In the 11th and final video of our first-time funds series, Guillaume Lavoie and Ana Ioanas of our Private Equity practice discuss funds focused for high-net-worth individuals, also known as retail funds, and what needs to be considered for a fund raised for individual investors, including:
dealing with liquidity concerns for individual investors;
closed-end funds; and
calling capital upfront to reduce risks of default.
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Ana Ioanas (00:06): Welcome everyone to our 11th and last section of our first-time funds video series. My name is Ana Ioanas, I'm an Associaten in Torys' Private Equity Group based in the Montréal office, and I'm here today with my colleague to discuss first-time funds focusing on funds for individuals, also sometimes called retail funds.
Guillaume Lavoie (00:23): Thanks so much, Ana. Hi, everyone. My name is Guillaume Lavoie. I'm a partner in Torys' Private Equity Group. I'm also based in Montréal and as Ana mentioned, we're going to try to describe to you today the particular aspects you need to take into account when you're raising a fund only for individual investors.
Ana Ioanas (00:40): Thanks, Guillaume. So I think you would agree that one of the main concerns when dealing with individual investors is dealing with the liquidity concerns of those investors, which will generally have stronger liquidity needs. A pension fund or a large institutional investor is able to invest large amounts indefinitely. But individuals—even if we're talking about high-net-worth investors—will not necessarily have the same ability to let their capital be managed for one or more decades. Managers definitely need to take into account when deciding how to structure the fund.
Guillaume Lavoie (01:12): I definitely agree, Ana, on that. So that means you'll need to structure your fund, taking into account the liquidity of your underlying investment. Historically, that's why most retail funds used to invest in very liquid securities. So on capital markets, for example. But over the last decade, we saw more and more retail and access funds being created in a structure to invest in the alternative investment class of assets, so in private equity and venture capital. Obviously if your fund is investing in a startup, for example, if your investor has high liquidity needs, you might not be able to get the capital back from your your startup in which you invested when needed. So you need to make sure that you're allowing your funds liquidity with your underlying assets. And the way it's often being done is structuring the fund as a closed-end fund. And I'll let Ana explain a little bit more what that means.
Ana Ioanas (02:00): Thank you. So a closed-end fund is a fund with a limited life, so what usually is 10 years, but without redemption rights Investors are entirely captive during that time. There aren't really any circumstances where they can get out. The details of that typical structure was explained in more detail in the fifth section by our colleagues, Mitchell and Bernard. But there are ways to provide redemption rights subject to redemption restrictions and have different structures. But with these, cash flow must be managed carefully, and you should consult us to really carefully structure these rights.
Guillaume Lavoie (02:34): Now, switching to another concern that's very important with respect to the individual is the default risk. Contrarily to institutional investors, if you're dealing with individuals, they may not necessarily have a dedicated team responsible of monitoring and responding to communication they receive from the funds they invest in. That means that if your fund is structured as the institutional investor funds are typically structured, in a way where you call all your capital over a certain period of time on a as-needed basis, you may find yourself in the situation where one of your investors might actually be more likely to default, even if it's only inadvertently. If you're faced in such a situation where you need the capital very badly to invest it in your assets, that might put you in a difficult situation. So because of that reason, retail funds often structure the deployment of the capital in a slightly different way, asking the investor to contribute their capital upfront at the moment where they subscribe into the fund. That's often the easiest way to deal with a risk of default. In the meantime, you put the cash that you've received in very liquid investment or in cash investment to make sure you have it available when you need it.
Ana Ioanas (03:48): Yeah, so the fast and the easiest way. But alternatively, a manager can take the risk of default and simply rely on a bit longer capital call by a notice period. So the typical capital call is usually ten business days prior to the cash being required, but a longer period can be granted. So if the cash is not transferred at the required date, investors must have been adequately warned that they will be in default and usually fund structures will have very harsh default provisions.
Guillaume Lavoie (04:18): Another way to deal with the risk if that option is available for you, so if you're a larger fund, more sophisticated investor, for certain types of access funds, is using a bridge facility. That means that you are going to be able to borrow the money that you need when you're ready to deploy it, giving you more flexibility on the timing of your capital call and particularly more flexibility if you face a situation where one of your investors is in default.
Ana Ioanas (04:44): Another large risk of default was the tax status of the investors. So often the fund will need for various reasons to qualify as a Canadian resident or Canadian partnership under Canadian tax laws, all of its investors must be Canadian residents. So it's really important to monitor the tax status of your investors in case one of them spends one too many days in Florida and loses their Canadian resident status under the tax laws during the life of the fund.
Guillaume Lavoie (05:10): And because of that particular risk, that will mean that contrarily to a typical institutional investor fund, you will probably need to rely on more than simply the standard representation that we would normally find in a subscription agreement with the investor preserves that it's a Canadian tax resident register deduction. So that likely means that you will need to have a stronger punitive or default provision for such a situation. And in particular the situation that was mentioned by Ana, for example, our change of tax residency because the best person to monitor the tax status is always the individual investor themselves. So you want to make sure that the failure of doing so is going to be so punitive that is going to discourage them to violate the representation that they're making to the fund. We can advise you obviously to the way to tailor that to your particular situation.
Ana Ioanas (06:04): Thank you, Guillaume. So these were the main points we wanted to highlight and we hope that was helpful for you guys.
Guillaume Lavoie (06:11): Thanks, everyone.
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