[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.
Use this simple illustrative spreadsheet to determine how the distribution of proceeds upon winding up works for an investment fund. For simplicity, the distribution here is done as a "European waterfall" i.e. liquidation is done at the end of the fund life and not on a deal-by-deal basis.
For more of these topics, click here.
At the most recent run of my LBO class, someone asked me this question,
"What is the difference doing a DCF using the WACC and a DCF in an LBO model?"
If we consider the same company in both cases i.e. the free cash flows (to firm), FCFF are the same, isn't the DCF like an LBO? In a typical DCF valuation, the weighted average cost of capital (WACC) is usually applied as the discount rate on FCFF. This discount rate comprises two main components - the cost of equity and the cost of debt.
Why does capital come with a cost?
Nothing is free in this world. The people who choose to fund your venture or your business are giving up something - more specifically, the option of being able to put their money elsewhere and getting more than what they had in the beginning.
Some common examples are: interest income earned from putting a cash deposit with a bank, government and corporate bonds, or even just buying a stock that pays dividends. By choosing to invest with you, these people are giving something up, and that lost opportunity comes at a price, which loosely translates to the cost of capital.
Every business is built and funded on either debt or equity. Conventional wisdom tells us that borrowing cash is cheaper than issuing equity because lenders typically get more security over the assets in the business and also priority in repayment from any cash flows generated. Because lenders do not partake in profit sharing of the business, they get no economical upside in the event the company becomes wildly profitable.
Equity holders (or shareholders) on the other hand, have a vested interest in the profits of the company, prorated to their share of capital contribution. They get paid only after the company's borrowings are repaid and therefore take on relatively more significant risk in their investment.
The optimal capital structure
Depending on the nature of the business and its underlying industry dynamics, each company has a "magic" number for debt and equity in order to get the lowest possible cost of financing. This allows them to maximize the business value. This magic number is the optimal capital structure.
In asset heavy industries whereby the companies have fairly resilient cash flows, the optimal capital structure will lean towards a greater proportion of debt - for example, in real estate, this refers to the core and core+ properties. For early stage enterprises, especially technology based startups, the optimal capital structure will consist of largely equity.
In reality, every company will have a different benchmark for what is optimal. A business which has a strong and proven track record of operations may have more debt in its capital structure because of its favourable credit rating and therefore access to cheaper debt, as contrasted to a younger and much less established firm.
We try to generalize an optimal cap structure across companies within the same sector because we expect the revenue dynamics and operating cash flow margins to be fairly similar.
Now, in a DCF model...
The discount rate represented by the WACC is a mix of debt and equity equivalent to the firm's target optimal capital structure. When we do a DCF based on the WACC, the resulting number yields the fair value of the business.
For the layman, fair value means: What the average or "marginal" investor should pay to acquire the business in order to get an appropriate risk-adjusted return had he/she had invested in all the public listed stocks in the target company's home market.
The risk/return-adjustment mechanism here is the beta, which is loosely speaking - calculated from - the correlation between the movement of similar companies' share prices against the broader market index. As we use the broader market index as the basis for justifying risk/returns, any minor deviation of a company's share price from this index is implied as "risk" (for more technical information on beta read this).
Because every investor has a different expectation on the equity returns (or the cost of equity), the output of a DCF using the WACC as the discount rate does not translate to how much an investor should offer to buy a company. The WACC gives you the fair value, but in reality, you can always choose to offer something higher or lower. Whether or not the seller agrees to the valuation is entirely up to negotiations and other qualitative factors influencing the target company.
All things being equal and agreeable...
Let's assume that the fair value is the offer price. The DCF on FCFF of the business results in the enterprise value ("EV") of the company. Loosely translated, this refers to the price of ALL operating assets in the company.
"Why don't we do the DCF on the FCFE (equity cash flows)?"
In theory, you can. But in the case of most buyouts, the incoming investor assumes responsibility for financing the deal i.e. they will assemble the best possible configuration of debt and equity to buy over the shares from the sellers, and repay / re-finance most or all of the legacy debt in the business.
If the buyers are creditworthy, they stand to increase the amount of borrowings obtainable from the banks, allowing the deal to be financed with the lower amount of equity capital.
In an LBO...
The incoming buyer (usually a PE fund) will test and push the limits of the cost of capital (the WACC) to achieve the highest return on equity possible. Discussions around the future cash flows of the business often result in lengthy negotiations between the buyer and lending banks. Some of these conversations entail iterative spreadsheet calculations that ideally would solve for the maximum amount of debt that will support the financing of the deal.
What the buyer is really trying to achieve here is to find the magic number for the debt that will allow for getting the HIGHEST equity return (or equity IRR). In most PE funds, this number is at least 20%, depending company and region.
The simple mechanics.
For example: If the returns for investing in this business is 10 percent, and assuming the investor doesn't borrow any cash to finance the deal, he/she would get a return of 10 percent. This 10 percent is also sometimes called the unlevered IRR. Unlevered means that the acquisition was purely financed with equity money and no bank borrowings were involved - obviously not a very wise and efficient use of money to the seasoned finance professional.
In order for the investor to achieve a higher return, he/she would try and minimize the amount of equity by looking for alternative sources of funds - such as debt. However, this would only make sense if the cost of debt is lower than 10 percent. Anything form of financing which costs more than 10 percent and the investor is better off using his/her own money.
Now, let's assume that approximately half of the total investment was funded with senior secured debt at a rate of 5 percent. The banks which are lending to the buyer at this stage not only have the first right to claim the assets in the event the business goes into distress, they also have priority over the cash flows generated by the company. The risk of this investment is relatively low as compared to pure equity, hence the 5 percent.
Based on the structure above, this would result in an equity return of 15 percent based on:
Unlevered IRR of 10% = (50% x 5%) + (50% x 15%)
Now, 15% may sound like a decent return but most PE funds are also subject to hurdle rates (typically in the ballpark of 8%), leaving them with only 7% after returning principal + hurdle to their LPs. Naturally, one way to overcome this is to try and get more cheap debt to minimize the equity outlay.
Because every financial institution is subject to their own credit risk matrix and lending exposures, the amount of "lend-able" senior secured debt (based on 5.0% interest rate) will be limited.
The hunt for more capital.
At this point, the PE fund tries to source for alternative sources of financing junior to the 5 percent debt. But this will come at a higher cost because the rights /security to assets and first priority to cash flows in the business have already been claimed by senior debt lenders. This alternative sources of financing would be subordinated. In order to entice this pool of subordinated lenders, the buyer has to make the cost of debt more attractive by increasing the interest rate.
For illustrative purposes, let's say this is going to cost 8 percent and the investor is able to syndicate 50% of it. The resulting calculations would give an additional uplift, bringing the equity IRR to 22 percent as compared to the original 15 percent.
15% return = (50% x 8%) + (50% x 22%)
You now get the idea...
Is 22 percent enough you say? Can we find additional sources of capital which are cheaper? This shouldn't be difficult.
But at this point, both the company cash flows and debt capital markets are going to be fully stretched, and it might be even more challenging to find a sufficient pool of investors who are willing to finance the deal at this level of risk. Some alternative sources of capital at this stage would come from either mezzanine investors or bridge loans.
The mathematics outlined above has been done on an illustrative basis to demonstrate how 'cheaper' bank debt and alternative financing sources can allow an investor to maximize the equity IRR in an LBO. While this may look simple, the complexities lies in the following:
FCFF considerations. In engineering the returns above, we have totally ignored the potential volatility in free cash flows, which could significantly influence equity IRR. This is why stable and visible cash flows are important in any LBO deal.
Depth of liquidity. The pool of available capital shrinks dramatically as we move from senior debt to subordinated debt to quasi-equity financing. As such, the term sheet for alternative financing will start looking a lot like equity further down the debt waterfall.
Cultural factors. The size and structure of the debt package is also partly driven by how sophisticated and comfortable debt investors are with the company and the jurisdiction that it operates in, including other factors such as cash repatriation and withholding taxes. This could also explain why many online LBO structures and templates are usually based on transactions done in the US and Europe. While the loan and corporate bond markets are fairly vibrant in Asia, quasi-equity financing structures still lag those in more mature capital markets.