Venture Capital Fund Lifecycle
Venture capital funds typically have long tenures, beginning the first closing and running for 8-10 years. Fund managers usually seek pre-determined extension periods (2-3 years for example) to allow them for a smooth exit from all investments.
Early termination is also possible, based on certain trigger events.
The lifecycle of a venture capital fund comprises:
- Investment period; and
- Divestment period.
Successful fundraising takes time and a successful closing is a factor of many variables, such as the economic outlook, the objectives and target sectors and geographies of the fund, and the track record and experience of the fund manager. It also depends on the network of the placement agents and distributors, and their relationships with institutional and professional investors.
Generally speaking, most private funds can only be distributed to qualified investors. In the case of the UAE, qualified investors have varying definitions. The SCA considers Qualified Investors to be Federal institutions, government and international bodies, and corporates and individuals that meet certain net asset criteria.
The DIFC and the ADGM have similar requirements, with the net asset criteria varying from US$ 500,000 in the ADGM, to US$ 1million in the DIFC.
Marketing of private funds to retail investors is not allowed, and adequate disclaimers are expected to be made on all marketing and promotional material of the fund.
The regulators are also particular on the mode of distribution. For instance, marketing material of the fund may not be presented at public gatherings or conferences, since there would be no practical way of pre-screening potential viewers of these documents. General solicitation is prohibited.
Finally, funds conducting capital raisings in non-UAE jurisdictions, including the GCC, should consult with local counsel as appropriate to ensure compliance with applicable local securities laws.
Many venture capital funds use placement agents and distributors to market their funds. Such agents introduce the fund manager to potential institutional and high-networth investors, to place interests in the fund. A placement agent agreement lays out the detailed terms related to this arrangement, and this agreement includes the scope of the services provided, the commission rate, and other clauses such as exclusivity and geographical restrictions of the placement.
Such placement agents are themselves required to be regulated. In case of the UAE mainland, they would have to seek license from the SCA, and in case of the DIFC and the ADGM, they would have to be licensed as investment advisors and arrangers.
Venture capital funds are usually closed-ended structures. The first closing of a fund occurs when the fund manager reaches it’s capital raising target, say US$ 10 million. Subsequent closings may also be held at intervals throughout the fundraising period. These usually end twelve to eighteen months after the initial closing, or when the fund reaches it’s fundraising caps, as specified in the fund’s prospectus.
At each closing, investors submit their capital commitments by executing a detailed subscription agreement and other documents that are required by the fund manager in order to subscribe to units of the fund.
Investors in VC funds do not fund their commitments all at once. There is an initial drawdown (usually 25%) and further drawdowns as requested by the fund manager on an as-needed basis.
During the investment period, the fund manager sources potential investments for the fund, and typically calls for committed capital on a deal-by-deal basis. These monies are then used to secure the investment in the identified portfolio companies, and also pay for the expenses of the fund.
Since potential investments cannot be identified all at once, and it takes time for the right deals at the right price, most venture capital funds have investment periods ranging from 3 to six years from the end of the fund’s fundraising period.
The fund manager may be permitted to acquire new investments even outside the investment period, but this would be to a limited extent, given that the deal may not mature in time for the divestment.
Unlike trading funds, VC investments cannot be divested all at one time. The fund manager monitors investments in portfolio companies, and determines the right time to exit such investments. Typically, the divestment period can range from three to five years, following the investment period.
There are no capital calls after the investment period, except for investments that were already committed to, pre-determined follow-up investments in existing portfolio companies and expenses that were already communicated in advance.
The divestment period ends with the distributions to the investors and the fund manager, in accordance with the distribution waterfall.
While the tenure of the fund is intended to be long, there are some events that can trigger an early termination.
Key Person Events:
One or more individuals who are considered critical to the execution of the fund’s strategy are called ‘key persons’. Key person events vary from fund to fund, but generally when triggered these events cause a suspension of the fund’s investment period. If triggered, the fund is prevented from making new investments until a sufficient number of new key persons are appointed to the satisfaction of the investors.
Removal for cause:
Fund management agreements also allow investors in the fund to replace the fund manager or, in extreme cases, trigger the liquidation of the fund, for ‘cause’. Such causes are material events that can challenge the ability of the fund manager to manage the fund, and include fraud, wilful misconduct, gross negligence or regulatory violations.
Fund constitutions also contain provisions wherein a supermajority (usually 75% of total capital commitments) of the investors can replace the fund manager or dissolve the fund. These provisions serve as safeguards in instances where an overwhelming majority of the investors do not wish to continue the fund or wish to change the fund manager.
Conflicts of Interest:
Fund managers of venture capital funds usually manage more than one fund at a time. They may also carry out other financial service activities, such as investment advisory and portfolio management services. The Private Placement Memorandum of the fund lists out the conflicts of interest and the measures adopted to mitigate them, and the fund management agreement also has clauses that address such conflicts.
Some fund management agreements may contain restrictive provisions that call for right of first look on potential investments and details on possible co-investments, but in most cases, this may not be practical given that an exhaustive list of possible future funds may not be feasible.
Usually, the fund documents disclose potential conflicts and are present more as disclaimers than actually addressable points of discussion.
Transactions with affiliates can also lead to potential conflicts of interest, including instances where the affiliates of the fund manager are engaged as service providers to the fund, or act as creditors or lenders to one of the fund’s portfolio companies. These are also addressed in the fund documents.
Some fund management agreements can call for exclusivity, thus preventing the fund manager from setting up and operating funds of a similar nature or objective. This does make sense, given that investors would not want the fund manager to source deals for other funds, that could otherwise have been sourced for the fund in question.
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