Funds Of One

Hello again.  When I previously contributed to Corporate LiveWire a year ago, I wrote about “funds of one” from an introductory perspective and laid out certain benefits and drawbacks in structuring these vehicles.  While the basic architecture of the fund of one has not changed, I have observed several interesting aspects to the structuring process in the past year and thought it timely to revisit the subject of funds of one in order to share with you some recent trends and experiences. 
 
FATCA
 
One of the biggest complexities I have had to work with in structuring funds of one has been factoring in compliance with the Foreign Account Tax Compliance Act (FATCA), which was enacted in the United States to reign in tax non-compliance by U.S. taxpayers with foreign accounts.  It is beyond the scope of this article (as well as beyond the comprehension of most people other than tax lawyers) to explain how FATCA works in all of its grisly detail, but in brief, according to the U.S. Internal Revenue Service (IRS) website, FATCA focuses on reporting: (i) by U.S. taxpayers about certain foreign financial accounts and offshore assets, and (ii) by foreign financial institutions about financial accounts held by U.S. taxpayers or foreign entities in which U.S. taxpayers hold a substantial ownership interest.  Although FATCA was enacted in 2010, it took some time for implementing regulations to be adopted by the IRS, including related to information reporting by, and withholding of payments to, foreign financial institutions.  This led to uncertainty as to how FATCA would be applied and created a bit of a headache when working with U.S. fund managers and non-U.S. investors such as sovereign wealth funds and other institutional investors in the formation of funds of one domiciled in an offshore jurisdiction given the need to ensure compliance with FATCA by “foreign financial institutions.”
 
Typically, a U.S. fund manager would replicate its co-mingled fund structure when creating a fund of one.  For a non-U.S. institutional investor, this usually meant forming an offshore feeder fund (such as a Cayman exempted company) in order to satisfy the non-U.S. investor’s need to be in an offshore “corporate blocker”, as well as an offshore master fund (such as a Cayman limited partnership) to enable the manager to receive its incentive allocation through an affiliated general partner entity. As was also typical, the feeder would have a class of non-voting, participating shares issuable to the investor and a class of voting, non-participating management shares issuable to the manager or its affiliate.  Based on this structure, however, it became clear in light of FATCA and the regulations implemented thereunder that the parties involved would risk being exposed to the full reach of FATCA because they would be deemed to be part of the manager’s “expanded affiliated group”, as is known under FATCA.  In other words, because the non-U.S. investor would own more than 50% of the offshore feeder with the management shares being owned by the U.S. manager, and because the feeder would own more than 50% of the offshore master with the general partner interests being owned by the U.S. manager’s affiliated general partner entity, there would be issues to deal with from a FATCA perspective – potentially being subject to withholding requirements on certain U.S. source payments to a foreign financial institution.  In terms of treating the offshore feeder as a wholly-owned subsidiary of the non-U.S. investor (and thus not part of the U.S. manager’s expanded affiliated group in order to take advantage of certain statutory exemptions under FATCA, particularly for sovereign wealth fund investors), there was little, if any, guidance under the FATCA regulations to suggest that the management shares would be disregarded because they do not participate in the fund’s profits and losses.  And, as to the offshore master, an entity that is not treated as a corporation for U.S. federal income tax purposes will be treated as part of an expanded affiliated group if the members of such group “control” such entity (i.e., the general partner controls the offshore master).
 
In each of these cases in which I was involved, the lawyers and business teams on both sides got together and determined that the best solution to minimise exposure toand ensure compliance with FATCA would be to establish the master fund in the U.S. (such as a Delaware limited partnership) and to eliminate the class of management shares in the offshore feeder.  While this seems a rather simple fix in retrospect, it was not the obvious choice in the beginning because it departs from the typical structuring used when a non-U.S. institutional investor is involved.
 
Is a Side Letter Still Necessary?
 
Funds of one have the same basic design as “co-mingled” investment funds.  They are generally formed as limited partnerships, limited liability companies or corporations.  And even though they have a single investor, these vehicles are still governed and operated by a full set of organisational and constitutive documents and require other “primary” fund documents that are typical in a co-mingled fund structure (i.e., subscription agreement, investment management agreement, etc.).  In addition, many fund managers with fund of one platforms will often draft an offering memorandum as they would for their co-mingled funds.  So from a documentation perspective, funds of one are very similar to co-mingled funds.
 
Given that a fund of one involves a one on one negotiation between the fund manager and a single investor, it may be natural to assume that the parties can bake into the offering memorandum, the limited partnership agreement (or articles of association) and the subscription agreement all of the customised arrangements they have agreed to.  And accordingly, since there are no other investors involved, there would be no need for a side letter, right?  To the contrary, I have found that the side letter remains a necessary component in many fund of one scenarios.  In a typical co-mingled fund, a side letter with an investor will be entered into by not just the fund, but often times the fund manager as well, since the fund manager is not generally a party to any of the primary fund documents (other than an investment management agreement, to which the investor is not a party) and may be making certain representations, covenants or undertakings for the benefit of the investor.  The same would be the case in a fund of one because notwithstanding all the customising you can do to the primary fund documents, the fund manager and the investor should still have a contractual relationship. 
 
When representing institutional investors in negotiations, I have found that fund managers will often assume that all “side letter” type terms can be drafted into the primary fund documents.  That would generally be correct only as to representations, covenants and undertakings of the fund vehicle; but not so with respect to the fund manager whose representations, covenants and undertakings need to be enforceable through some instrument.  Conceivably, special terms agreed to by the fund manager could be reflected in the limited partnership agreement and the fund manager can then execute that agreement specifically in respect of those terms (I have been involved in these arrangements before).  But what about the case of a fund of one organised as a Cayman exempted company, which is governed by a memorandum and articles of association (which cannot signed by the fund manager), as opposed to a limited partnership agreement?  You will most likely need a side letter in that scenario.  As such, the side letter will often remain a vital component in a fund of one.
 
Customisation Spectrum
 
With the increased fund of one activity I have seen in the last year, I have noticed a fairly consistent pattern as to the level of customisation that fund managers are willing to submit to.  In other words, if we assume that a fund manager’s co-mingled fund documents will be used as a basis to draft the fund of one documents, how much of a divergence can there be?  The investor’s business objective in investing through a fund of one will be the primary driver, which leads to a spectrum of customization that can broadly be divided into the following categories:
 

• A new direct investment platform with its own unique objectives and strategies distinct from other funds, separate accounts and platforms advised by the fund manager – will permit a high level of customisation.
• A separate vehicle to invest alongside the master fund of an existing co-mingled investment pool with a direct investment platform – will permit medium to high level of customisation.
• A separate vehicle to invest as a feeder in the master fund of an existing co-mingled investment pool with a direct investment platform – will permit moderate level of customisation.
• A separate class within an existing co-mingled investment pool or a “sub-fund” of a cell company (e.g., BVI segregated portfolio company) – will permit a low level of customisation.
   

Other examples of unique categories along the spectrum include:
 

• Transferring an investment in a co-mingled investment pool to a separate class within the pool or a separate new vehicle – level of customisation will depend upon the type of fund of one structure utilised (as described above) and whether the transfer is negotiated at outset of co-mingled fund investment or requested subsequently.
• A fund of hedge funds – will permit a moderate to high level of customisation.
• Seeding a new or emerging fund manager – will generally permit a high level of customisation.

There may be scenarios that do not fit neatly into one of these buckets or perhaps negotiations between fund manager and investor may yield results that depart from the conventional wisdom as I have set out, but the above should be a predictor in many cases.
 
Transferring an Investment in a Co-Mingled Fund to a Fund of One
 
I have been involved with several transactions in which a co-mingled fund investment was transferred to a fund of one.  In about half of these situations, the investor had negotiated at the outset of its co-mingled fund investment to move its investment into a fund of one at a future point in time.  In the other half, the investor requested its own dedicated fund subsequent to making the co-mingled fund investment.  Each case has its own set of challenges and expectations from both a negotiation and documentation perspective.
 
In the case of a planned transition to a fund of one, it is not unreasonable to assume that the process should function smoothly and efficiently.  However, this is not always the case.  It may be that the parties negotiated a simple side letter provision to the effect that the fund manager will consider a transfer to a fund of one or that the fund manager promises such a transfer, but without legislating how it is to be done, what the customised product will look like or what special rights will be given to the investor.  This will invariably lead to longer than expected negotiations on topics such as liquidity rights, fees, information rights, governance, consent rights, termination rights and expense caps, among others.  In addition, it may be the case that the parties negotiated a very detailed road map as to the transition, but unforeseen circumstances or issues subsequently arose that caused the parties to go back to the drawing board.  Examples of this would be the need to comply with FATCA or altering the investment strategy as between the co-mingled fund and the fund of one due to performance issues in the co-mingled fund, which change in strategy leads to desired modifications of liquidity, fee and other terms. 
 
While it is difficult to anticipate every issue and scenario, interested parties should give careful thought to the process and bring to bear the appropriate resources when “pre-planning” the move from a co-mingled fund to a fund of one.
 
Conclusion
 
As the fund of one becomes an increasingly utilised vehicle for investors, there will likely be variations on the way things are customarily done.  While I cannot predict what the new trends will be, experience tells me that I will have more observations to report on by this time next year.