So you want to raise a fund (Part 2) — Fund Strategy
[This is the second chapter in a 4-part series on fundraising]
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 factors are guided by the inherent attributes of the GP 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:
(i) Key industries that drive and underpin the broader economy
(ii) Population size and demographics
(iii) Consumption patterns and habits
(iv) 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 a Southeast-Asia focused manufacturing fund strategy 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
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 you are 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 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:
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.
This process is incredibly iterative and requires you to continously challenge your investment thesis. More importantly, it plays an important role in ensuring that your overall fund strategy is coherent.