You’ve said that insurance would be ideal for a GP. Why should a GP that’s just starting out bother to take out an insurance policy?
TA: We’ll just focus on a GP setting up a fund. Typically there are indemnifications in the Limited Partner Agreement “LPA.” If an LP sues the GP, then the fund has to cover the legal fees, which protects the GP but would cause his returns to be reduced.
There is a GPL insurance, or general partner liability insurance which would cover the GP in case of a suit not covered by the indemnification in the LPA. The GP would just have to pay the deductible if there was a lawsuit.
There’s also error and omissions policies. There could be an issue with the PPM, where the advisor had strategy drift and is sued by the LPs. The previously mentioned policies would cover that type of lawsuit. If one of the advisors becomes director of a portfolio company, then you would need D&O [directors and officers] insurance for that individual. Obviously sexual harassment claims have been in the news, so you should have employment practices liability insurance.
Does that mean to say GPs are better served spending their time focusing on issues more important to them, such as raising money for the funds?
TA: Their main concern is raising money, doing deals. Typically the advisors spin out of a larger fund, and they’ve never dealt with these operating issues. Now they are actually setting up their own business. One of the items you need to know about is the various types of liability insurance.
That is just one of the items that we discuss with the GPs.
How big of an insurance policy should be taken out?
TA: Insurance depends on the size of the fund. There are some insurance companies that won’t write anything less than $10 million. But if you raised a billion-dollar fund, you’re going to need a lot more coverage than $10 million. It really depends on the size of the fund.
What kind of firms are out there that would provide insurance?
TA: There are insurance companies like Aon, Chubb, Travelers. Some of them have private equity groups. So they’ll not only cover the funds insurance needs, but they’ll also place deal insurance to protect against a deal falling through. You could be covered for legal costs relating to lawsuits surrounding the deal. The insurance companies try to wrap their policies around the fund and its portfolio companies.
Raising money and seeing through the life of that fund usually ends up being a long-term commitment. Should GPs establish some sort of estate planning?
TA: It’s not a necessity. It’s something that we discuss with the GPs when we meet them. When you start your fund, your attorneys will set up the fund, which does the investing, a management company, which is typically the investment advisor and collects the management fee, and the GP, which collects the carry.
The management company covers expenses such as employees, rent, systems, software. The fund manager generates a management fee paid from the fund, typically 2 percent of committed capital, which is supposed to cover the expenses in the management company. The GP entity usually gets allocated 20% of the increase in the value of the LP’s holdings.
Depending on what stage the advisor is in his life, it may make sense to carve out some of the carry and put it in a trust for his children. If he or she does it at the start of the fund the value of the gift will be relatively low compared to if it is done once fund II comes into play.
As your business grows and you have fund two and fund three, that carry can becomes a large number. The money allocated to your children is taken out of the GP’s estate. Estate planning is another item we discuss at the start of a fund with the GP. The GP may not have focused on this issue. It’s just something they should think about.
In what capacity would Withum serve in helping with estate planning?
TA: We can do the planning, but an attorney would draft the wills and trust documents. There are a number of attorneys we work with who can assist us with that process. Typically, we deal with tax structural issues of the estate and trust not the document formation.
How should GPs think in terms of outsourcing services so that they could focus on raising funds and investing?
TA: What we discuss with them when they’re setting up their fund is to have enough capital to cover the costs for a year. Some of the expenses you need to cover are rent, health insurance payroll, furniture and fixtures, IT systems and security deposit on your lease. You won’t be receiving your management fee during your fundraising period. There are a lot of costs to cover until you get to your first close.
Those are a lot of things to consider for GPs. What other challenges might they face when outsourcing?
TA: On smaller funds, the GP may not hire an outsourced administrator or a CFO, but instead designate the GP as the CFO. The GP will be responsible for keeping the books and records and working on the audit with their auditors. However, this isn’t the best use of the GP’s time. It also could delay the release of the K-1s or the audit because the GP is tied up with a deal and can’t respond to auditor requests. The GP may not know accounting and may miss something key to the audit.
Hiring a CFO and other full-time staff can be expensive when starting a fund. How would someone go about in hiring someone to do the work of a CFO?
TA: We try and get the GPs to bring in a part-time CFO. We have a number of outsourced CFOs that we work with.
If you are lucky enough to attract institutional investors, they would like to see a professionally run organization. That would include having an outside administrator and CFO.
They have a checklist called a due diligence questionnaire, or DDQ. One of the questions on the questionnaire is do you have an outside administrator. They want a third party creating the books and records or being a second set of eyes on the internal record keeping.
Outside administrators do not rubber stamp the information supplied by the fund; they question certain items and will not finalize the books unless they’re comfortable with the information they receive from the GP and verify the accuracy.
If your fund gets large enough and you can hire an administrator, they’ll interact with the auditor and the tax preparer to give the information they need to prepare the audit and the K-1s and the 1065 for the funds.
As a GP you need to remove yourself from the CFO role. Otherwise, you’ll be spending too much time dealing with administrative functions.
What’s more valuable? Your time looking at deals and fundraising, or your time performing accounting work and answering questions from the auditor?
I think the answer is obvious.
This article was sponsored by WithumSmith+Brown and first appeared in the May issue of pfm.
For the video series on setting up a GP, click here.