Fund of one: Recent trends in separately managed accounts

Over the last few years, there has been a considerable increase in investors seeking bespoke investment arrangements with private fund sponsors through “fund-of-one” structures.  These are sometimes also referred to loosely as SMAs or separately managed accounts (although separately managed accounts in the hedge fund context are different animals and not the topic of this post).  

Funds of one or SMAs diverge from traditional blind pool funds or ad hoc co-investment vehicles.  These structures are most common where an investor is making a larger commitment to a particular fund sponsor.  As we enter 2024, we wanted to share some of the top insights we have observed on this trend, which sponsors and investors may want to consider in their investment objectives for the year ahead. Below are a few key considerations of SMAs, particularly in contrast to typical blind pool fund investments.

 A closer, two-way relationship

The economic and political climate has driven investors (particularly the largest asset owners) to consolidate and deepen relationships with fund sponsors through methods that supplement relationship building through the more traditional blind pool fundraising space.  Frequently, an investor may seek an SMA arrangement alongside its “main fund” investment and in addition to ad hoc co-investment opportunities. Since SMAs can be structured to suit specific business needs and objectives, they inherently result in closer, more collaborative relationships between an investor and an investment manager. This includes: 

• Substantive relationship: The operation of a fund-of-one is more of a “two-way street” than what an investor may typically experience when investing in a blind pool fund alongside many other limited partners.  
• Knowledge sharing: SMAs allow a more open exchange of ideas for the benefit of the parties, which can include knowledge-sharing arrangements through frequent one-on-one discussions between the investor and sponsor, employee secondment placements, and collaboration on deal flow and referral of investment opportunities. 
• Consolidated structure: A benefit of an SMA is that it can be continually extended to become the main investment platform between an investor and a sponsor, which can simplify subsequent negotiations, reduce organizational and structuring costs, and accelerate execution timing for future investments (whether specific to the SMA’s investment scope, or otherwise).  For example, a single SMA can be set up with distinct pools of capital to serve as an investment vehicle for multiple strategies.  

Overall, investors should seek and expect to have a more meaningful and flexible relationship with their sponsor via an SMA, with the goal of building and maintaining a lasting and mutually beneficial partnership.

Better economics and efficiencies 

The economics of an SMA typically do not follow the typical “2 and 20” fee and carry arrangements often found in blind pool funds. While commercial terms will vary from case to case, a mutually beneficial partnership is also fostered by a stronger alignment of the fund’s economics, in terms of: 

• Fees: Management Fees typically are charged on deployed capital instead of committed capital, which inherently incentivizes deal flow and attention from the manager to the SMA.  We also have seen investors negotiate deferred performance fees and carried interest arrangements to better match an SMA’s long-term performance over its short-term gains.  In cases where an SMA is set up alongside an investor’s “main fund” investment, investors may consider negotiating umbrella fee/carry packages for more favorable economics based on an investor’s aggregate commitments to a manager across different strategies and investments.  
• Flexible holding periods: Investment periods can be as short or as long as needed given a particular investment strategy, and it is not uncommon for SMAs to include pre-agreed options to extend investment periods, upsize commitments, or even change the investment strategy from time to time.  
• Alternative vehicles/expedited deal execution: With any given investment strategy, a step further can be taken in setting up lower-tier subsidiaries and alternative vehicles to facilitate and speed up deal execution, thereby potentially forgoing the need to set up a new underlying structure for each investment.  
• Increased investment opportunities: In terms of deal flow and investment opportunities, investors may be gratified that fee-charging SMAs are naturally more attractive to sponsors than no-fee no-carry co-investment arrangements and could lead to increased investment opportunities. Priority on deal allocation can also be negotiated, as discussed below. 
• Deal flow covenants: From a commercial perspective, investors should be mindful of the deal flow covenants for their SMAs, and whether they can secure a minimum level of guaranteed deal flow. For example, deal flow volume can be a condition to fee/carry discounts or could be tied to investment allocations to the manager’s “main fund.”  In thinking about the investment focus, investors should consider how to incentivize deal flow to their SMAs vis-à-vis the sponsor’s other competing investment vehicles and clients.
• Tax efficiencies:  From a tax standpoint, SMAs can be set up for tax efficiencies specific to a particular investor without needing to consider the tax positions of other investors. 

Overall, SMAs offer investors substantially more options and flexibility that permit a range of creative solutions to address their business concerns. Once set up, an SMA is often the primary relationship between an investor and sponsor and parties, providing efficiencies to both parties and allowing investors to tweak their investment strategies from time to time without needing to set up and renegotiate entirely new investment structures.

Special governance rights and protections

Maintaining an investor’s limited liability is a critical legal protection and SMAs can provide increased oversight and safeguards in this regard. Special governance rights and protections include: 

• Increased oversight: Certain jurisdictions may statutorily require periodic GP-LP meetings, but the closer alignment of interests that sponsors and investors have in an SMA may warrant more frequent discussions over the SMA’s lifespan. This opportunity to discuss the SMA’s performance and future direction again provides a more personalized connection between the two parties.  
• Non-discretionary SMAs: More selective investors will prefer to have non-discretionary SMAs, where the investor must approve each investment on a deal-by-deal basis, thereby giving the investor optionality in which investments they would like to pursue (and in some cases, also including investor approval rights over the sale of an investment or even an arrangement for the GP to seek buyers if and when the investor requests to exit an investment).
• Distribution in kind of an investment: Some SMAs provide investors with the option to request a distribution in kind of an investment, providing the investor flexibility to directly hold an investment outside of the SMA.  On the other hand, sponsors in such a situation may try to negotiate rights of first refusal or rights of first offer over the SMA’s assets.
• Valuation:  SMAs typically offer a higher degree of oversight and controls over valuations and pricing not typically found in blind pool funds.  SMA investors will often have a right to review and potentially challenge valuations by the manager – an increasingly important recourse when the bid-ask pricing gap is significant. 
• Bespoke reporting: Bespoke reporting is also a common feature of SMAs, and it has become increasingly common for sponsors to use an investor’s reporting format, and as part of this, to provide specific reporting metrics requested for the investor’s own internal reporting. 
• Key person provisions: In terms of a sponsor’s time and attention, investors often require specific individuals to be key persons with heightened time, attention, and obligations specifically to the SMA, rather than the sponsor’s general investment advisory business, which is a common standard for blind pool funds. As a result of this, key person provisions tend to be highly negotiated in SMAs. 
• Greater expense controls: With respect to expenses, investors tend to request limits and detailed reporting on SMA expenses for monitoring purposes and some SMAs will include a concept of an annual budget or a deal-by-deal budget, to be discussed with and approved by the investor to manage costs.

Overall, SMAs can provide a greater level of investor involvement through various controls.  This not only allows an investor to better monitor and manage their capital deployment and investments, but also permits a sponsor to better understand an investor’s objectives and to work collaboratively with the investor to provide suitable opportunities.

Going into 2024, we are still seeing increasing appetite for SMAs from institutional investors, pension funds, sovereign wealth funds, and other investors in the market.  In this challenging economy, SMAs can provide investors additional comfort with the role of being more than a passive “passenger” in a blind pool fund.  For sponsors, an SMA provides both a source of reliable capital and a client that is a meaningful and strategic partner to the sponsor.  

Whether your investment strategy is private equity, real estate, venture capital, credit, infrastructure, or any custom blend of various sectors, we encourage you to keep in mind the possibility of an SMA in addition to or in lieu of various blind pool and co-investment fund offerings.

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