are relatively straightforward, but it is easy for them to become increasingly more challenging as you introduce additional factors.
If you have any questions, we'd like to hear from you.
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