Parallel fund structures: An optimal framework to meet the evolving needs of investors?

A popular approach in the private equity industry is the use of strategies involving parallel fund structures, where one or more investment vehicles operate as separate legal entities to the main fund, that being the primary fund that an asset manager sets up to pursue its investment strategy and attract capital from investors. These additional vehicles invest and divest alongside the main fund, usually on a pro-rata basis per their capital commitments, and each structure shares many similarities with the main fund in terms of investment strategy, investment policy, portfolio of assets, and risk management.

The parallel funds are established by private equity (PE) firms to complement the main fund and address legal, tax, regulatory, accounting, or other considerations from specific investors.

The history

Parallel fund structures have been used in the PE market for several years. The popularity of parallel funds grew in the 1980s and 1990s as PE firms aimed to attract a wider variety of investors and expand their pool of raised capital by providing tailored solutions to investors depending on their investment goals and risk profiles. 

These structures have been an integral part of the alternative fund industry for decades, continuously adapting to the evolution of the market environment and the evolving needs of investors.

Today, parallel fund structures are widespread in the industry, as they offer several benefits and advantages to both investors and investment managers. The flexibility and diversification offered by parallel funds make it an attractive structure for limited partners (LPs), while the multiple funds allow global asset managers to adapt to changing market conditions while still meeting investor needs, and to raise more capital through vehicles that operate across multiple jurisdictions.

What are the key benefits and advantages offered by parallel fund structures?

Parallel fund structures offer several benefits and advantages in the Private Equity industry. These are laid out below.

Greater range of investors: A parallel fund structure provides the ability for non-European Union (EU) fund sponsors to reach out to alternative investment fund investors based in the EU. The EU presents a large market of institutional investors that are open to invest in alternative assets. The fund sponsors from Asia and the US are increasingly contemplating the set-up of parallel funds, based in Luxembourg, to reach out to these EU investors while managing their established domestic main fund. It helps these global asset managers to access new capital from a greater group of LPs while leveraging the main fund's track record.

Larger capital commitments: It allows fund managers to increase their capital raising capacity, creating more opportunities for the entire fund structure, including the main fund and one or more parallel funds, to develop a more substantial and diversified portfolio of investments.

Diversification and flexibility: Parallel fund structures enable PE firms to offer a diverse range of options, through multiple funds, to investors with different investment objectives, risk profiles, and geographic focuses. This approach enables investors to diversify their portfolios and mitigate their exposure to risks across different investments. The parallel structure provides LPs with the flexibility to identify and select the fund vehicle that aligns with their unique risk profile, regulatory obligations, and tax preferences while ultimately investing in the same portfolio of assets.

Legal and regulatory motives: Some investors may have internal policies or may be subject to tax or regulatory restrictions that limit their capacity to invest in an offshore entity. Given various legal and regulatory guidelines or restrictions, EU investors tend to favor investing through an EU-based fund vehicle, while US investors usually opt for a Delaware or Cayman fund vehicle. Under the Alternative Investment Fund Managers Directive (AIFMD), an EU-based AIF can access the EU marketing passport. This passport helps the fund manager to promote its products without the requirement of receiving approval, which can be time-consuming, from local regulators in each country beforehand, thereby saving valuable time during the marketing period. 

Efficiency: A more substantial pool of investments allows alternative investment managers to operate funds more efficiently and to attain their investment objectives more quickly. The incorporation of multi-jurisdictional vehicles could lead to the optimization of the fund structure. By leveraging a multi-jurisdiction structure, PE firms can accommodate more investors, and a global asset pooling approach could centralize assets to enhance profitability and efficiency. In addition, the set-up of a parallel fund enables the segregation of regulatory costs and expenses, providing a more cost-effective structure.

What are the primary operational and organizational challenges encountered by parallel fund structures?

While parallel fund structures can offer several advantages and benefits to LPs and PE firms, there are some challenges and concerns associated with this type of structure, including:

Operational efficiencies: The fund manager needs to manage multiple funds across jurisdictions and is still required to treat investors fairly. Numerous jurisdictions means different legal and regulatory requirements and creates more administrative responsibilities and complexities. From an operational point of view, it is also necessary to coordinate the services of different service providers in respective jurisdictions, including central administrators, auditors, depositaries, and others. The communication and transparency requirement to investors could also be an operational challenge as asset managers must ensure they have adequate communication and reporting procedures to keep all investors informed of the investments' activities and performance across the entire fund structure.

Fee structures: Parallel fund structures can also lead to confusion regarding specific costs, expenses and fees. Parallel funds may have different fee structures and charges, leading to increased complexity and possibly higher fees for some investors. For example, if a Luxembourg-based parallel fund is required to appoint an authorized Alternative Investment Fund Manager (AIFM), then a third-party service provider will be integrated into the fee and delegation scheme. Consequently, an adequate fee allocation mechanism among the main and parallel funds in the structure will be necessary.

Compliance challenges: Depending on the jurisdictions where the parallel funds are established, different compliance with local or regional laws and regulations may apply to each fund, adding to the complexity of managing multiple funds with different requirements.

Equalization and subsequent closing of LPs: Parallel funds can hold closings at various times during the fund’s fundraising period, until final closing, hence interest charges on late-closing investors will likely be applied within each parallel fund, as well as the rebalancing of LP interests regarding the portfolio investments existing prior to any subsequent closing. In addition, some organizational expenses could be imposed on such LPs investing through the parallel funds. It is crucial for fund managers, launching parallel structures, to have a clear understanding of whether these additional vehicles will be launched simultaneously to the main fund, and then establish, within the fund agreements, the relevant terms and conditions to preclude any inconsistencies or conflicts, especially regarding the marketing period for the launch of the parallel fund.

What about Luxembourg?

Luxembourg is one of the leading jurisdictions worldwide and the leading hub in Europe for setting up alternative funds. The legal and regulatory framework is constantly being improved to offer the best tools for investment managers to structure their investments and to protect investors interests.

Luxembourg is the number one investment fund center in Europe:

1. 90% of global PE investments are structured using Luxembourg vehicles
2. 19 out of the top 20 global PE houses have operations in Luxembourg
3. EUR 5.2 trillion of assets under management (AUM) in investments funds  

As US-based fund sponsors represent the majority of this market, it is apparent that the array of options provided by the Luxembourg fund structuring toolbox is adequate for structuring various investment strategies.

In Luxembourg, the Special Limited Partnership (SCSp) is a suitable option for establishing a parallel fund due to its flexibility and familiarity with common law vehicles, such as Delaware and Cayman Islands partnerships. For non-EU based fund managers, especially Asia-Pacific and the US, it also provides access to the European passport for marketing purposes where the fund appoints an authorized AIFM.

Furthermore, Luxembourg provides various other fund products, including the Reserved Alternative Investment Fund (RAIF) which has experienced a robust development since its initiation in 2016 and is well-suited for establishing a parallel structure in Luxembourg.

With respect to tax, it is worth mentioning that both the SCSp and the RAIF are by and large tax neutral vehicles and management services are VAT-exempt.

Outlook for parallel fund structures

Parallel fund structuring is currently experiencing a favorable trend linked to the rise of the mega fund

Over the past months, the fundraising activity for PE has been driven by a limited number of large global flagship fund, usually categorized as “mega fund”, which are typically funds that raise a significant amount of capital from a wide pool of investors, ranging from several billion to more than USD 20 billion, and are designed to invest in a diversified range of assets, geographical locations, and sectors. These mega funds are managed by global PE firms, and the use of parallel structures is common to manage the massive amounts of capital raised. In addition, mega funds usually require a significant amount of organizational infrastructure and personnel capable of handling multiple funds, hence parallel fund structures can provide global asset managers with an efficient and scalable organizational structure that allows them to manage mega funds effectively.

Today parallel fund structures are widely used by fund managers in the PE industry and are likely to remain a fundamental part of the industry in the future. The outlook for the use of Parallel Fund structures in the PE industry is positive, as the industry continues to grow and evolve.

The PE industry is expected to continue growing in the coming years, with more investors seeking to allocate capital to alternative assets. Currently, global asset managers are challenged to create the optimal and right structure to fulfill the ever-evolving demands of investors. The set-up of parallel fund structures continues to help PE firms to raise more capital, expand their geographic focus, and diversify their investment strategies to continue meeting investor demands.

1 LPEA, LFF

2 LPEA, LFF

3 ALFI, Q2 2023