Angel Funds |
Fund structures
There are two common structures used for equity funds: limited partnerships and open-ended corporate structures. Institutionally backed venture capital funds are virtually all limited partnerships. In the past few years, most other new equity funds including angel funds, non-institutionally back venture funds and mutual funds have predominately been corporate structures. There are several reasons for the recent increase in popularity of the corporate structure.
Institutionally Backed Venture Funds – Limited Partnerships
Institutionally backed venture funds operate differently from other funds in several ways. First, the institutions don’t advance all of the capital at once. When you hear that a venture fund has raised $50 million, their institutional backers have committed $50 million but may have only advanced them $10 million. As the fund manager makes investments, they make ‘capital calls’ or ‘draw downs’ on the institutions to advance more capital. Interestingly, they get to charge their management fee, typically around 2.5%, on the full $50 million, even from the outset. This structure works well because the institutions are reliable in contributing the additional cash when the fund managers are ready to deploy it. In the meantime, the institutions can invest that capital elsewhere, making their overall returns better than if they advanced the entire amount to the venture fund manager who would have much of it still in cash, even a few years later.
The fund also only gets to deploy the capital once. They make an investment and when there is an exit, they distribute all of the proceeds, less the fund company’s 20% performance fee (or carry) back to their institutional limited partners. An interesting effect of this mechanism is that venture fund managers cannot really afford to invest in low risk opportunities that might deliver a 3 or 5 times return in three years. To succeed, they need to invest in the highest return opportunities, ones that they hope will return 10x or 100x over 7 to 10 years.
Another very important distinction in comparing funds is to remember that virtually all institutions are tax exempt.
One result of this structure is relatively high up-front losses. Charging 2.5% on a ‘$50 million fund’ that actually only has $10 million in it means that the real, cash on cash, expense ratio is more like five times 2.5% or something around 12.5% per year. Additionally, because the managers are planning for liquidity events in the 7 to 10 year timeframe, these losses can be very significant compounded over the years before the liquidity events. In this situation, being able to shift these significant losses back to the investors can be a significant benefit.
In summary, because of the ‘use capital once and return it’ structure, higher up front losses, incremental ‘draw downs’ and tax exempt investors, the best structure for a institutionally backed venture fund is a limited partnership.
Other Equity Funds – Use a Corporate Structure
Over the past five years or so, other equity funds have increasingly been corporate structures.
It’s not reliable to use ‘capital calls’ with non-institutional investors
Funds which have larger number of non-institutional shareholders cannot practically structure a fund where the investors are committing to more capital than they are actually investing in the fund at the outset. There have been funds that did try this, probably due to the fund managers and lawyers familiarity with institutionally backed limited partnerships. Over the years, there have been lots of stories about those funds getting into difficulty when they made capital calls on their non-institutional investors. In some cases, the investors just didn’t have the capital when the fund managers needed it. In others, they did not have the inclination – sometimes because they were uneasy about the early losses in the fund. When only some of the investors honored the capital call it created significant accounting and ethical issues for the fund managers – especially when the fund was not performing as initially expected.
Better Returns and Lower Fees
The challenges with non-institutional capital calls led some funds to raise all of the cash at the outset. Raising a full $50 million before making any investments meant the managers could charge their management fee on all of the capital from the beginning without distorting the annual expense ratios. The fund managers usually kept the excess cash in save ‘treasury management’ type investments like T-bills or good quality bonds.
From the investors’ perspective, that was the worst of all worlds: they were paying high fees for fund managers to manage their cash and their funds were not performing well – at least for the first several years. It was also a significant disadvantage to the fund managers because it is now increasingly popular to build in a ‘hurdle rate’ return which has to be achieved before the fund managers can earn any of their carry. For example, a typically management performance incentive, or carry, is 20% of the gains in the fund above an 8% compounded return. If most of the funds capital is in cash for the first few years, it makes it much more difficult to hit the hurdle return and start to earn 20% of the gains.
The open ended corporate structure allows the fund managers to manage their non-performing cash balance by raise capital as they find opportunities to deploy it. This provides the managers a much better opportunity to maximize their returns and to earn a share of the gains above the hurdle rate.
Recent Capital Gains Tax Improvements
One reason for the relatively recent popularity of corporate structures is the lower capital gains tax rate introduced in 2000 and better tax integration. These mean that some of the previous tax disadvantages of corporate structures have been significantly mitigated.
RRSP Eligibility
Some high net worth investors now have many millions in their RRSPs. It’s a relatively simple matter to invest in a corporate structure from an RRSP, but I believe it’s relatively difficult to get a limited partnership fund to qualify as an RRSP eligible investment. Two ways limited partnerships can qualify is if the units are listed on a stock exchange or if they qualify as a ‘small business investment limited partnership.’
Lower Early Losses
Many new angel funds and venture funds are not incurring any significant up front losses. Some good examples are at www.angel-funds.com. If the funds are not expecting to have significant losses, it eliminates one of the biggest potential benefits of the limited partnership structure. This is because there are no significant losses to distribute and because the fund would have taken advantage of the losses pretty quickly as their earlier exits started to be realized.
More Familiar Structure
Many high net worth investors are not familiar with the mechanics of limited partnerships, but almost all are familiar with how corporations work. Regardless of their familiarity, a corporate structure is much simpler for the investors because they won’t have to make an annual tax filing to include the gains or losses every year like they would in with a limited partnership.
Simpler Accounting and Lower Costs
The accounting and tax filings for a corporation are much simpler than for a limited partnership. This keeps direct expenses much lower, but it also significantly reduces the indirect costs of communicating with investors regarding their questions about the annual tax filings associated with a limited partnership.
Simpler Structure for Management Performance or Carry
A corporation also provides for a simpler way to structure and pay the management performance incentive, or ‘carry’. This participation can be structured as shares in the fund. This mechanism allows the managers to receive very favorable tax treatment on their share of the gains.
Tax Free Switching Between Funds and Cross Fund Tax Deferral
A big advantage of the corporate structure is that managers can set up multiple funds under one corporate structure. This allows the investors to switch between funds without triggering a tax payment. A multi-fund corporate structure also allows the losses in one fund to shelter the gains in another.
Tax Efficiency
The question of whether a corporate structure or a limited partnership is more efficient from a tax perspective is complicated. It depends significantly on the taxability of the investor.
If the fund really is an equity investor, it should be reasonably easy to ensure the fund is not a ‘trader’ and therefore will enjoy capital gains tax treatment at the fund level.
Taxation of limited partnerships is complicated. Gains can be income, dividends or capital gains depending on a number of facts.
In most countries today, tax integration is fully implemented. This means that the overall, final tax rate on capital gains in either corporate funds or limited partnerships will be almost perfectly equal to the tax rate an investor would have paid if the investment were held individually.
Another advantage of the corporate structure is that the fund can be structured so taxable and non-taxable shareholders (for example in RRSPs) can have different classes of shares. This allows the dividends to be streamed to the taxable and non-taxable shareholders differently, producing a significant decrease in overall tax and an enhancement in fund returns for all shareholders.
Summary
For non-institutionally backed funds, the corporate open-ended structure is simpler, easier to account for, has lower expenses and can produce higher returns. The tax advantages, or disadvantages, depend significantly on the investor but the corporate structure is probably more tax efficient due to the ability to stream dividends differently to taxable and non-taxable shareholders.