The popularity of private capital investment funds has exploded over recent years. As the drive for attractive returns pushes investors to look at different assets classes, infrastructure, real estate and energy investments offer a real opportunity for portfolio diversification.
This demand presents an opportunity for asset owners and developers to reposition themselves as sponsors by offering capital providers access to a portfolio of initial assets, often referred to as "seed assets". Once the fund is closed, the sponsor can then diversify its portfolio with additional assets. The use of seed assets to launch a fund or platform gives sponsors a leg up on first-time sponsors with respect to fundraising because the existence of the seed assets gives the capital providers insight into, and, ideally, confidence in, a project owner's investment profile.
Whether the seed assets are already managed by the sponsor or are to be transferred to the fund or platform at its initial closing or at a later stage, they provide investors with a clear path for the deployment of their capital. There are a myriad of ways to structure seed asset portfolios and this article provides an overview of relevant considerations, specifically in the areas of energy, real estate and infrastructure.
Transfer of Assets
Often a sponsor (usually an owner and/or developer) will have several assets at various stages of development, from projects under construction to others having already achieved commercial operation. It is essential that operating projects can be successfully transferred and that there is also a clear path for the transfer of developing projects once ripe. The contractual arrangements put in place to ensure such orderly transfer may take many forms. One example is a vend-in agreement, whereby the fund or platform agrees in advance to purchase, and the owner agrees to sell, each asset upon the satisfaction of certain conditions precedent. Predefined conditions usually include the achievement of certain milestones in the development of the asset and meeting a predetermined model agreed to by the parties. The vend-in can also take the form of a right of first offer or a right of first refusal in favour of the fund or platform, provided that the fund or platform governance mechanisms allow for a sufficient degree of investor oversight regarding decision-making at that stage and the type of asset, region and other criteria are specified or the purpose of such options. From the sponsor's perspective, these contractual arrangements should be carefully crafted to ensure that assets that are not acquired by the fund or platform may be retained or offered to third parties.
Due Diligence and Representations and Warranties
When considering investing in a fund or platform with seed assets and unlike in a pure M&A context, investors will not systematically conduct extensive legal due diligence on the underlying seed assets. Investors will perform customary commercial diligence on the seed assets, the model and on the background of the manager, but whether an investor's diligence process will include or not legal diligence on seed assets (and its extent) may depend on the stake the investor is taking in the fund and other considerations which are specific to that investor. This is in keeping with the practical reality that, once invested in a fund or platform, an investor does not have the opportunity to conduct diligence on other assets added to the fund because its commitment is progressively called by the manager to make new investments. As such, when seed assets are transferred to a fund or platform at closing or at a later stage, investors may wish to have a condition that the assets meet predefined criteria and ensure that the fund or platform obtains representations and warranties from the seller regarding such seed assets to ensure appropriate protection, with adequate covenant support and/or mechanisms within the fund or platform to true up the investor against the equity, carry and/or distributions of the seller or affiliate (to the extent the seller or affiliate is also an investor).
Pricing
There is an obvious conflict-of-interest when pricing seed assets. In spite of the alignment of interests between the sponsor and the fund or platform as far as the future performance of the fund is concerned, the sponsor or its affiliate, as the transferor, still stands to profit from the sale of the assets to the fund.
One solution to this conflict is for the sponsor to obtain an independent valuation of the seed assets as the basis of determining a fair transfer price. However, this can add delays and cost to closing, and there is always the risk of variance between valuations of different valuators. In the case of infrastructure or energy projects, an interesting alternative exists. Because the value of the assets relies heavily on the cash flows they generate and because such cash flow streams are usually limited in number and are more predictable than those of a company selling various products or services, the sponsor and the investor can agree on a financial model that will be used to arrive at a purchase price by jointly updating some of the input variables (such as a discounted cashflow valuation model). Investment committees and/or advisory committees with independent members can also have input to determine a fair purchase price. By building sufficiently robust mechanisms for determining valuation adjustments and settling any disagreement that may arise about valuations, investors and sponsors can reach a sufficiently neutral result without excessive complications or delays.
Conclusion
This article provided a brief overview of some of the key issues that may arise when an owner or developer uses seed assets to launch a fund or platform. Although there are always issues to be considered, as is the case in any transaction, using seed assets to launch an attractive investment fund has become an increasingly popular strategy for sponsors in both Canada and abroad.
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