Managers of private alternative funds, such as real estate, private equity, infrastructure and debt funds, that are approaching the end of their life are now faced with the inevitable "what next?" question. Plans to sell the few remaining assets, liquidate the fund and reap the benefits of the carried interest arrangements have been put on hold as Covid-19 stifles transactional activity, depresses market values and slows down the raising of the next generation of funds.
For many managers, the immediate response is to extend the life of the fund, weather the storm and exit, possibly at a lower rate of return, once Covid-19 blows over. Some will look to change management fee arrangements and others may seek to restructure the carry so that the management team remain incentivised during the doldrums.
Some managers will start to think about GP led restructuring, including creating a "tail" fund to enable the existing fund to sell its assets and be wound up, while offering certain investors the opportunity to continue to invest in the remaining assets. Typically, the fund manager is appointed as the manager of the tail fund and the assets are sold between the existing fund and the tail fund on an arm's-length basis. Those investors who no longer wish to invest in the assets can realise their investment as part of the liquidation process, while those who still believe in the investment thesis can invest in the tail fund often on more beneficial terms.
For managers considering tail funds, however, the pitfalls are plenty and the benefits may not be as obvious as they first appear. So what are the challenges?
The creation of a tail fund creates obvious conflicts. The fund manager will be both the manager of the existing fund and of the new tail fund. While the assets being sold between the funds are likely to be subject to an independent valuation, the manner in which the valuation is instructed, the knowledge of the manager and the thoroughness of due diligence undertaken by the tail fund all create potential conflict issues. These become even more pertinent if the tail fund has third-party investors or investors whose economic stakes change and who may be less prepared to accept the assumption that they "know" the assets and the risks attached to them.
Even where a third-party valuation is instructed, how accurate will it be? Asset values have been significantly impacted by Covid-19. Unless the existing fund actually takes the assets to market, how will a true arm's-length value properly be determined? Valuers are not prepared to underwrite their values and selling investors will naturally want to ensure that they are selling for the best price, with tail fund investors not wishing to overpay. Where a tail fund is the most obvious buyer for assets, will third parties really be interested in conducting due diligence and entering into a costly sales process only to find that they are pipped at the line by the tail fund? This is particularly the case if the tail fund has rights of first offer or last refusal.
To be a success, the tail fund needs highly motivated members of the management team to run it. But who wants to run a fund with a few possibly illiquid or time-intensive assets? This is particularly true if the carry arrangements of the existing fund have fallen short of expectations and those of the tail fund are miserly. Convincing investors to give up a proportion of their profits in a situation where the original fund returns have not been met can be challenging, but unless the management team are suitably incentivised there is little point in investors backing a tail fund.
Is the manager actually able to raise a tail fund? Many managers will have raised new funds since the original fund was launched. Those new funds might still be in their investment period, during which the manager is typically prevented from raising a competing fund. Depending on the wording of the fund documents, the tail fund, as unlikely as it may seem, might constitute a competing fund, preventing the manager from raising it or, at the very least, requiring the manager to get the consent of its investor base.
All of these challenges can be overcome with foresight and planning, but, for fund managers embarking on a tail fund process for the first time, knowing what is around the corner can be a daunting prospect. A detailed review of existing documentation, a forensic roadmap and early, open and honest communication with investors are all vitally important. Tail funds can unlock, in the right situation, the malaise brought about by Covid-19, but, as the end of the life of a fund approaches, they require managers to look up, step back and deliver a solution that will appeal to exiting and continuing investors alike – and that's no easy task.