The answer is, in many cases, Delaware or the Cayman Islands. For managers seeking reputable institutional capital across the United States, Europe, Asia, Latin America, the Middle East and elsewhere, those two jurisdictions continue to be the most familiar and commonly accepted fund domiciles for many private equity and venture capital strategies.

But the analysis has become more nuanced in recent times.

Cayman funds are now subject to a more developed private funds regulatory regime than was the case historically. US national security regulation has become more important for funds investing in sensitive technologies, critical infrastructure, data-rich businesses or China-related opportunities. The US Corporate Transparency Act, which for a period was expected to create broad beneficial ownership reporting obligations for US entities, was narrowed substantially by the Financial Crimes Enforcement Network (FinCEN) March 2025 interim final rule, so that US-formed entities are currently exempt, and only certain foreign entities registered to do business in a US jurisdiction remain within the federal beneficial ownership information (BOI) reporting regime. The US outbound investment regime is now a live consideration for some cross-border technology strategies. European fundraising sometimes points managers toward Luxembourg or Ireland. Singapore, Mauritius and other jurisdictions may be relevant where a fund has a particular geographic strategy or tax treaty rationale. And yet, for many managers raising institutional private equity or venture capital funds with a meaningful US nexus, the practical question often remains the same: Should the main fund be Delaware, Cayman or some combination of the two?

This article is intended as a primer. It is not a substitute for a structuring discussion with legal and tax counsel, and it necessarily simplifies a number of issues that can become highly technical. But it should help identify the principal commercial, cost, regulatory and tax considerations that usually drive the domicile decision.

The short list is still usually Delaware versus Cayman

A fund’s domicile should follow its actual facts. A manager raising primarily from US taxable and US tax-exempt investors and investing mainly in US portfolio companies will often find Delaware to be the simplest and most efficient answer. A manager raising substantial non-US capital, investing globally or seeking to accommodate non-US investors that prefer not to receive US tax reporting may have stronger reasons to consider Cayman.

There are, however, situations where a more localized jurisdictional analysis is appropriate. A manager raising primarily from family offices in Southeast Asia may reasonably consider a Singapore structure. A manager investing substantially in India may need to consider Mauritius, Singapore or other treaty-oriented structures, recognizing that India treaty planning has become more complex and fact-dependent in recent years. For example, India-focused private equity and venture capital funds have historically considered Mauritius and Singapore structures for capital gains and other tax treaty reasons, although recent Indian tax developments, including the Supreme Court of India’s 2026 Tiger Global decision, underscore that treaty access cannot be assumed merely because a holding vehicle is organized in a treaty jurisdiction. A manager with a strategy involving European institutional capital may consider Luxembourg or Ireland, particularly where access to the EU marketing passport or an EU onshore fund product is commercially important. A manager investing in particular categories of income-producing assets, credit, infrastructure, real estate, royalty streams or natural resources may find that the analysis differs from the typical early-stage venture analysis.

Those situations should not be ignored. They are often the point of the structuring exercise. A domicile that is unnecessary or overly complicated for a generalist US venture fund may be essential for a fund investing into a particular country or asset class. If there is a specific tax treaty, regulatory, marketing, currency-control, local licensing or investor eligibility issue, that specific issue may override the usual Delaware versus Cayman analysis.

For many private equity and venture capital funds, however, Delaware and Cayman remain the most common starting points. The main decision is often Delaware versus Cayman, sometimes with parallel funds, feeders, blockers or alternative investment vehicles used to solve specific investor or investment issues.

A note for managers outside the United States

Although much of this article focuses on funds with a US nexus, the analysis is not limited to US-based managers.

We regularly see managers located outside the United States – including managers in Asia, Latin America, Europe and the Middle East – consider Delaware and Cayman structures. The right answer for those managers depends on a more global set of facts: where the manager and investment team are located, where the investors are located, where the portfolio companies are located, whether US taxable or US tax-exempt investors are expected, whether the strategy involves US portfolio investments, whether local licensing or marketing rules apply, and whether tax treaty access is relevant.

For a manager based in Singapore, Abu Dhabi, London, São Paulo, Mexico City, Hong Kong, Tokyo, Beijing, Mumbai or elsewhere, Delaware and Cayman may still be highly relevant. Cayman may be attractive as a neutral international fund domicile familiar to global investors. Delaware may be appropriate where the fund expects significant US investors, US portfolio investments or US tax reporting in any event.

The important point is that a non-US manager should not assume that “offshore” automatically means Cayman, nor should a US-based manager assume Delaware and move forward. The fund’s structure should be designed around the manager’s actual fundraising market, investment mandate and operating footprint.

Commercial issues

Commercially, reputable institutional investors globally are generally familiar with both Delaware and Cayman funds. A sophisticated investor is unlikely to be surprised by either choice. As a general matter, investors that regularly invest in private equity and venture capital funds will have seen Delaware limited partnerships, Cayman exempted limited partnerships, Cayman feeder funds, Cayman parallel funds and hybrid structures.

That does not mean the choice is commercially irrelevant.

Some non-US investors view Delaware as putting them too close to the US tax and reporting system. This may be true even where, as a technical matter, the investor’s US tax filing obligations would be driven by the character of the fund’s income rather than by the mere receipt of a Schedule K-1. Investor perception matters. Some investors simply do not want to invest directly into a US partnership unless there is a strong reason to do so.

Conversely, some investors continue to have a perception concern with Cayman. In some markets, particularly some European markets, Cayman is still viewed by certain investment committees, public institutions, corporate investors or family offices as carrying reputational baggage because it is an offshore jurisdiction. That concern is often more about optics, internal policy or political sensitivity than about the actual legal or regulatory quality of the jurisdiction. The Cayman Islands’ regulatory infrastructure for private funds, anti-money laundering/know your customer (AML/KYC), Foreign Account Tax Compliance Act (FATCA) and Common Reporting Standard (CRS) reporting is far more developed than the casual “tax haven” label suggests – and frankly more so than Delaware. The Cayman Islands also is not currently on the EU list of noncooperative jurisdictions for tax purposes; the Council of the European Union’s February 2026 list includes 10 jurisdictions, and Cayman is not among them. Still, some institutions, government-related investors, development finance institutions, pension plans, corporate strategic investors or regulated financial institutions may have internal policies or reputational sensitivities that make a Cayman fund more difficult.

This is the first practical point: The domicile decision should not be made in the abstract. Managers should map the likely investor base. If the fund is expected to be raised mostly from US individuals, US family offices, US funds of funds, US endowments, US foundations and other US institutions, Delaware may be the default. If the fund is expected to include substantial non-US investors, particularly investors that are sensitive to US tax forms or US partnership reporting, Cayman may deserve stronger consideration. If the fund expects material capital from Europe, Asia, Latin America or the Middle East, the manager should ask not merely whether those investors can invest in Delaware or Cayman, but whether a different structure would materially reduce friction with anchor investors or local regulatory expectations. If a small number of important investors have strong preferences, the fund structure may need to accommodate them through a feeder, parallel fund, blocker or alternative investment vehicle.

The second practical point is that true commercial “deal breakers” are less common than managers sometimes fear. A strong manager with meaningful demand can usually raise capital through either Delaware or Cayman. The choice more often affects friction, disclosure, investor comfort, tax administration and future flexibility than whether the fund can be raised at all.

Administrative, cost and adviser regulatory issues

Cayman is usually more expensive and administratively more involved than Delaware at the fund-vehicle level. That remains true, more so today than it was before the Cayman Private Funds Act regime became part of the standard operating environment in recent years.

A Delaware limited partnership is familiar, relatively quick to form, inexpensive to maintain, and deeply embedded in US private equity and venture capital practice. The legal documentation, tax reporting, subscription process, banking process and fund administration ecosystem are all well developed. For a smaller or first-time manager with a largely US investor base, simplicity and cost can matter a great deal.

That does not mean, however, that choosing a Delaware fund means being unregulated. For many managers, the more important US regulatory question is not the domicile of the fund vehicle, but the status of the investment adviser. A manager with a US office, US personnel, US investors or US-directed investment activity may need to analyze whether the manager must register as an investment adviser, may rely on an exemption from registration or must file as an exempt reporting adviser.

This adviser-status analysis is separate from, and often more important than, the Delaware versus Cayman fund domicile question. A US-based manager may need to register with the Securities and Exchange Commission (SEC) or state authorities, or file as an exempt reporting adviser, whether the fund is a Delaware limited partnership or a Cayman exempted limited partnership. A non-US manager may also need to consider US adviser rules if it has US clients or investors, US private fund assets, a US place of business or meaningful US fundraising activity. For example, the SEC’s private fund adviser exemption has different conditions for US and non-US advisers, including a less-than-$150 million private fund assets under management test in the relevant circumstances.

While a Cayman exempted limited partnership benefits from a very sophisticated legal and service provider ecosystem, a Cayman fund will generally require more procedural work at the fund-vehicle level. A Cayman private fund typically must register with the Cayman Islands Monetary Authority, with some exemptions available, and where applicable the Private Funds Act requires an application within 21 days after acceptance of capital commitments and prohibits accepting capital contributions for investment purposes until registration is complete. Cayman private funds also are subject to operating requirements relating to audit, valuation, safekeeping of fund assets, title verification and cash monitoring. The 2025 revision of the Cayman Private Funds Act requires at least annual valuation, sets out who may perform valuation functions and includes safekeeping/title verification and cash monitoring requirements.

These requirements are manageable. Most institutional-quality Cayman private equity and venture capital funds handle them without great difficulty. But they are real requirements, and they add cost, time and a compliance process. By contrast, a Delaware fund will generally be simpler at the fund-vehicle level. That said, as noted above, the manager will still need to consider adviser registration, exempt reporting adviser filings, Form ADV updates and state notice filings. Other requirements, such as those relating to the custody rule, pay-to-play rule, marketing rule, and books and records rule, may also be applicable if the manager is registered or otherwise within the US regulatory perimeter.

As a rough practical matter, Cayman should not be chosen merely because it sounds more “international,” and Delaware should not be chosen merely because it sounds less regulated. If the investor base, investment strategy and tax analysis do not support Cayman, the additional fund-level process may not be worth it. On the other hand, where Cayman solves real investor, tax or cross-border structuring issues, the incremental cost is usually not determinative for an institutional fund. In either case, the manager should analyze both layers: the regulation of the fund vehicle and the regulation of the adviser.

Other regulatory issues

Regulatory considerations rarely start as the primary driver of the domicile decision for a plain-vanilla private equity or venture capital fund. Tax and investor considerations usually do more work. But regulatory considerations have become more important, especially for managers investing in sensitive technologies, regulated industries, critical infrastructure, data-rich businesses, financial services, digital assets, defense-related companies or China-related opportunities.

CFIUS and US national security review

For funds investing in US businesses, particularly businesses involving critical technology, sensitive personal data, infrastructure, defense, AI, semiconductors, quantum technologies, telecommunications, aerospace, biotechnology or other sensitive sectors, Committee on Foreign Investment in the United States (CFIUS) analysis should be part of the structuring discussion.

The domicile of the fund is not the only relevant fact. CFIUS analysis can turn on control, governance rights, information rights, board or observer rights, foreign person status, limited partner rights, the nature of the portfolio company’s business and other facts. A Cayman fund with significant US management may present a different analysis than a Cayman fund managed and controlled outside the United States. A Delaware fund with substantial non-US investors may still raise CFIUS questions depending on the rights granted and the facts of a particular investment.

The “principal place of business” concept is relevant in this area. The CFIUS regulations define principal place of business, for an investment fund, by reference to where the fund’s activities are primarily directed, controlled or coordinated by or on behalf of the general partner, managing member or equivalent. The list of CFIUS-excepted foreign states currently includes Australia, Canada, New Zealand and the United Kingdom, but for this purpose the United Kingdom does not include British Overseas Territories or Crown Dependencies. This matters because Cayman is a British Overseas Territory, not the United Kingdom, for purposes of that exception.

The practical point is not that every sensitive technology fund must be Delaware. That would be too simplistic. The point is that a manager expecting to invest in sensitive US businesses should not treat domicile as a tax-only question. The fund’s structure, governance rights, investor base, side letter rights and investment strategy should be reviewed together.

US outbound investment rules

There is now also a US outbound investment regime. The Treasury Department’s final outbound investment rule became effective on January 2, 2025, and applies to certain US person investments involving covered persons of a country of concern in specified technology areas: semiconductors and microelectronics, quantum information technologies and AI. The country of concern identified in the program is the People’s Republic of China, including Hong Kong and Macau.

For private equity and venture capital managers, this can matter in at least two ways.

First, a US manager investing directly or indirectly in China-related companies in covered technology sectors may have prohibited transaction or notification issues. Second, US investors investing as limited partners in non-US pooled investment funds may have their own issues if the non-US fund is likely to invest in covered China-related technology companies. The final rule includes an exception for certain limited partner investments of not more than $2 million, aggregated across related investment and co-investment vehicles, or where the US limited partner obtains a binding contractual assurance that its capital will not be used for transactions that would be prohibited or notifiable if engaged in by a US person.

This is not primarily a Delaware versus Cayman rule. It is a US person and covered transaction rule. But it can affect fund structuring, side letter requests, excuse rights, investor diligence, parallel fund arrangements and the design of China or China-adjacent investment programs. A US manager should not assume that forming a Cayman fund moves the issue outside the US regulatory perimeter.

AML, KYC and beneficial ownership

Cayman funds have long required a meaningful AML/KYC process. Cayman funds also typically have FATCA and CRS classification, diligence and reporting obligations.

The US side has also evolved. When the Corporate Transparency Act was first implemented, many US-formed private funds, general partner entities, management companies and related vehicles had to analyze whether they were reporting companies or qualified for exemptions. That analysis changed significantly in March 2025, when FinCEN issued an interim final rule narrowing the BOI reporting regime so that US-formed entities are currently exempt, and only certain foreign entities registered to do business in a US jurisdiction remain subject to BOI reporting.

Separately, FinCEN adopted an investment adviser AML rule, but later postponed the effective date from January 1, 2026, to January 1, 2028, while indicating that it intends to revisit the substance of the rule. Managers should be careful here because the investment adviser AML landscape remains dynamic. Even where a manager is not yet subject to a comprehensive US AML program requirement, institutional investor expectations, bank onboarding, sanctions screening, Cayman requirements and best practices may effectively require a robust AML/KYC process.

The practical lesson is that Cayman is not the “lighter” compliance choice from an AML/KYC perspective. In many cases, it is the more formalized one. Delaware may be simpler at the fund-vehicle level, but managers should expect investor diligence, sanctions screening and bank compliance requirements regardless of domicile.

Tax issues

Tax remains the heart of most domicile decisions.

The following issues are not an exhaustive list, and the analysis can change materially based on the investor base, the manager’s location, the investment strategy, the expected investment geography, the possibility of US effectively connected income, the likelihood of non-US portfolio company investments, treaty planning, blocker structures, co-investment structures, and future continuation or secondary transactions. But the following issues are the ones most often discussed at the beginning of a Delaware versus Cayman analysis.

Issues of highest importance

Requirement for the fund to file a US tax return

A Delaware limited partnership generally files a US partnership tax return on IRS Form 1065 and issues Schedule K-1s to its partners. IRS guidance describes Form 1065 as the form used to report the income of every domestic partnership and every foreign partnership doing business in the United States or receiving income from US sources.

A Cayman exempted limited partnership is a foreign partnership for US tax purposes. Whether it must file a US partnership return depends on the presence of US source income, effectively connected income or other filing triggers. In practice, some Cayman private equity and venture capital funds file US partnership returns and issue US tax reporting to US investors, while others may not file where the tax analysis supports that position.

This can matter greatly to non-US investors. Some non-US investors do not want to receive a US Schedule K-1. They may view it as creating administrative friction or as evidence of unwanted proximity to the US tax system. That perception may persist even where the technical US tax filing analysis is more nuanced. Cayman can be helpful for those investors because, in some structures, US tax reporting may be limited to US taxpayer partners rather than sent to all partners.

This is one of the most common reasons managers consider Cayman.

Withholding documentation the fund must provide to third parties

A Delaware limited partnership is a US entity for US withholding documentation purposes and generally provides a Form W-9 to banks, brokers, portfolio companies, paying agents and other counterparties.

A Cayman partnership is a foreign flow-through entity for US withholding documentation purposes and generally provides a Form W-8IMY. The IRS describes Form W-8IMY as the certificate used by a foreign intermediary, foreign flow-through entity or certain US branches for US withholding and reporting. In many cases, the Form W-8IMY process requires attaching or maintaining underlying withholding documentation for partners and providing a withholding statement.

This difference should not be minimized. It can create awkward disclosure issues when a fund invests into another fund, receives certain US-source payments or interacts with counterparties that insist on complete withholding documentation. A Delaware fund may provide a Form W-9. A Cayman fund may be asked to provide a Form W-8IMY package that reveals more about its investor base than the manager would prefer.

Some Cayman funds resist providing detailed second-layer information. That may be understandable as a business matter, but it should be done only after understanding the withholding and documentation risk. In some cases, the administrative privacy gained by using Cayman at the investor reporting level can be offset by additional disclosure requests in the withholding chain.

Treaty benefits and local tax treatment

Domicile can affect the availability of treaty benefits or the local tax treatment of investments in certain countries. Some countries historically have applied less favorable tax treatment to investors from jurisdictions they view as tax havens or low-tax jurisdictions. Cayman may appear on particular country lists even where it is not on the EU noncooperative jurisdictions list. Delaware, Luxembourg, Ireland, Singapore, Mauritius or another jurisdiction may be better for a particular investment strategy depending on the target country and the treaty network.

For a classic US-focused private equity or venture capital fund, this may not matter much. For a fund investing meaningfully in India, Brazil, China, Southeast Asia, Europe, Africa or other non-US markets, it can matter a great deal. In those cases, the answer may not be simply “Delaware or Cayman.” The answer may involve a main fund, treaty-eligible holding vehicles, alternative investment vehicles, blockers or parallel funds.

India is a useful example. Many India-focused funds have historically considered Mauritius or Singapore structures because of treaty access and investor familiarity. That does not mean Mauritius or Singapore is always the right answer, and recent Indian tax developments have made the analysis more fact specific. The point is broader: A particular country strategy may create a particular tax or regulatory reason to use a jurisdiction that would not otherwise be the default choice.

Managers should be cautious about over-engineering this issue. A treaty structure that solves a theoretical future investment problem can be expensive, slow and unnecessary if the fund ultimately makes only a small number of relevant investments. But managers with a clear geographic investment mandate should address treaty and local tax issues early because retrofitting structure after signing a term sheet can be difficult or impossible.

Issues of lesser but still real importance

Requirement for the fund to act as a withholding agent

A Delaware partnership generally acts as a withholding agent with respect to certain US-source withholdable payments. A Cayman partnership may have different withholding documentation and withholding agent considerations depending on the income and structure.

For many early-stage venture funds, this issue is not usually determinative because venture funds typically do not earn large amounts of US-source interest, dividends or other income subject to withholding. The analysis may be more important for private equity, growth equity, credit, real estate, infrastructure, revenue-interest, royalty or structured equity strategies. A fund that expects current income, dividend recapitalizations, debt instruments, royalties, token income or other nonstandard income streams should consider withholding issues more carefully.

Impact on US taxation of non-US limited partners

The choice between Delaware and Cayman does not, by itself, determine whether a non-US limited partner has a US tax filing obligation. The more important question is whether the fund earns income effectively connected with a US trade or business, or other income that triggers US tax filing or withholding obligations.

Most private equity and venture capital fund agreements with non-US investors contain covenants or operating provisions designed to avoid generating effectively connected income for non-US investors absent consent, excuse mechanics or an appropriate blocker. Those provisions matter in both Delaware and Cayman funds.

In other words, Cayman may reduce certain reporting friction, but it is not a magic shield against US tax consequences. Delaware may create more visible US tax reporting, but it does not necessarily create substantive US tax filing obligations and/or income tax liabilities for non-US investors unless the fund’s income or activities do so.

PFIC issues

Many non-US early-stage companies can be passive foreign investment companies (PFICs) for US tax purposes. US taxpayers investing in PFICs may need information to make a qualified electing fund (QEF) election and satisfy related reporting obligations.

A Delaware fund, as a US partnership, is generally positioned differently from a Cayman fund for these purposes. In broad terms, a Delaware fund may make or facilitate QEF elections at the fund level, while US partners in a Cayman fund may need to make elections at the partner level. Under proposed rules that are not yet in effect, US partners in a US partnership would need to make a QEF election at the partner level, which would make the PFIC reporting rules between Delaware and Cayman funds similar. In either case, the manager will often need to identify potential PFICs and obtain sufficient information from portfolio companies to support US investor reporting.

As a practical matter, the domicile choice affects who bears the tax reporting mechanics (under current law). It does not eliminate the need for PFIC diligence if the fund invests in non-US companies and has US taxable investors.

CFC Issues

Controlled foreign corporation (CFC) issues have historically been a key reason some managers preferred Cayman for non-US investments or formed Cayman alternative investment vehicles alongside Delaware main funds.

The basic issue is that a Delaware fund is a US person for CFC determination purposes, while a Cayman fund is not. A Delaware fund’s ownership in a non-US portfolio company may therefore contribute to CFC status in ways that a Cayman fund’s ownership may not, though the ultimate tax consequences require a more detailed analysis of fund ownership, investor ownership, attribution rules, portfolio company ownership and the type of income earned by the portfolio company.

The 2017 Tax Cuts and Jobs Act and subsequent Treasury regulations changed the practical significance of some CFC planning. The old shorthand that Cayman “solves” CFC issues is no longer reliable. A Cayman fund is still less likely to cause a non-US portfolio company to be treated as a CFC, but managers should assume that a CFC analysis has become a technical issue requiring current tax advice rather than a simple domicile-based answer.

For venture funds investing only occasionally outside the United States, CFC considerations may be handled through alternative investment vehicles or investment-by-investment planning. For buyout, growth equity or other funds with a broad non-US investment mandate, CFC planning should be part of the initial structure discussion.

FATCA and CRS

A Delaware fund is not a foreign financial institution for FATCA purposes. It may have withholding and documentation obligations in certain contexts, but it does not register as a Cayman financial institution.

A Cayman fund, by contrast, will generally need to consider FATCA and CRS classification, registration, diligence and reporting. The IRS describes FATCA as generally requiring foreign financial institutions and certain other foreign entities to report on foreign assets held by US account holders or face withholding on withholdable payments. Cayman’s Department for International Tax Cooperation describes FATCA and CRS as part of the Cayman reporting framework for financial accounts and automatic exchange of information.

This is another reason Cayman can be more administratively involved than Delaware. Again, the requirement is manageable. Fund administrators and Cayman counsel are accustomed to it. But it is not costless.

What about Luxembourg, Ireland, Singapore, Mauritius and other jurisdictions?

Delaware and Cayman remain the usual short list for many private equity and venture capital funds with a US nexus, but other jurisdictions are increasingly part of the conversation.

Luxembourg is commonly considered where European institutional fundraising is central to the strategy. Luxembourg can be helpful for EU marketing, particularly where the manager wants an EU onshore product, but it brings a very different cost, regulatory and service provider profile than Delaware or Cayman.

Ireland has also become more relevant for private funds, including through the investment limited partnership. Ireland may be attractive for certain managers seeking an English-language, common law, EU onshore structure, but it is not usually the default for a US-connected private equity or venture capital manager unless EU capital or strategy considerations justify it.

Singapore is a serious fund domicile for managers with a meaningful Singapore or Southeast Asia nexus. Singapore may be especially relevant where the management team, investor base, investment strategy or tax planning has a meaningful Asia connection.

Mauritius remains relevant for certain Africa- and India-focused strategies, although India-related treaty planning has become more complex and should be analyzed carefully. Mauritius is often discussed as a fund domicile for managers deploying capital into Africa, India and other emerging markets, but the answer depends heavily on treaty access, substance, investor profile and the current tax position in the relevant investment jurisdiction.

Managers may also consider the Dubai International Financial Centre (DIFC), Abu Dhabi Global Market (ADGM), Jersey, Guernsey or other jurisdictions depending on investor base, manager location, regulatory permissions, tax analysis and market expectations. For some Middle East managers or managers raising heavily from Gulf investors, an ADGM or DIFC element may be commercially or regulatory relevant. For some European or UK-adjacent strategies, Channel Islands structures may be familiar to investors. For some Latin America strategies, the answer may turn on local tax, exchange-control or investor eligibility issues rather than on global fund market convention.

The practical point is that these jurisdictions are not “better” or “worse” in the abstract. They are tools. They solve particular problems. They also introduce cost, regulatory substance, service provider and timing issues. A manager should choose them because the fund’s facts support them, not because they appear more sophisticated.

Parallel funds, feeders and alternative investment vehicles

The domicile decision is not always binary.

A manager may form a Delaware main fund with a Cayman feeder for certain non-US or tax-sensitive investors. A manager may form parallel Delaware and Cayman funds that invest side by side. A manager may form a Cayman main fund with a Delaware alternative investment vehicle for particular US investments. A manager may use blockers for effectively connected income (ECI), unrelated business taxable income  (UBTI) or other tax-sensitive investments. A manager may use special-purpose vehicles or co-investment vehicles for particular investors or deals. A manager with a country-specific strategy may use one fund domicile for the main fund and a different jurisdiction for holding companies or investment vehicles where treaty or local tax considerations support that approach.

These structures can be highly effective. They can also add complexity.

Parallel funds require allocation mechanics, governance coordination, borrowing and collateral coordination, subscription facility analysis, tax allocations, expense sharing provisions, Employee Retirement Income Security Act (ERISA) and Venture Capital Operating Company (VCOC) analysis, regulatory analysis and careful disclosure. Feeders require attention to tax reporting, withholding documentation, investor rights and cash movement. Alternative investment vehicles (AIVs) require clear lasting power of attorney (LPA) authority and disciplined implementation.

A manager should not reflexively build a multi-vehicle structure to solve hypothetical issues. But where a small number of real issues would otherwise distort the entire domicile choice, a targeted feeder, parallel fund, blocker or AIV may be the right answer.

Practical decision framework

For many private equity and venture capital managers, the following questions will drive the analysis:

1. Where are the investors? A mostly US investor base points toward Delaware. A meaningfully non-US investor base may point toward Cayman or a feeder/parallel structure. A concentrated investor base in Europe, Asia, Latin America or the Middle East may point toward additional local or regional structuring considerations.
2. Where is the manager located? A US-based manager, Singapore-based manager, London-based manager and Abu Dhabi-based manager may all be able to use Delaware or Cayman, but the regulatory, tax and commercial analysis may differ materially.
3. What will the fund invest in? A US-focused software venture fund is different from a global deep-tech fund, China-related technology fund India fund, Latin America growth fund, crypto fund, credit fund, real estate fund, infrastructure fund or buyout fund investing in regulated industries.
4. Will the fund invest materially outside the United States? Non-US portfolio investments can raise treaty, PFIC, CFC, local tax, withholding, currency-control and reporting issues.
5. Is there a specific country or asset-class tax issue? If yes, that issue may override the usual Delaware versus Cayman analysis. India, Brazil, China, Southeast Asia, Europe, Africa and Latin America can each present structuring questions that should be considered before launch.
6. Will sensitive technology or national security issues be common? If yes, CFIUS, outbound investment rules, sanctions and export control-adjacent issues should be considered early.
7. Are there anchor investors with strong domicile preferences? One or two large investors can change the practical answer, particularly if they have internal restrictions on US partnerships, Cayman vehicles or offshore vehicles more generally.
8. How much complexity can the manager operationally absorb? First-time managers should be especially careful about creating structures that are technically elegant but operationally burdensome.
9. Is the incremental cost worth the benefit? Cayman, Luxembourg, Ireland, Singapore, Mauritius and other jurisdictions can all be excellent choices in the right situation. They are rarely the cheapest or simplest choices.

Conclusion

The answer to “Where should I form my fund?” is still usually found by working through commercial, cost, regulatory and tax considerations in that order, with tax often doing the most work.

Delaware remains the simplest and most familiar domicile for many US-connected private equity and venture capital funds, especially those raising primarily from US investors and investing primarily in US companies. Cayman remains a highly accepted and often very useful domicile for funds raising substantial non-US capital, investing globally or seeking to reduce certain US tax reporting friction for non-US investors. Luxembourg, Ireland, Singapore, Mauritius and other jurisdictions may be appropriate where the investor base, marketing strategy, management footprint, investment geography or treaty analysis points in that direction.

The most important advice is not to choose based on labels. Delaware is not always too US-centric. Cayman is not always too offshore. Cayman also should not be treated as suspect merely because it is an offshore jurisdiction; in many cases, investor concerns about Cayman are more about perception, internal policy or optics than about the actual legal or regulatory framework. Luxembourg, Ireland, Singapore and Mauritius are not automatically more sophisticated. Each jurisdiction solves some problems and creates others.

The right approach is to map the expected investor base, manager location, investment strategy, regulatory profile and tax posture before launch. Once those facts are clear, the domicile decision usually becomes much less mysterious.

The principal reason for the low incidence of serious defaults is that typical venture capital fund agreements impose very onerous default remedies against the defaulting investor, including up to full forfeiture of the capital account value associated with the interest, inclusive of paid-in capital and any gains.  Once material capital has been contributed to the fund, there is considerable impetus to make further contributions timely.  If I’ve paid in $1 million of my $5 million commitment, am I really willing to walk away from that $1 million and any attendant gains?  Even if I’m seriously distressed financially, there’s a high incentive not to simply abandon my capital account value.  In short, paying in contributions timely is something that investors are well advised to try to remain on the right side of, and most often, they do. 

With that said, occasionally cases of serious default arise, and fund managers are put in the position of acting on the default remedies found in their fund agreements.  This article explores typical options available to venture capital fund managers when defaults reach a serious level demanding action.

Do I Have to Act?  When?

The preliminary question we usually get is: do I have to act and when?  We are often contacted at a point when a contribution is several months past due, the manager may have had some initial conversations with the investor, and the investor isn’t taking, or seeming likely to take, timely remedial action. 

From a manager’s perspective, defaults are not ideal.  They disrupt budgets for future investments and follow-on activity and potentially cause shortages of cash for quite immediate investment activity, which can then require unplanned additional capital calls from other investors.  If you raised a $500 million fund, you want to end up with $500 million to invest, not $450 million.  Furthermore, defaults will eventually work their way into audited financials if there are not direct contractual notification provisions in the fund agreement or side letters in the first place.  Other investors will eventually learn of the situation, which may raise questions.  Managers typically prefer to avoid this for reputational reasons.

With the above in mind, our first advice is to try to work with the investor to rectify the situation.  Perhaps the investor is not aware of the possible onerous consequences and/or is trying to manage many different capital demands.  A stern letter reminding them of their obligation and the potential outcome can often lead to a reprioritizing of payment to the fund.  Take the case of a distressed corporate investor that has money to pay some but not all obligations.  On reminder, it is often a result that the payment to the fund is moved to the front of the payment queue after awareness is focused on the impending downside.  In our experience, stern letters of explanation may cure something like 25-40% of serious default situations.

Another potential early conversation is to encourage a secondary sale, in which the purchaser will catch-up on missed contributions and take over the interest going forward.  In the preceding example, even if the distressed investor ends up with 70-80% of FMV in a secondary (i.e., $700,000 to $800,000), the result is much more favorable than forfeiting the $1 million of value under the fund agreement’s default clauses.  Where a seller just simply does not have cash, and there is capital account value, this path almost always makes sense and a distressed investor that is rational will pursue it.  They may do that largely on their own once prompted (say by approaching typical secondary buyers), or in some cases the fund manager may wish to get more involved, for example to “steer” the interest to a friendly existing or prospective LP that is or may be a long term investor in the manager’s other funds (i.e., usually not a secondary buyer, unless they have a fulsome primary investment platform).

As to the question of whether a manager is required to do anything, and if so when, fund agreements we work with generally provide that the choice of a manager to enact or not enact default remedies, and the timing thereof, is at the manager’s discretion.  Even on this typical drafting, there may be an ultimate fiduciary duty at law to take action in good faith for the benefit of the fund and its partners as a whole.  We are not often distressed by this concept because typical contracts make it clear enough that ample time is to be permitted for rectification of the situation, and give the manager a lot of discretion on how to handle each case in particular.  Regardless, interest is frequently aligned as the manager has its own capital at stake, has the reputational concern of keeping the books and records free of evidence of serious default and more than anything, has an interest in preserving originally targeted capital to ensure budgeting for follow-ons isn’t disrupted.  In practice most managers we work with might give a long standing, credible investor suffering temporary distress some leeway to rectify, but not likely in excess of say 6 months at the outer edge.  Less known, newer investors, or those as to which there is specific doubt as to creditworthiness, would typically get less leeway, with formal default provisions enacted sooner.

That Didn’t Solve It – What Do I Do Now?

In a few cases, no matter how sensible it may be on that part of the defaulting investor to cooperate, the above methods won’t yield successful results.  So what then?

First, make sure to follow any technical “notice and cure” periods in the fund agreement, if not already done by this time.  Usually there is a requirement for a formal notice of default letter, and 10 or 20 days cure time.  There may be multiple notices and cure periods in some cases.  Given the serious nature of the situation, and notwithstanding notice procedures in the relevant fund agreement, we recommend dispatch by both trackable courier and email.  Once this box is checked, the manager is free to pursue remedies under the default provisions of the fund agreement.  Typically, the choice of which remedy or remedies to pursue is at the discretion of the fund manager, and not mutually exclusive.  Among the typical remedies we would expect to see in a typical fund agreement are the following:

1. Sue for Damages and/or Performance:  This is ordinarily provided for, including the right to collect interest on the defaulted contribution(s) at an interest rate significantly in excess of the prime rate (say 12-18%).  It is not often, however, relied upon because by the time an investor is in serious default there are likely to be collection issues on any judgment, and proceeding along this route takes time and money.  Furthermore, there is reputational risk (fund managers generally don’t want to be seen suing their investors) as well as the potential for the lodging of counterclaims, such as breach of fiduciary duty or other “complaints”.  Even where meritless, the simple potential risk of the filing of a counterclaim can deter the initiation of legal proceedings by the fund manager.  In any event, the typically found remedies listed below are stronger, faster and easier to implement. 

2.  Enact a Transfer:  Under this approach, the fund manager may designate one or more parties (which usually may be existing limited partners or third parties) to be transferees who will receive the defaulting investor’s interest (or parts of it if there are more than one transferee) in exchange for agreeing to contribute capital toward the outstanding capital calls and make good on future capital calls.  This approach usually will not involve payment of any purchase price to the defaulting investor (i.e. the “seller”), other than assumption of these liabilities.  So this approach involves a forfeiture by the defaulting investor of 100% of the existing capital account balance.  Notice that this approach results in aggregate commitments being unchanged, and therefore this is commonly a preferred method by managers.  It is also simpler to deploy (less parties to transact with) and in a sense more “private” (in terms of not “outing” the situation with each and every investor) than #3 below, and thus tends to be more frequently considered.

3.  Enact a Sales Waterfall:  Under this sort of provision, the non-defaulting investors are offered, essentially in a “ROFR” type offering, their proportionate pieces of the defaulting investor’s capital account balance in exchange for proportionate contribution of then-unfunded and future calls.  If not all investors make the election, commonly a second tranche may occur where investors initially electing can get “more”.  Ultimately if the whole interest is not spoken for, third parties may be invited to participate.  In some sense this is not vastly different from #2 above: the defaulting investor suffers a 100% forfeiture, and the fund manager (assuming a successful process) ends up with an undisturbed amount of aggregate commitments.  However, this remedy requires undertaking a significant formal process from a logistical standpoint, and furthermore involves effectively notifying all investors of the situation.  So why would a manager choose this?  Sometimes, there is a view that the most equitable result since some party stands to get a windfall is to share that windfall proportionately with the entirety of the investor base. 

4.   Run To Zero Rights:  This type of provision calls for declaring that the defaulting investor is no longer a limited partner, has no right to vote on any fund matters, and is held back from income/gain allocations into its capital account (and usually distributions as well, discussed further below); however, expenses including management fee may be debited against the capital account (and in doing so “full scheduled management fees” may be collected at the fund level) until such time as the capital account reaches zero.  If that does not occur by liquidation, the remaining balance is often forfeited and allocated proportionately to the other partners.  While this provision protects the fee base, it does not maintain the full aggregate commitments, and as such, is seen as an inferior approach to methods #2 and #3 above.  However, this type of provision is commonly present in most fund agreements in the venture space and can play a role in certain situations where macroeconomic or other events beyond the specific limited partner limit participation in amelioration efforts by other sources of capital.

5.  Pure Forfeiture Provisions:  The most punitive commonly available remedy is the provision allowing the enactment of a simple, pure forfeiture, either of the capital account balance, the right to future profit allocations, or both.  These will commonly cause the forfeited amounts to be redistributed proportionately amongst the other partners, creating a windfall for them to the extent of any capital account balance being shifted.  As is the case with #4 above, this causes aggregate commitments to decrease, and as such, is not usually a preferred method.

6.  Distribution Withholding Provisions:  Recall that the above remedies are not mutually exclusive.  Distribution withholding provisions usually exist and are used in tandem with other default remedies.  These are rights to refrain from distributing cash or securities to an investor in default, and apply proceeds to outstanding calls and expenses, including outstanding interest.  In the case of securities, a well drafted provision will allow the right to sell the securities to generate cash to satisfy such items, which for tax purposes should expressly provided to be a deemed distribution to the investor, followed by sale by them and a deemed recontribution (with a pre-agreed hold harmless in favor of the fund manager).

Anything Else To Consider?

There are a couple of closing thoughts on the issue of investor defaults to keep in mind.  First, a well drafted fund agreement will place the right to act for the defaulting investor squarely in the hands of the fund manager by reference to the power of attorney provisions.  For example if a transfer is to be enacted to rectify the situation, there should be no need to chase down the recalcitrant investor for signatures; the fund manager should be able to act on that directly using a pre-agreed power of attorney.  Ideally, the drafting is very broad, to the effect of the power of attorney being available for any needs arising under the default provisions.

Next, consideration should be given to making sure parallel funds are properly included in the default provisions.  As an example, if a sales waterfall will run to all investors, it will usually (though not always) be appropriate to include parallel fund investors for this purpose.  This should be considered and resolved appropriately in the given context.  Another item to consider is the potential for cross-default provisions, meaning a default by investor X in fund A may be deemed to be a default in additional fund B automatically and lead to the potential for enactment of remedies in both funds A and B.  This is rarely appropriate, but in some cases may be.  For example funds that are literally stapled (say a growth fund with a top up fund for home run deals that has no management fee and lower carry, and everyone is subscribed in a 2:1 ratio; in this case access to the preferred terms fund is “part and parcel” of an investment in the growth fund, and it would not be equitable for an investor to default in the growth fund and keep the preferred piece).

Another concept to keep in mind is credit security.  In venture funds with typical default provisions along the lines discussed above, credit security comes from drawing down cash in order to put value in the capital accounts.  The greatest credit risk exists right after the fund is formed, and until the time capital account balances are sufficient to provide incentive to perform contribution with respect to the remainder of the commitment.  This often deserves special consideration, especially when holding a dry closing in turbulent economic times.  Some fund managers will call a small amount of capital (~5%) in order to create this credit security at the outset of the fund. 

In the case of fund managers that utilize capital call lines or other credit instruments, there will often be borrowing covenants in their loan agreements with respect to defaults by investors in the fund that may require self-reporting or other remedial steps.  Fund managers should review their loan agreement to fully understand the implications of a default on the credit arrangement.

Yet another issues centers around questions about the extent to which a fund manager may itself participate in default remedies.  For example, could the fund manager assign itself to be the transferee of the interest where there is a material capital account balance, taking all the windfall for itself?  There are potentially significant contractual and fiduciary limitations in this area, so consult carefully with counsel before acting in this manner.

Our best closing advice is to get a health check.  Have you reviewed your default provisions with fund counsel lately?  Default provisions have come a long way in the last few market cycles, and if this area of your fund agreement has remained untouched for several vintages, the default provisions probably do not reflect the “latest and greatest” techniques being deployed.  This is an unusual area of the fund agreement inasmuch as investors are generally aligned with the fund manager to provide greater protections and remedies to the fund; unless the investor plans to be the defaulting investor, updating it serves to both help ensure the fund is fully capitalized to make investments, and create stability within the investor group.

Three Year Holding Period for Carried Interest

This blog has previously discussed how to structure a fund manager’s carried interest, meaning the contractual right of a fund manager to receive a percentage of the fund’s profits that is unrelated to any capital commitment. Prior to the enactment of the TCJA, both carried interest holders and capital interest holders were entitled to long-term capital gains rates (for individuals, generally 23.8% at the federal level) on gain from the sale of a portfolio company held longer than one year. However, the TCJA introduced a new three-year holding period requirement solely applicable to carried interest in the fund context. If an investment fund holds stock in a portfolio company for three years or less and sells it at a gain, the fund manager will now be taxed on its share of the gain allocated in respect of its carried interest at short-term capital gains rates (for individuals, as high as 40.8% at the federal level).

In order to mitigate the impact of the new three-year holding period, many fund agreements drafted after the enactment of the TCJA provide fund managers with the option to waive their right to receive carried interest from an investment that does not meet the three-year holding period. In return, fund managers have a right to receive a corresponding increased amount of future appreciation in investments that do meet the three-year holding period requirement. In ideal circumstances, this would permit a fund manager to achieve the same results economically while avoiding the higher tax imposed on short term capital gains. The waiver is typically drafted such that limited partner investors are generally not disadvantaged (e.g., the fund manager generally cannot waive interest or other ordinary income, or gain from the sale of investments held for one year or less).  It should be noted, however, that this strategy involves inherent risks. Catch-up allocations of profits must derive from appreciation in portfolio company equity after the waiver is made, making the catch-up entirely contingent on future upside.  There is no guarantee that the fund’s investments will continue to rise in value (or will rise in value in an amount equal to the waived carry), in which case the fund manager will not have new gains to completely (or partially) recover the waived carry. In addition, this structure has not been blessed by Treasury or the IRS, and may be subject to challenge by the IRS, or may be prohibited by future legislation. Nevertheless, managers we work with are somewhat regularly inserting this architecture in their existing and/or new partnership agreements and will decide whether to utilize the waiver depending on the facts at the time of an exit.

Passive Foreign Investment Companies

U.S. investors in non-U.S. corporations that are classified as passive foreign investment companies (“PFICs”) are subject to special anti-deferral rules under U.S. federal income tax law.

At a high level, a foreign corporation is a PFIC if either 50% or more of the foreign corporation’s assets are passive assets (such as cash, securities, or certain intangible assets) or 75% or more of the foreign corporation’s grossincome is passive income (such as dividends, interest, and certain rents or royalties). Technology companies, life science companies, and other IP-driven companies are often categorized as PFICs because these businesses are less likely to generate any active income during the early stages of their life cycle but can often generate passive interest income.

Typically, a U.S. investor in a PFIC is required to recognize ordinary income instead of capital gain as well as interest charges upon a distribution from the PFIC or a disposition of its stock. These are harsh consequences that can significantly decrease an investor’s profits on an eventual disposition. However, a U.S. investor can avoid these consequences by making a “QEF Election”, which will cause the investor to be currently taxable on the net income of the PFIC (whether or not distributed). Many PFICs have little or no net income, so the practical cost of this election is often minimal. In addition, an investor with leverage may be able to negotiate for distributions from the PFIC in order to pay its tax liability.

When investing in a foreign corporation, it’s important for a U.S. fund to request covenants in the deal documents that require the foreign corporation to cooperate to manage any negative tax consequences to the U.S. fund (or its investors) that could result from the corporation being a PFIC. The foreign corporation should be required to consult with U.S. tax advisors to determine if it is a PFIC on a yearly basis. This can be a complicated analysis that requires detailed information about the corporation and the corporation’s shareholders.  Accordingly, the foreign corporation is in the best position to make this determination. The deal documents should require that, if the foreign corporation determines that it is a PFIC, the foreign corporation will provide its U.S. investors with any information that they need in order to fulfill their tax reporting obligations or make a QEF Election. Taking these steps could help mitigate the negative consequences that otherwise arise from investing in a foreign corporation that is treated as a PFIC.  

Controlled Foreign Corporations (CFCs) and Global Intangible Low-Taxed Income (GILTI)

U.S. investors in foreign corporations should also consider whether those corporations are classified as controlled foreign corporations (“CFCs”). A foreign corporation is a CFC if U.S. shareholders each owning at least 10% of the corporation’s voting power or value (“Significant U.S. Shareholders”) collectively own over 50% of the total combined voting power or value of the corporation’s stock. This determination is made by applying a complex constructive ownership regime, pursuant to which shareholders can be attributed ownership by certain related parties.

If a foreign corporation is a CFC, its Significant U.S. Shareholders will be taxed on their share of certain types of income of the CFC (whether or not distributed). In the past, CFCs were only taxed on certain types of income (known as “Subpart F Income”), which includes dividends, interest, and certain income generated from related party sales and services. However, the TCJA greatly expanded the scope of current taxation to Significant U.S. Shareholders by creating a new, shareholder-level tax based on the CFC’s global intangible low-taxed income (“GILTI”). GILTI generally includes all of the income of a CFC that is not Subpart F Income (other than a deemed modest return on tangible property).

When investing in foreign corporations, investment funds should carefully consider the impact of their choice of investment entity. When determining if a foreign corporation is a CFC, a U.S. partnership is treated as a separate entity and all stock owned by the U.S. partnership is included to determine whether the partnership is a Significant U.S. Shareholder and the foreign corporation is a CFC. In contrast, a foreign partnership is disregarded as a separate entity for CFC testing purposes and each of its partners are treated as owning a proportionate amount of the stock held by the foreign partnership. As a result, an investment by a U.S. partnership is more likely to cause a foreign corporation to become a CFC than an equal investment by a foreign partnership, even if the ultimate beneficial owners of each investment are the same. 

New tax rules now treat domestic partnerships like foreign partnerships for purposes of applying the GILTI rules, meaning the U.S. partners of domestic partnerships can account directly for GILTI and if no U.S. partner is a Significant U.S. Shareholder, no GILTI tax should apply.  Proposed tax rules (which can be applied now under certain circumstances) would extend this treatment to Subpart F determinations, i.e., the proposed rules, like the final GILTI rules, would treat U.S. partnerships like foreign partnerships for purposes of determining if a U.S. partner has taxable Subpart F income under the CFC rules. However, a U.S. partnership would still be treated as a U.S. entity for purposes of testing whether a non-U.S. company has the status of a CFC.  The IRS and Treasury have not yet clarified how the new CFC rules that treat a U.S. partnership like a foreign partnership will impact PFIC reporting and PFIC taxation,

Funds with U.S. investors should require a foreign portfolio company to determine its status as a CFC each year, and to covenant to assist each U.S. investor of the fund to determine if it is a Significant U.S. Shareholder if the foreign portfolio company is a CFC. In addition, the foreign corporation should be required to provide its Significant U.S. Shareholders with the information that they need in order to comply with their tax reporting obligations and determine the amount of any current income inclusions. Funds making significant investments in a portfolio company may be able to require the portfolio company to make tax distributions to cover any tax triggered by the CFC rules, although distributions to cover GILTI tax are not common in our experience.

For any business, one’s good name is one of its most essential assets.   That is especially true in venture capital, where, according to a 2004 study[1], firms with high reputations are much more likely than others to have their startup funding offers accepted.  A VC firm’s name or logo is a symbol of its reputation, and trademark law protects the goodwill those identifiers embody.

As more and more VC firms and other financial services firms come into being, protecting the uniqueness of their names has become increasingly important.  Indeed, as of May 2020, there are over 5,000 applications or registrations with the U.S. Patent and Trademark Office covering venture capital services. 

Having a name that stands out from the crowd and protecting that name by trademark registration can help a VC firm safeguard its valuable reputation and position in the industry.  

Choosing a Unique Distinctive Name

One of the most critical steps in the formation of a new VC firm is choosing a name.  A VC firm should have a memorable name that differentiates itself from others in its field.   Bad things can happen when a firm chooses a name like someone else’s.  If the other business is hit with bad publicity, the similarly named firm’s reputation may suffer from such confusion, or it may have to spend time and effort explaining that it isn’t the guilty party.  If a firm chooses a name like another’s, it could also face an infringement suit costing $1 million or more to defend, which is also very time-consuming and distracting to management’s attention.  

Once a name is chosen, trademark counsel should do a thorough search at the outset to help minimize the risks of confusion and infringement claims.  What is “infringement” is notoriously subjective, and trademark searching is an art. An experienced trademark lawyer won’t just give you a list of trademarks that came up in a search – he or she should give you an assessment of the risk and, where applicable, strategies for reducing it. Using a “low-cost,” cookie-cutter search service is false economy, and often will cost more in the long run.

When a firm is fixated on a particular name – whether because of its meaning, for sentimental reasons, or because a desirable domain name is for sale – that can complicate the selection process and increase expense.  Too often the name that seems “perfect” is unavailable – because someone else thought it was “perfect,” too.  There are workarounds like coexistence agreements, purchases of trademark rights, and licenses, but they always cost money and the firm often ends up with a name that’s far from unique.   

It’s best to avoid names that describe what the firm does, because the law generally doesn’t allow businesses to monopolize descriptive terms as trademarks.  Descriptive names like “Biotech Partners” or “Bay Area Ventures” can’t be protected as trademarks – if at all – unless they have developed enough recognition over time to have “secondary meaning” as brands.  Instead, choose a distinctive name.

What matters most is to select a unique and distinctive name that the firm can own exclusively.  Keep in mind that the meaning of a business name is not the one in the dictionary – it’s the meaning the people who make up the business put into it by developing a strong reputation.

Logos and Tag Lines are Trademarks, Too

Distinctive logos and tag lines also identify a business and its products, and they can be protected just like word trademarks.  Before investing in a logo or tag line, it’s important to do appropriate searching, and applying for registration as with the name to ensure that you are well protected. 

Benefits of Trademark Registration

Once the searching is done and the firm chooses a strong and unique name, it should take advantage of the protection of federal trademark registration.  While trademark rights in the U.S. come from using a mark to identify one’s goods or services, a federal trademark registration enhances those rights with a number of legal benefits.  They include:

• The nationwide right to use the mark for the services listed in the registration, with priority as of the filing date.  Unregistered or “common law” trademark rights only extend as far as the geographic area in which the business trades.
• A legal presumption that the mark is valid and the registrant is its exclusive owner.  This usually makes it easier and cheaper to pursue infringement claims in court.
• A public record of the registrant’s rights, which can discourage others from trying to adopt a similar mark.
• A defense against others’ claims of trademark infringement.  As noted above, infringement cases can cost $1 million or more to defend, and a registration can help a business defeat a claim early or dissuade others from claiming infringement in the first place. 
• Protection against registration of similar marks.  The Patent and Trademark Office will refuse registration of marks that it finds are likely to cause confusion with earlier-filed marks.
• Constructive nationwide notice of the registrant’s rights as of the registration date, which keeps later users from trying to claim that they adopted their marks in good faith. 
• A basis for seeking foreign registration of the mark – important for any business that operates outside the US.
• Enhanced monetary remedies when suing infringers in federal court.
• The right to use the ® symbol, denoting a federal registration. 

While it’s not necessary to have a lawyer file a trademark application, the process is filled with pitfalls and traps for the unwary, so it’s best to have experienced trademark counsel do it.  After an application is filed with the U.S. Patent and Trademark Office, an examining attorney will review it and search for conflicts with earlier-filed marks.  It’s not unusual for examiners to raise issues about the application.  Examiners may flag problems that may not exist in the real world – for example, an examiner may refuse a VC firm’s application because of a similarly named hedge fund or wealth management firm.  Experienced trademark counsel can help anticipate and avoid those issues or address an examiner’s concerns. 

Registrations will protect a mark for defined goods and services.  Because VC firms provide advice to their portfolio companies as well as capital, we typically apply to register their marks for business advisory services as well as venture capital services.  Where firms offer other services, like incubator services, educational seminars in a particular field, blogs, or podcasts, the trademark application should cover those, as well.

Protecting Your Trademarks Abroad

If you plan to conduct business outside the U.S. or license your mark to others, it’s important to protect your trademark by registering it in all foreign jurisdictions in which you plan to operate.  Otherwise you could be at the mercy of trademark squatters, infringers, and unscrupulous local partners.  International trademark protection doesn’t have to break the bank if done according to a well-thought out strategy. 

Policing Your Brand

Once you’ve invested time and energy in developing your good name, you’ll want to protect that investment.  If others adopt names like yours, that can cause confusion or harm to your reputation.  Your trademark counsel can subscribe to a watch service that will identify applications for similar trademarks so that your counsel can take appropriate and swift action to defend your marks. 

Your personnel and their contacts are on the front lines of your brand protection, so it’s important that they know what to do when they see a possible infringer.  There should be a point person to whom they can report possible infringements, and who can then alert counsel. 

If someone is infringing your trademark, it’s important to take quick action.  If you delay, and the infringer itself starts to become invested in the mark, it will likely be harder to get it to find a new name.  Also, if two businesses use a similar mark over a sustained period of time without substantial evidence of confusion, a court may decide that the marketplace has sorted out the difference between the two, and decide there’s no infringement.  As a result, the brand loses its uniqueness, and becomes less valuable. 

In Conclusion

Because it embodies the goodwill and reputation that a successful business develops over time, a trademark – whether a word, a logo, or a tag line – is one of a firm’s most important and valuable assets.  Choosing a distinctive trademark, searching to ensure others aren’t using it, and registering it are important steps for every VC firm to take.

[1] D. Hsu, What do Entrepreneurs Pay for Venture Capital Affiliation, The Journal of Finance (Aug. 2004), p. 1085 https://onlinelibrary.wiley.com/doi/pdf/10.1111/j.1540-6261.2004.00680.x (“Offers made by VCs with a high reputation are three times more likely to be accepted, and high-reputation VCs acquire start-up equity at a 10-14% discount.”). 

With that in mind, at a high level, there are three things to consider generally when structuring management fees: first, what is the amount of those fees; second, when in time do those fees start and end; and third, will the amount of fees reduce (i.e., “step down”) at some point in time reflective of perhaps a lesser level of work later in a fund’s lifecycle.

As to amount, management fees are typically based on an agreed percentage rate applied to an agreed capital base, and are usually described annually in the legal agreements (though in terms of cash payment they are most often divided up and paid quarterly or semi-annually).  In actively managed venture capital funds, the market rate is 2.5% of aggregate committed capital in the first part of a fund’s life.  This is contrary to say the buyout side of private equity where you often hear “2/20”, i.e. where the fee rate is often 2% instead of 2.5%.  Rates in venture capital funds are quite regularly 2.5% reflective of the fact that whereas a buyout fund may have a very large committed capital base and do 5-10 investments over its lifespan, a venture capital fund usually has a smaller capital base, often much smaller, and over time can make a quantity of investments on the magnitude of 2-3x that of a private equity fund.  In short, there is a lot to do, and where the capital base is more modest, management fees are not typically a source of a high degree of residual profitability over fixed expenses, if any.  With that said, in some very large venture capital funds (say $750 million and north), fees can sometimes drop to 2.25% or 2%, though depending on the size and nature of the organization, even these larger funds may often have a fee rate of 2.5%.  The preceding is widely applicable in the United States and Asia venture capital markets (as to USD-denominated funds); in Europe there may be more tendency for fees in venture capital funds to be in the 2% range, possibly reflective of a much smaller overall industry and an accordingly less degree of market term separation from private equity.

As to the start time for the payment of fees, they are often assessed from the initial closing (including retroactively for later admitted investors) though sometimes they are assessed beginning later, such as from the time of first capital draw or first investment.  This is somewhat dependent on the strategy in raising the fund and the expected time at which the team will start looking to place opportunities therein.  If the predecessor fund is out of dry powder and therefore necessarily the fund being raised will be the place where the next new opportunity is taken down, then there is significant justification for fees from the initial closing.  The team is after all “working” for the new fund already, in the sense they are out there sourcing deals for it; as such, the justification for payment of fees is clear.  In other situations, an existing fund may have remaining available capital for a couple of new deals, and there is an intent to put identified opportunities into the existing fund accordingly.  In this situation, the new fund is being effectively raised but put on the shelf, so as to be ready when capital is needed without any chance for a period of time without capital for new deals.  Where this is the case, a later inception of fees in the new fund may be warranted.

One also needs to consider when fees end.  This is a point that has been undergoing some change in the last 5-10 years, and may be subject to some negotiation.  There are three ending times that are most common: at the end of the natural term (say, 10 years in); at the end of any extensions to the term (say, 12 years in); or at the final liquidation of the fund (say, 13 years in).  In the last couple of years, we have seen increasing instances in which fees are paid all the way to final liquidation, albeit often at much lower rates than initially (see below, regarding fee step downs).  The theory here is that there is work to be done, someone needs to do it; and that is not free to provide, nor should it go unpaid for.  We see a number of venture capital funds with whom we work collecting fee to final liquidation on this basis, more in number than was the case some years ago.

Finally, there is the issue of the potential for fees to reduce (i.e., “step down”) at some point in time.  This is usually at the time that investments in new portfolio companies ceases, and the venture fund enters a period where it is doing solely follow-on investing and harvesting.  The theory in reducing the amount of management fee at that time is primarily that there is less work to be done, and secondarily, as a corollary thereto, that there is likely to be a successor fund providing a “full” fee base and therefore it is not necessary to collect high fees in the fund that has reached this level of maturity.  One way or another, most venture capital funds do have some “step down” concept.

A connected issue is, where fees reduce, how is that done exactly?  There are three ways the reduction in fees can be accomplished: the percentage rate can be reduced and the capital base can be left unchanged (a “rate step down”); the percentage rate can be left unchanged and the capital base can reduce (a “base step down”), or both the percentage rate and capital base can be reduced (a “double step down”).  In the years immediately following the reduction, say years 5-10 or 5-12, double reductions are quite uncommon and usually reflect quite a bit of lack of negotiating leverage on the part of the fund manager.  This is versus reductions during liquidation, where a double reduction is more common.

So, again focusing on what happens at or around year 5, in almost all cases it will be one or the other of a rate step down or a base step down.  Most venture capital managers will prefer a rate step down.  The reason is that this leads to a situation where one can state with specificity (at least from the time of final closing when the capital base amount is known) the exact amount, in dollars, of management fees in later years.  Since management fees are meant to be used for fixed expenses (think rent, equipment, hiring staff) and are usually consumed fully in furtherance of those expense requirements as opposed to leading to retained earnings, not knowing the dollar amount fees you will get in say year 6 (as would be the case where those fees are some percentage of a capital base not known until that time) is an extremely hard position for a manager.

With that said, while savvy investors understand this and will work to support the needs of the managers they invest in, they often prefer a base step down.  Their point of view is that no matter how low a percentage rate drops, it may be inappropriate to apply any rate to the full committed capital base later in the lifecycle when there are few remaining investments.  With that said, especially in smaller venture capital funds (say, $500 million and south), usually the method of rate step down prevails.  Sometimes, a compromise may be agreeing to a double reduction in the liquidation period to address the foregoing concern very late in the fund’s life.

It is important to get these concepts right.  We have found that getting them wrong can amount to “penny wise, pound foolish”, in extreme cases, hampering a manager’s chance of success.  What we mean by that is, investors put fund managers in business.  They pay a lot in fees to do that, no matter how negotiations on the above issues work out.  Fees are needed to compete for talent in the marketplace.  It is a shame to see negotiations to reduce fees result in a situation where the fund manager can’t hire and retain the “A” team from a compensatory standpoint.  Careful attention to market norms can assure the manager avoiding a competitive disadvantage, yet doing so in a way that is respectful of the investors’ perspectives on these matters.

The answer lies in a set of provisions that reside in the fund’s partnership agreement.  We generally refer to these as “LP governance rights”.  The common theme is that these LP governance rights represent ways in which LPs can take action if, in fact, they do become deeply concerned about the fund’s prospects or the conduct of the manager.

LP governance rights are best thought of as a suite of options.  Not all of them will exist in every fund agreement, but usually some of them will.  They can differ based on the duration of engagement between investors and the fund manager and the adherent level of trust that has developed over time amongst the parties, or for other reasons (including business leverage and precedence of prior funds).  It is safe to say that where investors are very demanding of attaching unusually strong LP governance rights to a deal, they probably have a heightened level of concern about issues of team stability, trust or just generally a lack of familiarity with the manager.  Certain investors may, internally and in light of their nature, be prone to requesting stronger than middle-market LP governance rights; for example managers of public pension or sovereign wealth assets may have strong legal or fiduciary reasons for such requests compared to private sources of capital.

So, what encompasses this suite of options comprising LP governance rights?  At a high level, there are three broad categories to be aware of: (1) provisions which can lead to the fund’s investment period ending prior to its scheduled time; (2) provisions which can lead to the fund’s entire term culminating early and the fund being completely shut down; and (3) provisions which leave both the investment period and overall term of the fund intact but cause the existing fund manager to be replaced with a new fund manager of the investors’ choosing.  Let’s examine each of these in turn.

Termination of the Investment Period

In a typical venture capital fund, an investment period will apply.  This is the period of time after closing, usually four to six years in duration, that the fund may make investments in brand new portfolio companies.  Beyond this time, only follow-on investments will be permitted.  The goal is to ensure that the fund can liquidate reasonably on-time, say after ten to twelve years.  That won’t be possible if investments in brand new portfolio companies, especially early stage ones, are made late in the fund’s lifecycle.  The investment period duration regulates this.

An investment period may end early if a fund becomes fully invested ahead of schedule, but from an LP governance perspective, there are two ways it might end even earlier.

The first is in association with a key person event, in which a certain number or particular persons of a select group of the fund’s investment personnel are no longer meeting their time devotion to the fund (usually substantially all business time) or are no longer managers of the fund.  For example, perhaps a fund is targeting 30 investments, and has five professionals expected to identify and nurture, on average, six deals each.  It might be the case that investors would tolerate some level of departures and still be comfortable with the team’s ability to fulfill the investment mission, but what if a supermajority of the five investment professionals has left and replacements have not been found and approved?  It may no longer be feasible to invest in 30 deals if these departures happen a couple of years into the investing cycle.  In many agreements, this happenstance, called a “key person event,” may call for the suspension of the investment period either automatically or by LP / Advisory Committee vote.  During this suspension period, the manager seeks to find replacement talent or otherwise formulate and propose some go-forward plan.   After exhausting efforts to find suitable substitute talent over a period of time, the fund’s investment period will terminate under the fund’s governing documents.  In this case, the remaining team will stay in place to guide the fund’s investments that have been made to fruition, but the investment period will terminate and opportunities in new portfolio companies cannot be pursued.

The second way an investment period may end earlier than scheduled is upon an investor vote.  This term is present in only a minority of deals to begin with, but where it is seen, it will almost always require bad conduct on the part of the fund manager team (“cause”, in industry parlance), usually proven in court, arbitration or a similar tribunal to the stage of final adjudication.  Very infrequently, it may be the case that a supermajority of investors may vote to terminate the investment period without any such cause.  It’s worth careful emphasis to highlight that this is a very uncommon clause, and one that most venture capital managers will not agree to.  The position is usually that such a punitive action should require wrongdoing and not be arbitrary, especially where venture fund managers by their lengthy mandate invest in and contract for long duration assets and obligations (offices leases, etc.) that can be difficult and costly to unwind.

Termination of the Fund

Whereas investment period termination is usually driven by a concern over the ability to make all of the contemplated investments, as reflected in a typical set of key person provisions, if concerns run deeper, the investors may in exceptional circumstances wish to completely terminate the fund.  If this occurs, the fund is liquidated and the securities – marketable and nonmarketable – are simply distributed in kind to the investors in connection with the winding up of the fund.

This remedy is in fact truly exceptional inasmuch as investors typically do not desire to hold private venture-backed securities in their portfolios.  This is what they hire fund managers to do, and they are often ill-prepared to take this on, especially if they are outside the domicile of the investments (like a UK pension fund trying to deal with U.S. portfolio securities).  In addition, the diffused, small positions that each particular investor may receive are not likely to carry the weight of the position as a whole that was previously held by the fund (think of things like the leverage to obtain a board seat or major investor rights); and the act of seeing the positions to fruition through follow-ons or if not disposing of them privately, perhaps in a secondary transaction at a discount, are not terribly appealing either.  So this remedy is reserved, in application, for the most serious situations.  Reputable fund managers need not lose much if any sleep that such a provision will be acted on.

The flip side is, in light of this sort of “natural bias” on the part of investors to call for application of the termination right, it is in fact often able to be exercised without cause.  In comparison to say a right to terminate the investment period or substitute a fund manager for no cause, the strong “downside” of enacting the fund termination serves as a natural check and balance.  The result is that in the industry, a majority of venture deals have no-fault termination rights.  These are usually on supermajority investor votes – perhaps as high as 85% in interest.  Sometimes, the right to terminate the fund in entirety on a lesser vote is seen where there is adjudicated cause and/or after a key person event – perhaps in these cases, on a 66% vote.

Replacement of the Fund Manager

The final type of LP governance right we see in venture capital deals involves an option for investors to replace the fund manager (often referred to as “GP removal”).  Where this happens, the fund will continue, but under the supervision of a new manager they choose.  The former manager is likely to retain some carried interest and possibly some transitional management fees, but won’t be involved in the going-forward management of the fund and ultimately will be likely to cede some economics, perhaps to a significant degree, to the new manager.

Some deals, especially in the case of emerging managers or managers struggling in fund raising, have some sort of removal and replacement right, almost all of which run off adjudicated cause.  In this case, following that sort of final determination in court of a serious bad act, a supermajority vote may lead to the right to remove and replace the fund manager; provided that in some deals where the bad conduct is resulting from a particular team member and that team member is terminated, the removal right may disappear (it being intended that an otherwise well-run organization shouldn’t be punished as a whole for basically “lone wolf” type conduct that isn’t pervasive in the firm).  Investors may ask for no-fault removal and replacement rights on a high supermajority vote – 85% or north, for example.  In reality, this type of provision is highly infrequent; a positive number yet approaching somewhere close to zero percent of deals we see today have this sort of provision.  As with no-fault investment period termination, most managers are simply unwilling to concede that they can be put out of business where there is no adjudicated bad conduct.

In the case of a removal and replacement right, whether for cause or otherwise, the departing manager is almost always afforded carried interest in the prior deals (often up to 100% though in some cases less) and sometimes a transitional amount of management fees permitting the outgoing manager to gracefully wind down operations.  These provisions are meant to be a deterrent to enacting the removal rights, such that those rights are invoked only where circumstances truly warrant it.

A Suite of Rights

In the end, most deals will have some collection of the above rights.  Having no such LP governance rights is rare, as is having everything listed above in any particular deal.  Fund managers and investors are well advised to cooperate to put in place a standard set of provisions encompassing some of the above and as the situational facts dictate.  In deals where provisions are too favorable for LPs, team retention issues may result.  That is to say, an excellent investment professional at the top of her game may not be satisfied to work at a firm where provisions can be enacted, especially on a no-fault basis, to effectively shut the company’s doors.

With that in mind, at a high level, there are four things to consider generally when structuring carried interest.  First, what is the percentage rate of gains that will apply and will that percentage rate be fixed, or will there be the potential for it to change (for example on superior investment returns).  Second, how will the amount of investment gains be calculated when sitting down to apply that percentage rate.  Third, at what point in time will be fund manager be permitted to take cash or securities distributions constituting carried interest.  Fourth, and finally, in the event that cash or securities distributions are in excess of the agreed amount, will there be a return obligation (i.e., a “clawback”).

As to the percentage rate of gains that will apply, it is widely accepted that as a starting point this rate will be 20%.  It is rare for a mainstream venture capital fund to assess a rate lower than 20%, though in some cases the rate may be higher.  Some exceptionally well performing funds with superior investment track records or similar pedigree attributes assess flat, headline rates of 25%, 30% or in just a few outlier cases in the industry something higher.  We call this “flat premium carry”.

Where there is the potential for premium carried interest above 20%, in today’s marketplace this will tend much more frequently to be “earned premium carry” (as opposed to a “flat” model), meaning that it will only apply if investment gains warrant it.

In an earned premium carry model, investment gains are measured, most frequently with reference to cash-on-cash returns (2x, 2.5x, etc.) but in a minority of cases using more complicated models such as IRR-based calculations.  The higher rate of carried interest will either apply solely after meeting the applicable condition (i.e., the manager gets 20% carry for some time then later gets 25% carry), or much more frequently on a retroactive basis using a catch-up to the fund manager (i.e., once the condition is met the manager gets 100% of the next gains until it has received 25% of gains on a from-inception basis).  Sometimes, such a catch-up is effectively slowed down by providing if not 100% of the next gains to the fund manager, some amount over 25% (like a 50/50 share until the fund manager has 25% of total gains from inception).

Sometimes, there may be two tiers of increases, for example a model where the fund manager gets 20% of gains until a 2x cash-on-cash return, then 25% of gains until a 3.5x cash-on-cash return, then 30% of gains beyond that (with catch-ups likely to apply at each tier).  Cash-on-cash measurements are likely to apply to contributed capital, as opposed to committed capital.  This means that as more capital is drawn, a fund manager that had previously met say a 2x condition may no longer be in that position.  Where this is the case, the manager will usually have to cede the collection of carried interest until the applicable condition is met again.

The second general issue in structuring carried interest is to determine the amount of investment gains that will be used when applying the agreed upon percentage rate.  Two general approaches seen in the industry.  In some cases, the percentage rate is applied against the total investment gains in the portfolio net of total investment losses, without taking into account fund expenses.  In other cases, fund expenses in addition to total investment losses are debited against total investment gains in determining the relevant amount against which to assess the carried interest percentage rate.  Each model is associated with numerous funds in the marketplace and neither model is exclusive.

The next issue to consider is the issue of when in time the fund manager can take cash or securities distributions representing its carried interest.  It’s important to note that while the accrual of carried interest on an accounting basis into the fund manager’s capital account will always begin from inception of the fund, the right to take the balance out of that account in the form of a distribution is almost never from inception.  A delay until some condition or another is met is seen in essentially all typical venture capital deals.

The reason for the delay relates to the potential for overdistribution.  Venture funds will typically do many deals in their whole lifecycle.  Consider a $100 million fund that draws down $5 million for a first investment and sells it relatively quickly for $25 million.  If there is a 20% carried interest rate, there will be $4 million of carry (20% of the $20 million gain) to put in the fund manager’s capital account on an accounting basis.  What if the fund draws down the other $95 million and the results are not as glamorous?  There is no assurance on these facts that this fund will, on a whole lifecycle basis, make money.  Despite the early investment success of that first company, it’s possible that this fund won’t even be able to return the entirety of the $100 million in commitments if later investments don’t perform.

Since carried interest will be assessed on a whole fund basis, investors (and in many cases the fund manager itself) will want to defer taking the $4 million in this example.  Deferring the distribution of this amount in cash until a later time provides more certainty that in fact at the end of the day the $4 million will be able to be kept and not be an overdistribution.  Put another way, by waiting to take the distribution, one can see if there are investment losses which will wipe out, in whole or in part, that $4 million accounting entry in the fund manager’s capital account.

By far the most prevalent method of delay is to require the manager to return contributed capital prior to taking cash or securities carry distributions.  This is called a “European waterfall”.  Consider the above example but say that by the time the $25 million in cash exit proceeds are obtained on that first investment, the fund manager has called down $30 million of capital to make some other investments, and pay fund expenses.  In a European waterfall model, no carried interest distribution is permitted yet, because the $25 million is not sufficient to return the $30 million that has been contributed.

If the fund will not use a European model, it will probably use some form of a deal-by-deal distribution model (called an “American waterfall”) though in the interest of avoiding an overdistribution some form of test will again be quite likely to apply.  There are many permutations of this but a common test will look at the fair market value of the remaining portfolio in determining the eligibility to take carried interest distributions.  For example, such a model might require the fair market value of the remaining portfolio after the proposed distribution to be 125% or greater of such portfolio’s cost basis.  This is in effect a delay mechanism, since it will take some time for the portfolio to mature to this point.  The important point is that the appreciation of the remaining portfolio cushions the potential for an overdistribution, because the fact pattern that leads to such a situation is “early winners, later losers” (think back to the $5 million example in a $100 million fund).  If the remaining portfolio is nicely appreciated, there is much less of a chance of those later losers occurring and accordingly an overdistribution is far less likely.

It is worth noting that in the U.S. and some other similar tax regimes, the fund manager’s team will be taxed not on cash distributions but on the original allocation of carried interest into the capital accounts.  In early years, it is not likely they will be permitted to take carry distributions in light of the above concepts, and so, the issue arises of how they will pay their taxes.  Almost all deals solve for this by creating an exception to the “delay” rules permitting partial distributions sufficient for that purpose, aptly referred to as “tax distributions”.  Tax distributions are always an advance against the future actual distributions that the team will be entitled to once the agreed-upon delay conditions are met.

The final issue to determine is whether a return obligation (called a “clawback”) will exist if there is in fact an overdistribution situation, and at what time.  Most frequently in venture capital deals, there will be a clawback.  It is most frequently assessed one time: upon liquidation.  In a minority of deals, it may be applied earlier as well, though because venture capital funds typically invest in a material quantity of deals, hypothetical overdistribution situations inside of a fund’s lifecycle will usually “self-correct” in the course of allocating gains and taking (or not taking) distributions in later years of the fund’s life.  Especially with a European waterfall, while there is a statistical chance for a clawback situation to exist on liquidation, it is not incredibly likely.  As such, investors are usually comfortable with a clawback applying once, at liquidation, and additional “interim” clawbacks are not seen with much regularity in these deals.

An associated issue is credit security for the payment of the clawback.  If the clawback is in fact a liquidation clawback, there is a need to have the underlying carried interest recipients return money to the general partner (or directly to the fund) in order for the clawback to get paid, because, at this juncture neither the fund nor the general partner, on an entity basis, have material remaining assets.  Some years ago, this may have been handled by an escrow account where those recipients had to store some value for this future situation.  This is very unlikely today.  The credit security issue in most deals is solved by the signature (or sometimes stand-alone guaranty) of those recipients where they make an explicit agreement to return their part of the carried interest.

As is the case with management fees inasmuch as fees are a means to pay salaries, carried interest is a compensatory matter in the venture capital industry, and probably a more vital one in most cases.  Fund managers will do well to pay attention to market norms, so as to avoid a situation where the team is not incentivized to stick around and perform.  This is in the mutual best interest of managers and investors alike, and most sophisticated investors in the space will want a market-based set of carried interest provisions as much as the fund manager itself.

Some years ago, there was considerable concern with respect to a number of states that a fund manager’s information (be that pitch books, PPMs, partnership agreements, quarterly and annual reports or other materials) might be subject to disclosure to the general public upon demand. As it turned out, given how the laws have developed in this area, this has not proven to be a major concern today, as nearly all of the relevant laws have come to expressly provide, or at least have been interpreted by regulation or otherwise to provide, that essentially all of the sorts of highly sensitive information about themselves and their underlying portfolio companies that fund managers would most care about protecting from public disclosure now qualify for protection from such public dissemination (most frequently because such information is considered a “trade secret” in nature, and thus, protected by specific provisions in applicable state laws and regulations).

The type of protected information described above usually includes all portfolio company level information and all information about the strategy and terms of a fund’s offering. A number of states do permit the request by the public and subsequent dissemination of certain fund level (as opposed to portfolio company level) information, and some states go so far as to mandate its public disclosure even without a specific FOIA request from the public. For example, California requires that its public entity investors (CalPERS, CalSTRS, etc.) affirmatively disseminate to the public such fund level information, which is usually done by way of website. Fund level information varies by the location in question, but generally includes items such as name of fund, year of formation, aggregate capital commitments, the dollar amount of capital contributions, the dollar amount of distributions, the fair market value of the interest as of a specific time, the amount of fees (and sometimes carried interest) assessed, and so forth. Note, though, that the preceding is not reported on a portfolio-company basis, as information at the portfolio company level is generally viewed as trade secret.

Funds exist for a long period of time and these laws do change. California, for example, recently broadened the list of information deemed to be “fund level,” and thus, required for public disclosure. Accordingly, fund managers generally rely on two levels of protection to put them in the best position to disclose as little information as possible about their funds and the underlying portfolio companies. First, upon inception of a relationship, they analyze the current conditions of the investor in question with respect to what disclosure risks such investor poses to the fund manager (presently, for example, public investors in certain states are typically viewed as a bit too “leaky” to accept as investors, whereas the other states are viewed as mostly tolerable in our experience). Thus, concentrated planning for FOIA exposure issues during the investor intake phase is important.

Second, fund managers craft partnership agreement provisions which offer ongoing protection through several typical methods: (i) the confidentiality provisions are carefully crafted to provide that only a limited set of “fund level” information may be publicly disclosed by public agency investors or by fund-of-fund investors to their own public agency investors; (ii) the public agency investor is required to notify the fund manager of any FOIA requests and handle, or provide assistance for the fund manager to handle, resisting the request to the extent it is overbroad; (iii) the fund manager is permitted to demand the destruction or return of information from the investor if there is a later determination that there is a material likelihood of the public gaining access to it (this information being information beyond the broad fund-level scope, i.e. the type of information that is expected to remain confidential from public view); (iv) the fund manager, on a prospective basis, can stop providing sensitive information to the public agency (or fund-of-funds) investor if there is a non-permitted disclosure of information or there is a material likelihood or risk of the public gaining access to or being disclosed such information; and (v) in some cases, the fund manager may be able to cause a mandatory withdrawal of a particularly troubling investor.

In practice, a fund manager will need to decide whether it wishes to cross the line of accepting public agency investors or fund-of-funds investors with public agencies in them. Some managers determine that they do not even want fund level information available in the public domain and they elect to refrain, wholesale, from relationships with such investors. Other managers determine that they are fine with fund level information being publicly available, they accept these types of investors, and they rely on the above stated “typical protective provisions” to provide protection over the long life of the fund. No matter what course you may take, you will need to plan adequately for this issue in advance and determine the position your fund will take in respect of these sorts of prospective investors.