Unlike most hedge funds, the investment holdings of private equity and venture capital funds typically are not liquid. Consequently, private equity and venture capital funds usually do not have any redemption rights and are organized to have a limited life cycle, often in the range of 7 to 15 years. During this life cycle, the fund manager will raise the capital for the fund, deploy that capital into investments, hold those investments, and then sell those investments and return the capital to the fund’s investors. This activity occurs over several distinct phases – the marketing period, the commitment period, and the post-commitment period.
The Marketing Period
The first task of a manager of a new fund is to raise the capital for the fund. This process begins before the formation of the fund. The manager will determine the terms of the fund and have legal counsel draft the offering documents (which include the limited partnership agreement, the private placement memorandum, and the subscription agreements). Then, it will approach potential investors and when it has obtained sufficient investor interest, it will hold an initial closing for the fund, at which the fund will commence its operations and the initial investors will be admitted as partners in the fund. However, in many funds, the marketing period continues past the initial closing, typically anywhere from 6 to 18 months, so the fund can amass additional capital in subsequent closings. The Marketing period can end earlier if the fund reaches its preset fundraising cap.
The Commitment Period
The commitment period, also called the investment period, marks the official start of the fund’s operations. It starts once the initial closing is completed. Because marketing typically continues past the first closing, there is often some overlap between the marketing period and the commitment period.<
The commitment period is when the fund manager actually starts deploying the fund’s capital into investments. Throughout this period, the manager is sourcing new investments and calling on capital from investors as needed on a deal-by-deal basis to fund each new investment. Except as described below, this is the only period of the fund during which the fund manager can freely enter into new investments on behalf of the fund. The limited investment period typically lasts for 4 to 6 years after the initial closing.
The Post-Commitment Period
The post-commitment period, also commonly referred to as the divestment period, is when the fund manager holds and then liquidates the fund’s investments. The liquidation doesn’t happen all at once. Rather, there are typically a series of liquidations over the course of several years. The divestment period usually lasts anywhere from 4 to 7 years after the end of the investment period.
In contrast to the commitment period, new investments are largely prohibited during the post-commitment period. Generally speaking, under the terms of the fund’s limited partnership agreement, during this time the fund manager is not allowed to cause the fund to invest into new companies, except in certain circumstances, such as follow-on investments in the already existing investments or investments to which the fund committed prior to the end of the investment period.
Many limited partnership agreements provide that the fund manager has some ability to extend the term of the fund for certain limited periods. The terms of these extensions vary significantly in various ways, such as the number of times the fund manager may extend (often 1-3 times), how long each extension is (often 1-2 years), and whether the fund manager must obtain the investors’ consent to the extension. The extensions are often useful to help the fund manager obtain the best return on the fund’s investments, as the process of divesting interests in private companies can take a significant amount of time.
Dissolution and Liquidation
At the end of the post-commitment period, unless the fund’s term is extended, the fund will be dissolved, at which point, all remaining investments must be liquidated by the fund manager, and the proceeds distributed to investors and the fund manager according to the terms of a pre-arranged distribution waterfall.
Choosing an Appropriate Term for a Fund
Private equity and venture capital funds vary significantly in their investment strategies and consequently the length of these various phases and the entire term of the fund will also vary. A fund’s individual investment program will determine the appropriate length for the commitment and post-commitment periods.
For example, a fund that invests in quickly maturing or relatively liquid investments might find it preferable to have a shorter investment period. Conversely, a fund that makes investments with a longer time horizon like emerging growth companies or real estate will likely see a longer investment period.
It’s not uncommon for marketing considerations to dictate the time periods the manager will pick for each phase of the fund’s life cycle. Shorter terms are generally more attractive to investors because they mean a quicker return on capital. However, if the term seems too short to meet the fund’s objectives, sophisticated investors may be reluctant to invest. Determining the correct length of each phase of the term requires balancing the amount of time that will allow for maximum returns on the underlying investments while allowing investors to see returns as quickly as is practicable.
© 2017 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.