Happy Friday, Funds Family!

Previously, we discussed 🛠️ how to call capital and 🛠️ what happens if an investor doesn't send the money when called.

But what happens if an investor joins the fund after the initial closing date? How do you call capital then?

📆 Fundraising after the initial closing date

As discussed in this article outlining the 🛠️ lifecycle of a closed-end investment fund, most funds continue fundraising for 12-18 months after the initial closing date.

During this time, the fund typically invests and fundraises simultaneously.

Now, let’s discuss what happens when an investor subscribes after the initial closing date.

In summary, four main things can happen:

1. Equalization of capital contributions

2. Penalty interest

3. Catch-up management fees

4. Interest on management fees

1️⃣ Equalization of capital contributions

When a new LP joins a fund, the LP must contribute an amount to the fund such that, after the contribution is made, each LP has contributed the same percentage of its capital commitment.

Let’s work through an example to see how this works in practice.

🧮 Example

LP1 joined the fund on the initial closing date with a capital commitment of $100, which she funded immediately. LP1’s funded commitment is $100 and her unfunded commitment is $0.

LP2 joins the fund one year after the initial closing date and has a capital commitment of $100.

Option 1: LP2 contributes 100% of his capital commitment ($100) to the fund and is treated as if he contributed the $100 on the initial closing date. Both LP1 and LP2 have contributed 100% of their capital commitment.

Option 2: LP2 contributes 50% of his capital commitment ($50) to the fund and is treated as if he contributed the $50 on the initial closing date. The fund then sends that $50 to LP1. The $50 sent to LP1 can be called again by the fund. Both LP1 and LP2 have contributed 50% of their capital commitment and 50% may be called in the future.

After this equalization process, LP1 and LP2 are treated as complete equals going forward.

2️⃣ Penalty interest on equalization amounts

You might be thinking: “Why would anyone invest at the initial closing date if they can wait and see whether the fund has been successful before investing?” 🤔 

Most LPAs have a provision requiring late LPs to pay interest on the catch-up equalization payments (i.e., $100 in Option 1 above and $50 in Option 2).

GPs can choose the interest rate, but it’s often somewhere around the Prime rate plus 2% (which would be around 10% per annum as of the date of this writing).

This interest is paid by the late LP (LP2 in the example above) to the earlier LPs (LP1). The interest payment mechanism acknowledges the time value of money and the fact that the early LPs took more risk when the fund’s success was less certain.

⚠️ Waiving interest payments

The GP often has the right to waive 👋 the catch-up interest payment. While this is sometimes done, I don’t love this philosophically.

The interest is paid to the early LPs, not the GP. In my opinion, the LPs should get the interest payments they’re due.

Regardless of my opinions, sometimes GPs do waive this interest. If a big LP wants to join the fund at a late closing, you might see them ask for a waiver of the catch-up interest in their 🛠️ side letter.

3️⃣ Catch-up management fees

In many fund agreements, late LPs must pay the GP management fees from the initial closing date (in a lump sum).

The GP can typically waive these catch-up management fees in its discretion (which is more reasonable than waiving the interest paid to LPs in my opinion).

4️⃣ Interest on management fees

The GP can also theoretically charge interest on the catch-up management fees. This is usually waivable in the GP’s discretion.

Thanks for reading, everyone.

Have a great weekend! 🙌 

⚠️ Note: This newsletter is for informational purposes only and nothing should be considered legal advice. For that, hire a lawyer! I am a lawyer, but not your lawyer (unless I actually am your lawyer because you’ve signed an engagement letter and we’re working together). This newsletter may be considered attorney advertising.