The second webinar in the Capria Catalyst series covered various fund structuring options and the factors to consider while choosing and customizing each one.
First, we heard from David Munnich about Investisseurs and Partenaires’ investment in and support of Teranga Capital, the first national fund dedicated to small businesses in Senegal. Teranga is an open ended fund, set up as a corporation, with three quarters of the money invested coming from local investors. The approach allows local money to stay within the country and be recycled across small businesses in Senegal.
What questions to ask before setting up a fund
The fundamental questions David Munnich suggested to ask are:
- Open-end or closed-end?
- Pros (Open): With an open-end structure, you can start investing with less money. This can be advantageous for first-time fund managers and the investment strategy is easier for local investors to understand. Local investors can also be more involved in governance. Since there is no deadline for raising additional capital or deploying capital, you can continue to look for investors that have strategic value.
- Cons (Open): Include a lower IRR and less liquidity for investors.
- Do I incorporate locally?
- Pro: Local incorporation can attract local investors even if they do not have much investing experience and it may produce tax advantages although this will be influenced by where investors are located.
- Con: There can be potential tax issues at the time of exit and double taxation of dividends is something to be on the lookout for, depending on your approach.
- Local or foreign investors?
- Local investors are familiar with the investment/business climate in their countries and have less fear of currency risk. They also have a long-term view and vested interest in the strategic vision of the vehicle.
- Foreign investors typically have more money to invest and have the ability to bring additional sector-specific expertise.
Key Structural Considerations
Legal expert Dave Riley, a Venture Partner with Capria, then covered some of the other key structural considerations to think about when setting up a fund based on his experience supporting the set-up of more than 100 funds globally. The overall goal is to match deal & investor liquidity.
- Open-Ended Funds: Challenges
- Valuing the fund’s portfolio as investors are coming in and out can get expensive. The more illiquid the fund, the harder it is to value.
- Performance fee structure is paid based on value of fund at a given point, leading to the same issue as above.
- “Hot” capital, meaning investors are not committed to the fund for enough time, could potentially drive up operating costs.
- Tailoring Open-Ended Funds
- One solution to “hot” capital is to have a lock up period, where the investor is locked in for pre-determined number of years (at least 1-2 years). Another option is to use a gate, where only a certain proportion of investor’s capital can be redeemed within a certain timeframe (ex: 25% per quarter).
- Limiting when people can subscribe & withdraw is one way to approach the challenges of allowing investors to come in and out of the investment vehicle over time.
- Closed-End Funds: Challenges
- Since most closed-end funds lead to setting up another fund, often times within 3-5 years post the initial fund, the costs & effort required to raise a new fund while managing an existing fund can be substantial.
- Agreements are more complicated since there is a longer term relationship at stake and you must have fundamental protections that are not an issue in open-ended fund (an example would be a key persons provision).
- As you launch multiple funds there are a lot of considerations to take into account in order to avoid inter-fund conflicts.
Impact of Investment Instrument on Fund Structures:
- Equity: Given securities are harder to value, if you’re choosing to use equity as your instrument of choice, there is an obvious bias towards a closed-end structure.
- Debt: Either structural approach could be taken if you’re using debt, and given the ability to quickly recycle in some cases, more cash can be available which makes an open-end structure an option.
- Revenue-Based Financing (RBF): RBF deals can be difficult to value. Since they are self-liquidating, if you apply long lockup periods or gate thresholds, an open ended structure could be something to consider.
Read more about the pros and cons of alternative deal structures in Dave Riley’s blogpost.
The overall takeaway from this webinar according to Munnich was to really understand requirements of investors. There are some who will immediately disregard an open-end structure, while others will be receptive to learning about how the alternative structure works. Riley stressed the importance of not only finding good legal counsel to help you navigate some of the questions and challenges you’ll find, but also finding a good CPA firm.
At Capria, we’ve seen a number of unique structures proposed since we began accepting applications in September 2015. Anything “alternative” will immediately cause some friction between you and potential investors, which is something you want to avoid where possible. If you’re going in the direction of setting up an open-end fund, be sure to take into account the key points mentioned in this post and be prepared with an arsenal of responses on how you’ll address them while you look to build investor confidence. Regardless of the structure you decide, raising an impact fund is difficult. We look forward to learning more from each of you who are out there looking to raise impact investment vehicles.
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