Designing a fund strategy
[This is the second article in a four-part series on fundraising] Read the previous section on GP team.
While the background and experience of the GP naturally drives the fund strategy, there are also numerous external factors to consider, such as: geopolitical landscape, the overall demographics of the economy and market forces. These considerations are also guided by the inherent attributes of the GP (their experience and capabilities in those areas), and should ultimately shape the overall direction and strategy of the fund.
When looking at extrinsic factors, the geopolitical environment forms the overarching consideration, followed by other macroeconomic factors such as:
Key industries that drive and underpin the broader economy
Population size and demographics
Consumption patterns and habits
The depth of liquidity in the market and access to capital such as commercial bank lending, public and private capital markets
For example: a company based in an emerging economy such as Myanmar or Laos, without abundant sources of domestic bank funding, is more likely to rely on equity funding (or foreign debt) rather than traditional bank debt for its business expansion.
The macroeconomic factors are also closely linked with the spread of industries targeted by the fund, which in turn, determine the possible pipeline of target companies.
For example, the theses for designing the investment approach for a Southeast-Asia focused manufacturing fund could include:
(i) Shifting of regional production bases to Malaysia, Vietnam or Indonesia due to US-China trade tensions
(ii) Strong emphasis (and dependance) on the manufacturing sector as a core part of Southeast Asia’s GDP
(iii) Trends of companies relocating to Southeast Asia due to comparatively lower production costs and easy access to human capital
(iv) Precedents of foreign companies investing into and/or trading in the market
Size matters In addition to industry sectors, the geographical location of the portfolio plays an important part in the ticket size i.e. the amount of capital to be deployed in each company.
Assuming your fund is prepared to write checks for companies with more than $100 million in EBITDA, there may or may not be a sizeable pool of companies in the region that could fit the bill of a $600 million EV (enterprise value) assuming we apply a 6x valuation multiple.
Access to leverage (debt) is important too as this ultimately also determines the EV and equity ticket size. Banks have differing risk appetites for different industries. Consider a real estate focused fund with hard underlying assets -Being able to get bank funding at 70% loan-to-value will enable you to just put in $300 million of equity capital to acquire a $1 billion portfolio.
Minority or Control? The considerations for control of minority deals are largely driven by the ability of the GP team to create value within the portfolio, and to a certain extent, the operating dynamics of the underlying businesses. For venture deals and early stage companies, fund managers tend to allow the existing founders to retain a larger portion of shareholding so that they (the founders) remain sufficiently motivated to make the business a success.
I generally adhere to these three principles:
Is there a viable roadmap to exit? While it is important to build a good pipeline of deals, it is even more important to ascertain whether or not there is a viable roadmap to a liquidity event. A liquidity event could be:
(i) An Initial Public Offering (IPO);
(ii) Selling the business to a competitor (consolidation play) or;
(iii) Someone who wants to enter the market
(iv) Selling the business to another fund
(v) Selling the business back to the original owners (a put option)
Some indicators of whether a liquidity event in the market is possible include:
Is your fund size realistic? So, you got your estimated fund size, your ticket size and your pathway to exit, but what does this mean in terms of the number of companies under the your fund’s portfolio? Let’s use a simple calculation to derive this:
Consider this: Most funds charge a management fee of 1.0% to 2.0% i.e. if you are raising a $1 billion fund, that translates to approximately $20 million in management fees every year - well enough to pay the rent, accounting and fund administration expenses, as well as a sizeable headcount.
However, if you are raising a $20 million round (assuming this is your first fund) or your check sizes are a lot smaller, the corresponding management fees would amount to between $400k to $1 million. If this is your first fund, you could be looking at even lower management fees of 1.0%. The bigger question here is: will this be sufficient to operate the portfolio? Will there be enough professionals to work on transactions and due diligence? Not to forget, travel expenses, due diligence costs, etc.
Let’s look at some illustrative estimates:
The figures above do not yet include organizational fees such as licensing the fund (could be fixed/billable hourly expenses), fund formation fees such as LPA advisory, drafting and closing (billable hourly) as well as fund administration expenses (these are generally fixed but subject to complexity).
The US market has some good disclosures on fund organizational expenses from publicly listed private equity firms. They can be used as a general guide, but differs for different fund types, structures and jurisdictions.
To summarize: Assuming your annual operating expenses are about $1 million and you apply a 2.0% fee structure, this implies that your minimum fund size should be at least $50 million.
You can of course choose to raise less than that but may need to revisit your fund strategy and/or tweak some of the operating expenses.
A special note on GP commitment For first-time funds, GPs have to practically fund themselves. If you think for a moment that you can make a living out of just collecting management fees over the fund life, then you are very wrong.
In order to show ‘skin in the game’, managers are usually required to commit 4 to 5 percent of the total fund size as part of the fundraise based on a report by Preqin. Assuming a $100 million fund, this translates up to $5 million. For many first-time fund managers, this is not a small sum and most of it will probably be financed from internal resources, which can put a significant strain on cash flow.
Since LPs are paying GPs to manage their monies, they ultimately want them to work towards maximizing the returns on exit rather than relying on management fees for revenue. If the first fund performs well, GPs enjoy their share of the carry, but it is usually with the subsequent funds that the GP team can really rely on the management fees for a more steady income stream.
Taking all of the above into account, you should ask yourself these questions:
(i) Does the fund size and strategy still sound reasonable?
(ii) Is there a well balanced and realistic professional-to-portfolio company ratio?
(iii) Does the envisaged team size have sufficient bandwidth to execute deals?
If the answers to one or more of the above is not a affirmative ‘yes’, you might want to consider revisiting the fund size, organization set up or refining the investment strategy. Repeat this process as many times as required so that the equity story checks out in the bigger scheme of the macro-economic climate and industry landscape.
Designing a fund strategy is all about research & iteration…This process is incredibly iterative and requires you to continuously challenge your investment thesis. More importantly, it plays an important role in ensuring that your overall fund strategy is coherent.
Someone asked me about paychecks recently.
"Paycheck? What paycheck? We are business owners, we don't draw paychecks."
Once you've owned a business before, it becomes nearly impossible to revert and think of work-life in terms of five-day work weeks, the concept of weekends, annual leave days and monthly paychecks.
The definition of work is not about clocking hours in the office and just getting stuff done. It's also not purely about meeting sales targets and looking forward to that big bonus payout at the end of the year. It is about managing resources - both people (talent) and money (financial).
So we don't live paycheck to paycheck, have no golden parachutes and no notice periods / "gardening leave". We also do not 'cash-in' any unused leave days (no leave days to speak of really), have virtually no possibility of getting fired from employment or taking severance pay.
An entrepreneur is constantly kept on his toes not because he is afraid of losing his job but because he fears for his survival, he fears for cash flow as well as the supply of the resources around him - both people and money.
That constant worry is what keeps him alive.
[This is the first article in a 4-part series on fundraising]
In the last four years, I’ve had the opportunity and privilege to speak and consult with many acquaintances and friends expressing interest in starting their own investment funds. Most of them have very decent credentials: having worked in large corporates, Fortune 500 companies, reputable advisory and consulting firms, as well as investment banks. Some had spent decades in their current roles, have acquired the operational know-how in their industries and were at a point in their professional lives where they feel a desire to take their expertise to the next level.
The common denominator here is: Whether it comes down to starting a business or a fund, most people are driven by the notion that they could be creating more value than what they are doing in their current roles and achieving better monetary returns with the knowledge and resources accumulated over the years.
This no-frills article isn’t a standardized blueprint, framework or a holy grail for successfully raising any private equity or venture capital fund. The perspectives shared here are personal opinions and catered generally for anyone thinking of setting up a fund, are new to this area and do not really want to sound stupid when making conversations with investors, Limited Partners (“LPs”) or other aspiring fund managers.
Budgeting is an important part of this process and in part 3 of this series, I include a very indicative estimate of what are the expenses required. Every manager has a different budget and uses a different approach towards raising capital. I do not think there is a one-size-fits-all solution.
Starting a fund is an extremely entrepreneurial journey. The process and fundraising roadmap for everyone is different. It depends largely on credentials, investment strategy, geographical location and organizational setup. I hope the perspectives and anecdotes trigger your thoughts on the resources required and that you find them useful, logical and applicable in the real world.
Team composition is probably the most important consideration in starting any venture.
The General Partner (commonly known as the “GP”) is the “product” of the business. A fund manager sells itself in the same way a retail shop sells its merchandise. The quality of the product is the quality of the team, both collectively and individually. To manufacture a great product in the fund management world is to assemble an all-star team, thereby maximizing the GP’s chances in successfully raising a fund.
The most ideal configuration is the team comprising professionals from an existing private equity (“PE”) or venture capital (“VC”) shop. They have the relevant experience, track record and industry knowledge of how fund managers operate. To a certain extent, they also inherit some of the branding and relationships from their previous shops, although the key success factor in fundraising still rests solely on their personal achievements.
But not everyone has that privilege to work in a PE role.
So I’m not from a PE/VC shop…
The combination of experienced professionals from investment banks (“IB”) and management consulting firms (depending on their level of experience and functional roles) are quite popular. Consider The Carlyle Group, which was founded by two bankers and a lawyer, and TPG, which was founded by a management consultant and a seasoned lawyer.
The success of this concoction is driven by a few factors including the parties’ collective experience of working alongside the same transactions (in different capacities), but also largely because they share a common lingo — they understand the nuances and intricacies of sourcing deals, carrying out due diligence, structuring transactions and approaching business valuation.
Perhaps the achilles heel in such an arrangement is the lack of skin in the game.
Unfortunately (without prejudice), most bankers and consultants work predominantly on the sell-side of things i.e. their commercial interests tend to be limited up to the point when the deal is closed and fees paid. And in the process of doing so, they may not consider too much, the implications of their recommendations after the investment.
Of course, the financial and operational impacts on the acquired entity are being assessed and taken into consideration during the negotiation phase and at closing. But without skin in the game, any valuation and due diligence done, bluntly put, is just a desktop exercise. Sell-side advisors and consultants today rarely bear any tangible responsibility for the future performance of the target company.
Beyond the banking and consulting world, industry practitioners also make one of the most ideal PE operators - especially those in key management roles or C-suite positions. These people are responsible for driving top-line growth and profitability in the business, ‘fight fire’ on a day-to-day basis, and responsible for keeping up the quarterly reports to shareholders and investors.
More than just technical knowledge, good operators also have the management skills in operating the day to day activities of a PE portfolio. This skillset is nurtured from working many decades across different divisions with the companies they are in. They manage the sales teams, are familiar with pricing strategies, costing and the bill of materials, are up-to-date on what competitors are doing, and at times, have the ability to forge invaluable relationships with external stakeholders across the industry value chain.
What they lack in innovative financial structuring, they make up for in operating experience — something not all consultants and bankers are able to replicate.
That said, a group of seasoned industry operators coming together to form a fund may not necessarily have the complete know-how in terms of fundraising, legal/financial due diligence, deal structuring, and sometimes even access to additional resources beyond their sector of expertise.
Finding the right balance.
For many private equity funds, having an “operating partner” onboard allows the GP to mitigate the execution ‘gap’ in the team’s collective capabilities. The ideal set-up for a fund that invests in more mature and later-stage businesses could include a good mix of experts in M&A/strategy and industry veterans. Even better if all parties had collaborated previously in some capacity, and in particular, if and how they have leveraged complementary capabilities between each other.
The team should have at least two founders. Most investment funds do not have a single member. However, this model seems to work with some funds that focus on technology and angel investing. They are probably limited in their ability to scale compared to other mainstream PE/VC funds as the underlying concentration risks around one key person is just too huge.
Read the next section on designing a fund strategy.