by Michael Schmanske
Special Purpose Vehicles (SPV’s) are the smaller, older sibling of a product that made a huge splash last year, the Special Purpose Acquisition Company (SPAC). I won’t detail the differences, but suffice to say the motivation, fee structure and investment targets are drastically different between these products. The benefit of SPV’s, or “Syndicates”, is that they mostly solve regulatory and operational optimization.
Private equity markets are regulated more loosely than public markets to preserve the entrepreneurial dynamics and needs of startups. Unfortunately, this means that as a company grows in size, age or number of investors, they are progressively held to higher levels of regulatory oversight and reporting requirements. To delay these requirements, companies often enforce a minimum investment size, or group investors together as syndicates into an SPV. In short, the initial creation of syndicates was predicated on the need to meet a regulatory requirement, not to make lives better for the companies or investors.
A syndicate or SPV (We will use them interchangeably. Many in the industry refer to them as the same even though that’s not technically accurate) has a specific structure. Investopedia usually does a great job on definitions. Unfortunately, for our purposes, they attempt to discuss every use case of an SPV. You can find their take HERE
The following is a more relevant breakdown for our purposes: The Structure:
A Limited Liability Corporation (LLC) is formed (often in Delaware) with an Organizer, a General Partner and an Investment target. The LLC collects investment capital from the Limited Partners, aggregates the capital, withholds a certain percentage of the raised money to pay for management and administration expenses over the expected life of the investment and then passes the balance to the investment target. The syndicate shows up as a single line item on a company’s cap table rather than a list of every individual investor in the SPV. Upon a successful exit (Acquisition, or IPO) the SPV management receives a % of the outperformance as a performance incentive (The “Carry”).
The Investment: the company, property or other asset that the group of investors wish to purchase.
The Organizer: The group or individual that pays the upfront fees and coordinates the legal documents required. This may, but need not be…
The Administrator: A third party entity that provides tax, accounting, audit and other support services to the SPV. They receive an annual servicing fee paid from a reserved capital pool and add a layer of security and legal certainty to investors.
The General Partner (GP): The lead partner of the investment group. Typically, they perform due diligence and maintain ongoing legal and tax reporting requirements. For these efforts, they may or may not receive a fee share.
The Lead Investor or Partner: The first external investor to commit and whose term sheet is accepted. They are usually a professional investor, but this is not a requirement. Typically, they perform due diligence and other valuation, structural or legal vetting. Sometimes they are also the GP. They often receive a portion of the performance fee, the “Carry”.
The Manager or Portfolio Manager (PM): Receives compensation from the syndicate to manage the investment. For Asset transactions like startup investments, they are responsible for communicating with the company on an ongoing basis ideally to support the companies growth towards success.
Limited Partners (LP): The investors in the SPV. This can be individuals, family offices or even investment funds with their own Portfolio Management (PM) teams (aka – Fund of Funds).
That’s the framework. But, as we will see, there is a big hole in the process. More and more SPV investments are being offered in the market. On the one hand, this is fantastic. They can be a great mechanism for investors and startups alike. On the other hand, I read the fine print for most of these being offered and I come unglued. Who are they fricking kidding? I don’t think most of them have bad intentions, they just have little experience building investment instruments that work for both parties. They don’t understand the costs to effectively manage the investments and they apply fees in the wrong areas.
The fact is, you get what you pay for. There is no such thing as a free lunch in finance. Anyone telling you diligence is being done voluntarily is essentially telling you to invest your money into amateur-hour. Go get a Monkey and a Dart Board; You’ll probably do better.
However, you can design fee structures so they are win-win. Investors want to have their funds managed enough to give them the best chance at a positive outcome, but they don’t want the fund managers getting wealthy if the investments aren’t successful. (When you see a fund of $500M+, you can rest assured their performance is not great and their lifestyles on the fees is comfy.) With some thoughtful innovation, there is a better option. Follow this Blog Series to develop a stronger grasp of syndicates.