Many fund managers either do not know the right questions to ask or ask certain questions too late. Once the fund has investors and investor expectations are set, it can be more complicated (or sometimes even impossible) to switch directions. If you’re a fund manager planning to launch your first fund or planning to scale into your next fund, below are the top seven questions you should think through:
1. Does the fund’s structure align with its marketing plan?
Securities regulations impose stringent restrictions on the marketing efforts of private funds. Managers often intend to raise capital through social media and investor presentations without confirming that their marketing plan aligns with securities law. Selecting the correct Regulation D exemption is imperative to ensuring the fund’s structure aligns with its’ capital raise strategy.
Under Rule 506(b), the fund may not generally advertise or solicit and all accredited and sophisticated investors must have a substantive, preexisting relationship with the fund’s management team. In contrast, under Rule 506(c), the fund may generally advertise or solicit so long as all investors are accredited. If the fund’s structure and marketing plan are misaligned, the fund can face significant hurdles when it comes to capital raising.
2. Do the fund’s economics actually align with anticipated cash flow?
The fund’s legal documents can make the fund’s waterfall, fees, and withdrawal provisions look simple and clean. However, in practice, practicalities and timing mismatches can create serious investor issues or strain cash flow. Many fund managers underestimate the impact that certain distribution structures, fees, and withdrawal rights can have on the fund. Even profitable funds can feel financially unstable when the fund’s economics are misaligned with actual cash flows. When thinking through the appropriate structure, it’s important to stress test cash flow, rather than just develop projected returns.
3. What happens if the fund’s management team disagrees?
Early-stage funds typically launch with an optimistic management team that does not foresee management disputes down the road. When the management team disagrees over investment strategies, compensation, or exit timing, a weak operating agreement for the management entity (or one that is not truly aligned with the management team’s preferences) leaves no clear path forward.
Strong manager operating agreements should have mechanisms to overcome deadlocks, buyouts, and decision-making for key or major decisions. Discussing these issues in depth at the beginning of the fund’s formation minimizes issues down the road.
4. What disclosures need to be made to investors?
Under securities law, all information that could be considered “material” to the offering needs to be disclosed to investors. Fund managers often underestimate the scope and importance of disclosure obligations, particularly when they involve conflicts of interests, fee arrangements, related party transactions, track records, and risk factors. Incomplete, inconsistent, or inadequate disclosures increase regulatory scrutiny and investor disputes, even when underlying conduct may be appropriate.
When in doubt, it’s best to over disclose than under disclose to minimize potential regulatory issues and investor disputes.
5. How flexible is the offering once investors are admitted?
Once investors are admitted to the fund, fund managers are required to operate within the constraints of the operating agreement or limited partnership agreement. Day to day activities are typically reserved to the fund manager. However, amendments, related party transactions, major decisions, or strategy shifts may require formal investor approval. Oftentimes, fund managers do not realize this until an issue arises down the road.
Fund managers should ensure that they think through and understand investor voting rights and the fund’s constraints.
6. What are side letters and how should investor concessions be handled?
Side letters are supplementary agreements that may grant certain investors rights or terms that are different from those contained in the fund documents. Major investors sometimes request decreased fees or preferential terms in side letters in exchange for large investments. However, side letters are currently a gray area of the law and preferential financial, redemption, or information rights may need to be disclosed to all investors.
Fund managers should ensure that the appropriate framework is incorporated in the fund documents and that they understand the limitations in place when a side letter is requested by an investor.
7. What ongoing obligations continue after the fund launches?
With so much discussion concerning compliance at the beginning of launching the fund, ongoing compliance concerns are sometimes forgotten. After the fund launches, the fund is required to complete annual filings, blue sky renewals, recordkeeping, taxes, audits (as set forth in the operating agreement), and investor reporting (as set forth in the operating agreement). Operational gaps impacting these ongoing obligations can both create regulatory and reputational risk.
Fund managers should ensure they understand the full scope of their obligations and maintain compliance even after the fund launches.
Effective fund formation requires more than just speed. Managers who address and understand these foundational questions early preserve flexibility, enhance investor confidence, and position their funds for disciplined growth.