Pledge or synthetic funds: a structural overview

In today's difficult environment, a number of prospective fund managers have, given the extraordinary length of time and due diligence hurdles imposed by skittish investors these days, switched their model from a standard private equity fund to what is currently called a 'pledge' or 'synthetic' fund.

The difference is that, in a pledge fund, the investors' commitments are either absolute or for a ten year period. The interested investors are shown investment opportunities by the managers and are allowed to elect to participate, or not, on a deal-by-deal basis. Ted Forstmann, as I understand it, started in business with a pledge fund; and, given today's climate, some quite talented and experienced individuals are electing that route.

That being the case, it is important to understand the basic structure of a pledge fund. In my experience, the documentation of the structure is relatively simple. The manager of the fund assembles a group of investors (14 or fewer, in order to avoid the necessity of registering under the Investment Advisers Act of 1940) and asks each to execute a memorandum appointing the manager (or, more probably an LLC composed of two or more managers) as an advisor to the investor group. The investors are each identified one to another; each investor agrees to contribute so much per year in order to participate in reviewing (and at its option investing in) investment opportunities presented to the group by the management vehicle (the 'Manager').

The relationship is not, of course, employer/employee or indeed principal and agent; the only binding provision is that, for the term of the agreement… perhaps as short as a year, perhaps as long as two or three years (renewable of course, by the parties by mutual agreement)… the investor kicks in his, her or its share of what amounts to a management fee. The amount is calculated as sufficient to enable the managers to open an office and use their network of contacts to attract, analyze and evaluate investment opportunities.

Much of the documentation (although somewhat abbreviated) mimics the language in the private equity fund agreement. Thus, the managers enjoy a carried interest after the investors have recouped their advances from first profits … perhaps with a stated interest rate as well. The managers owe an obligation to bring all eligible investment opportunities to the fund; the remaining incidentals (and the devil is in the details) are covered in the instrument… credit for fees from portfolio companies; indemnification; distribution of proceeds on realization. However, since we are not dealing with a ten to twelve year lock up, a number of the provisions can be ignored or are less intense… 'no fault divorce' for example.

The problem is that the decision process is somewhat elongated; moreover, pledge funds are not usually in the mega-millions of dollars, so it can be lean times for the managers as the fund gets started, even with a collective commitment to pay a management fee. On the other hand, the investors are usually a lot more relaxed about allowing the managers to be paid as well by the portfolio companies, without recoupment from the management fee. And, the object of the exercise is, in the first three or four years let's say, to create enough of a track record that the next initiative is a real live private equity fund, structured along conventional lines.