What is a Special Purpose Vehicle?

People often think of private equity, venture capital, and hedge funds when considering the various alternative investment opportunities available to investors. These vehicles provide a mechanism for investors to access the expertise of fund managers across the investment management industry.

Unsurprisingly, the world of alternative investments is vast and includes another widely used but lesser-known investment structure called a special purpose vehicle.

A special purpose vehicle is a separately established fund structure that can be organized quickly and is designed to hold a limited number of investments that are generally acquired within a short period of time.

Oftentimes, these vehicles are formed to take advantage of discrete opportunities that would otherwise not meet the liquidity, concentration, or asset class constraints of the main fund.

A special purpose vehicle is commonly formed as a limited liability corporation or limited partnership and is structured in a way that isolates financial risk and opportunity and is relatively easy to create and maintain.

Because most special purpose vehicles often pursue specific opportunities on an expedited basis, in most cases the manager will use a detailed term sheet rather than the full set of offering documents that are typically used for a private fund.

The term sheet describes the underlying investments and the vehicle’s material terms and considerations, including relevant risks and tax and ERISA considerations.

Generally, these vehicles do not permit investor liquidity and the carried interest follows the private equity fund model, meaning there is no annual incentive allocation, and the carried interest to the general partner is made only upon realization.

Hedge Funds

Hedge funds typically invest in liquid, publicly-traded securities and provide liquidity terms to investors that are commensurate with the liquidity profile of the fund’s investments.

At times, managers may find compelling opportunities in less-liquid securities that are not appropriate for the main fund but may be of interest to its clients. For example, a US investment-grade credit manager might find that there is price dislocation in emerging market high yield bonds and would like to take advantage of the opportunity.

To exploit this opportunity, a fund manager might consider creating a special purpose vehicle that invests alongside the main fund but is formed to serve as a venue for housing the illiquid assets.

Venture Capital and Private Equity

Source: JPMorgan (2014). The Emergence of Hedge Fund Co-Investment Vehicles

For venture capital and private equity, special purpose vehicles are typically offered as a co-investment. A co-investment is an investment in a specific transaction made by limited partners of a main fund alongside, but not through, such main fund.

Firms typically offer co-investments in instances where there is a capacity constraint, such as when a sponsor is seeking to invest in a company to take control but is limited in the amount of capital that it can invest because of concentration limits or because the fund lacks sufficient capital.

The vehicle also provides a general partner the ability to invest outside of their general mandate when a target company does not fit within their traditional opportunity set.

For example, a venture capital firm that focuses on early-stage technology companies might source an investment opportunity in a pre-IPO consumer services company. Because this company would not fit within their venture fund strategy, the firm might consider creating a special purpose vehicle to pool assets and invest in the company.

Limited Partners

For limited partners, the investment minimum for direct investments in private companies can be significant and this vehicle oftentimes helps reduce this minimum. This flexibility allows more investors to participate and obtain a larger share of the desired investment.

Limited partners will often gain access to enhanced due diligence or general partner materials that would otherwise be unavailable, allowing for a deeper understanding of the target investment.

A drawback, however, is that individual investors do not obtain individual rights in the company and will not have a say in the direction of the company as an otherwise direct investor would.

The investor could also be subject to fees such as carried interest and any matters of concern must be taken up with the owner of the vehicle.

Hedge Fund Special Purpose Vehicles

A hedge fund manager will alert investors if they intend to offer a separately established fund to hold investments that may not be appropriate for the main fund. At that time, the investor must review whether they will elect to opt-in or forgo the opportunity.

The suitability of the vehicle will be dependent on the unique considerations of each individual investor and can be better understood by asking the following questions:

• Will the co-investment vehicle have a different general partner and/or investment manager than the flagship hedge fund?
• What will the likely investment holding period be?
• Will investors have any right to liquidity?

Of course, this is just the tip of the iceberg as financial advisers need to conduct independent research and evaluation of special purpose vehicle opportunities as well as the risks and goals of their clients before determining the suitability of a particular investment.

Venture Capital and Private Equity Special Purpose Vehicles (Co-Investment)

There are several factors to consider when deciding whether to participate in a co-investment and it is supremely important to consider the experience and knowledge of the vehicle owner or general partner by asking the following questions:

• Who is the general partner organizing the co-investment?
• What type of experience does the general partner have investing in private companies?
• Does the general partner have experience in operating special purpose vehicles?
• Does the target company align with the general strategy focus of the firm? If not, why are they participating in the deal?

Furthermore, an investor should ensure there is the proper alignment of interest between the general partner and the limited partner.

• Has the general partner invested internal capital in the deal? If so, how much?
• Does this deal represent a large allocation from an existing fund offered by the general partner?
• Has the general partner provided prospective investors adequate resources to conduct thorough due diligence?

In alternative investing, special purpose vehicles are formed to provide investors with specialized exposure to either a single investment or a limited number of investments. A well-structured co-investment vehicle, with diligently prepared fund agreements and related documents, can address and alleviate many of the potential pitfalls.

But even with all this present, it is still possible for investors to lose all or substantially all their investment in a special purpose vehicle. As such, it is important to consider the nature and unique risk of the underlying investment(s) to appropriately understand how this added exposure could alter the risk and return profile of an investment portfolio.

Separately, when the vehicle is formed to fund a single, early-stage company, an investor should understand that startups face considerable uncertainty and have a high rate of failure.

While investors can be more diligent in their analysis because the target company is known, as opposed to investing in a black box of unknown investments made by a traditional drawdown vehicle, an investment in an early-stage company is often thought of as a satellite investment and not a core investment because of the unique risk of less mature and smaller sized companies.

However, despite the potential risks and limitations of special purpose vehicle investing, which are not exhaustive of the risks discussed, financial advisers may find unique opportunities in this space through proper due diligence.

Fund managers continue to seek out new ways to offer alpha opportunities to their clients. In doing so, the special purpose vehicle has risen in popularity as they can be quickly organized to take advantage of distinct opportunities.

At its core, the special purpose vehicle is organized to invest in a single investment or a limited number of investments.

Hedge funds looking to invest in illiquid securities might consider creating this vehicle to serve as a separate and distinct venue for housing the illiquid assets.

For venture capital and private equity, special purpose vehicles are typically offered as a co-investment in a specific transaction made by limited partners of a main fund alongside, but not through, such main fund.

Investing in this manner is not without risks, yet these concerns may be mitigated and better understood by conducting prudent investment analysis and asking questions to the general partner or platform organizing the special purpose vehicle.

Sources:
Hedge Fund Research. HFR Hedge Fund Strategy Definitions - Relative Value
MicroVentures, (2019). Special Purpose Vehicles: Things to Know
CFI. Special Purpose Vehicle (SPV)
Carta (2019). What is a special purpose vehicle (SPV)?
Seward and Kissel LLP (2019). How Hedge Fund Managers Can Access Illiquid Investments
Seward and Kissel LLP (2015). Key Issues When Establishing A Co-Investment Vehicle
Morgan Stanley (2022). The Rise of Hedge Fund Co-Investments
Hedge Fund Law Report (2017). Beyond The Master Feeder.pdf
JPMorgan (2014). The Emergence of Hedge Fund Co-Investment Vehicles