How can an alternative asset manager ‘acquire’ permanent capital via a BDC or closed-end RIC?

May 2023  |  SPECIAL REPORT: FINANCIAL SERVICES

Financier Worldwide Magazine

May 2023 Issue

Regulated investment vehicles, such as business development companies (BDCs) and closed-end registered investment companies (RICs), have been in existence for decades. But these investment vehicles are now receiving new interest from the world of alternative asset management. Apollo, Bain, Blackstone, Carlyle, KKR, Sixth Street and many other alternative asset managers have all moved, to varying degrees, into this aspect of the regulated funds universe.

There are many reasons behind these moves, one of the most significant being that the capital in these vehicles is often ‘permanent’, meaning that the vehicle never has to return capital to the investors (or must only offer to return capital in a modest and predictable manner, such as 5 percent per quarter). This is a key advantage over traditional private equity and hedge fund structures, where the manager must periodically return (or offer to return) capital. Many alternative asset managers find this permanence attractive, as it frees them from the risk and burden of regularly having to raise capital, while simultaneously allowing investment strategies that are too illiquid for more traditional structures. Further, this permanence turns the management fee stream generated by the vehicle into something that more closely approximates an annuity, as the amount of assets under management (AUM) in the vehicle, and thus the size of the annual management fee, becomes almost solely dependent on investment returns and losses, rather than also being dependent on investor redemptions or other returns of capital. This revenue stability can be a significant benefit for publicly traded asset managers, which are often valued by the market as a multiple of their management fee income.

Thus, if you are an alternative asset manager, how do you become the manager of one of these attractive vehicles?

You can go the traditional route, and organically create the vehicle from nothing. This is time consuming and expensive, as it basically involves creating the investment vehicle from scratch and then raising capital. This may involve significant US Securities and Exchange Commission (SEC) filings and, in some cases, investment banker or placement agent fees. Additionally, in the capital raise, it will likely be necessary to have one or more seed investors who act as the cornerstone of the fund, and those investors will likely demand financial incentives to participate. These incentives will be unattractive to the founding manager, as the manager (rather than the investment vehicle) often has to bear the economic burden of these incentives, which may continue for several years or in even in perpetuity. A new asset manager also needs an appropriate compliance, administrative and accounting infrastructure to support these regulated vehicles and their public reporting obligations. As with any startup endeavour, there is entrepreneurial risk and uncertainty, and it may take several years for a vehicle to gain scale and recover startup costs.

Given these difficulties, many asset managers find it preferable to ‘acquire’ an existing vehicle. There are several ways to accomplish this goal but none of the methods actually involves the new manager taking ownership of the target investment vehicle. Instead, the new manager is really just acquiring the right to manage the vehicle and be paid fees by the vehicle. Legal and economic ownership of the vehicle remains in the hands of the investors.

There are four primary methods of ‘acquiring’ an existing vehicle, as outlined below.

Fund adoption. A ‘fund adoption’, which is sometimes also referred to as an ‘adviser swap’, is when an asset manager finds an existing BDC or closed-end RIC that has an external adviser, and then negotiates with the incumbent external adviser (or the governing body of the vehicle) to take over as the new manager. Thus, management of the vehicle is swapped from one adviser to another.

Adviser acquisition. An ‘adviser acquisition’ is when an asset manager finds an existing BDC or closed-end RIC that has an external adviser, and then acquires legal ownership of the existing external adviser. If done properly, the BDC or closed-end RIC will remain as a client of the target adviser, and thus effectively becomes a client of the acquiring adviser.

Fund merger. A ‘fund merger’ is when an asset manager already manages a BDC or closed-end RIC, and then causes that vehicle to acquire another BDC or closed-end RIC via a merger. In the merger, the assets of the target vehicle become assets of the combined company, thus increasing the AUM of the acquiring manager.

Externalisation. An ‘externalisation’ transaction is when an asset manager finds an existing BDC or closed-end RIC that does not have an external adviser (i.e., the vehicle is ‘internally managed’ by employees of the vehicle), and then convinces the governing body of that vehicle to replace the internal management team with the new manager, acting as an external adviser. Thus, management of the vehicle is externalised to the new adviser.

Whether to use one structure or another often depends on factors that are outside the control of the acquiring adviser. For example, to complete an externalisation, the acquirer must locate an internally-managed target. Or to complete a fund merger, the acquirer must manage an existing BDC or closed-end RIC. Thus, the first step in the acquisition process is to identify the target investment vehicle. Once the target is known, the method of acquisition usually becomes easier to pick.

The most important issue across all acquisition structures is incentivising the target to engage in the transaction. In that regard, there are several distinct audiences that must support the deal.

The first is the governing body of the target vehicle. This body, most likely a board of directors or a board of trustees, will have fiduciary duties that obligate it to do what is best for the target vehicle and its investors. Directors take these duties seriously, and thus will need to be convinced by the acquirer that the transaction is better for the target and its investors than the status quo and other available transaction alternatives. This often requires a strong and personalised sales pitch to the governing body, coupled with financial incentives for the investors.

But the acquirer should not lose sight of the fact that the transaction will probably result in members of the governing body losing their positions and associated salaries, as these types of transactions often involve the board being replaced. This reality will be hard for the governing body to bear, and fiduciary duties can only go so far in counteracting ordinary human emotions. Accordingly, in addition to providing incentives to the target investors, the new manager might also look at ways to provide appropriate incentives to the target governing body. For example, the new manager could invite one or more of the incumbents to remain on the governing body post-closing to help facilitate the transition and retain institutional knowledge, or the new manager could offer consulting roles for similar reasons. These types of incentives will help blunt the pain of losing a salary. That said, these incentives cannot be excessive, pitting the governing body against the investors. A balanced approach is required, as is disclosure to the target investors. In that sense, incentives that benefit both the governing body and the investors at the same time are preferable to incentives that only benefit the governing body.

The second audience is the investors of the target vehicle. These investors will most likely have some type of voting right over the transaction. For example, if two funds are being merged together, the investors in the target fund will have to vote to approve the merger. These investors may be passive, or they may be activists who actively negotiate with the acquirer and the target governing body (and possibly have been agitating for a deal if they are unhappy with current management). But regardless of whether the investors are passive or active, it is typically necessary to incentivise them to vote in favour of the deal. Common incentives include fee waivers that apply for a transitional period post-closing, and expense caps that apply for a transitional period post-closing. It is also common to see transitional periods of downside risk support from the manager where the manager will reimburse the fund for losses over a period up to a cap, and even cash payments that are made directly from the acquirer to the target investors in a fashion that simulates a dividend. A new manager also may commit to buy shares of the vehicle, either by buying shares in the open market to support trading liquidity for a listed vehicle or buying newly issued shares, in each case to show alignment of interests with other investors.

The third audience is the existing manager of the target vehicle, including the people who actually work on a day-to-day basis managing the vehicle. While these people do not, under the law, have any formal say over the transaction, they have significant influence because they are in day-to-day control of the vehicle and often have intertwined relationships with its governing body. The goal of the acquirer will be to incentivise these people to support the transaction without pitting their interests against those of the investors. These incentives often take the form of post-closing transition service arrangements, or other consulting agreements, where the incumbent management team can continue to provide services (and be paid) for a transitional period post-closing. It is also somewhat common to see members of the incumbent management team join the new manager in a full-time employment or consulting role.

A host of other issues can arise, such as clearing the proxy or registration statement through the SEC, negotiating the transaction agreement, obtaining exemptive relief from the SEC to allow the target fund to co-invest alongside other funds also managed by the acquirer (if the acquirer does not already have such relief), dealing with pre-closing liabilities of the target vehicle or incumbent asset manager, fending off activist stockholders who may squeeze the acquirer for additional economics, negotiating parallel investments by the acquirer into the target vehicle, fixing antiquated or undesirable terms in the target vehicle’s governance documents, or simply dealing with a dysfunctional governance body. But these issues can be overcome, and despite the length and seeming complexity of this list, the option of ‘acquiring’ permanent AUM can offer a faster and cheaper path than organically growing it from scratch.

 

Jonathan Corsico and Christopher Healey are partners at Simpson Thacher & Bartlett LLP. Mr Corisco can be contacted on +1 (202) 636 5839 or by email: jonathan.corsico@stblaw.com. Mr Healey can be contacted on +1 (202) 636 5879 or by email: christopher.healey@stblaw.com.

© Financier Worldwide

BY

Jonathan Corsico and Christopher Healey

Simpson Thacher & Bartlett LLP

©2001-2024 Financier Worldwide Ltd. All rights reserved. Any statements expressed on this website are understood to be general opinions and should not be relied upon as legal, financial or any other form of professional advice. Opinions expressed do not necessarily represent the views of the authors’ current or previous employers, or clients. The publisher, authors and authors' firms are not responsible for any loss third parties may suffer in connection with information or materials presented on this website, or use of any such information or materials by any third parties.