Many financiers have a dream of starting a fund. The initial private equity fundraising is fraught with uncertainty. While the focus tends to be on deal-making and investing, it’s not uncommon for investors to concentrate their attention on these areas.
This guide outlines the most important considerations when raising funds, including the challenges you will face in the areas of legal, accounting, and staffing.
Fund vehicles have helped many fund managers build businesses and create substantial wealth. It could be the next step in your industry. The increase in the number of private equity funds over the last decade confirms that raising funds is becoming more popular.
All that being said, raising funds requires a completely different mentality than managing money either as an employee, a personal shareholder, or as part of an informal syndicate. Here is a primer for managers who are considering investing in a fund. It will tell you what to expect, how to approach it, and what questions to consider.
Understanding the Strategy of a Private Equity Fund
Understanding the fund’s operation and profit model is one of the biggest challenges for first-time managers. Early on, creating a set of complete and well-thought-out proformas is the best thing you can do to make sure that your fund will succeed in raising money and operating it.
Profits, fees, and costs
When raising funds, it is important to remember that the profit model can be significantly different than a single syndicated investment. Separate investments can be straightforward. The manager can easily determine the expected results, fees, and profits. The manager can quickly determine the time and costs associated with managing an investment and, therefore, project a net profit accurately. If one investment fails to perform as expected, the other investments will still be profitable.
Before starting, it is important to understand the interconnected entities and money flows that make up a fund’s legal structure. Below is an image of a typical design for a private equity fund.
When planning a fund, the manager must assess future investments, which are not yet concrete and available when the fund is raised. It is, therefore, much harder to calculate profitability and understand the financial results likely from a fund. It can be hard to predict the timeline for investments. Since the investment profits and fees paid by sponsors are dependent on when and how investments are made, it is difficult to predict a fund’s revenue up-front.
It is also difficult to estimate costs for a single investment. It’s difficult to predict the amount of money that will be invested at any one time.
Fund structures can be a major factor in determining if a fund will succeed or fail. Most funds have cross-collateralized investments. A single investment failure could have large implications for the bottom line.
There is no simple answer to the question of how to set up a fund with the right revenue and cost parameters. The size of the fund, its investments, the types of investors it attracts, and its expectations will all be different. Capital markets are often given a vote, and the risk is that the “most profitable fund” will never be raised.
To deal with these issues, the best way is to carefully design the fund’s business model, taking into account both likely outcomes and the sensitivity to changes, unanticipated events, and market shifts.
Cash is a drag.
Cash management is another oft-cited problem in managing money. Cash management is not a complicated issue when making one investment. The funds are only accessed for an investment and never before. Cash reserves are usually only held by the manager, and additional portfolio financing is not available.
It is more complex for funds. By contrast, funds must manage their cash carefully. The first danger is having too much money. Cash on hand can reduce a sponsor’s profit because most fund profits are based on the value of time. Fund investors are paid regardless of whether the dollar they call and have in their possession is invested. Since many funds earn their profits by exceeding a base return rate, the fund manager can be directly impacted by a reduced performance.
Funds should also have enough reserves to protect or shore up investments in trouble, as well as to cover any unexpected costs that might arise during the term of the fund but after the period of acquisition.
The chart below illustrates an example of the cash flow of a private equity fund and the delicate balance between capital withdrawals, distributions, and returns.
A well-designed cash management plan, just like a revenue and profitability plan, can help fund managers avoid challenges and achieve success.
A new fund manager faces another challenge in determining the best investment criteria and plans for the fund. Investors can do whatever they want outside of the fund context. This is even if their investment strategy or current plan does not align with what they believe will be a good return.
On the other side, although most funds do have discretionary capital, the majority of fund agreements define in the contract the limits to that discretion. Fund sponsors often strive to make sure that the definition of discretion is wide enough to give them room to maneuver. However, fund sponsors who push for a very broad definition often struggle to attract investors. Investors prefer funds with a clear focus and expertise on a specific investment strategy or asset category.
A too-narrow definition can also be problematic. If the market changes and the fund’s mandate is no longer relevant, it may be forced to miss out on good opportunities. All of this is influenced by the type of investors the fund targets and the level of expertise and track record the sponsor has. Some investors, such as a group of friends and family who have done business with the sponsor in the past and trust them completely, may give the sponsor a wide range of latitude when it comes to choosing investments. However, an institutional investor might demand that the sponsor has a specific mandate and even approval rights on every investment. A successful fund sponsorship requires a strategy that is both feasible from an investment perspective and appealing to investors.