There were 13,376 active investment funds in the US in 2022. Limited Partners, or LPs, have many choices to diversify their portfolio. So as a fund manager, how do you drive LPs to your fund and convince them to trust you with their money?
Before anything else, the first thing that LPs will see and ask about is your investment strategy. They will have their diversification strategy and already be exposed to specific industries, geographies, or asset classes. Before exploring whether they trust you to deliver a good return on their investment, they will take a high-level view of how you intend to invest their money.
Your investment roadmap is what defines you as a fund manager. Amongst the different types of LPs, funds of funds give great importance to the macroeconomic view. Your investment thesis is equivalent to your first impression in an interview. LPs, especially institutional LPs, will categorize you based on your investment strategy and even decide whether they want to engage with you further based on a glance at the front page of your pitch.
So have you thought through your investment strategy? If you’re currently working on your first or next fund’s strategy, you can use the below as a fund strategy checklist of all the parameters to consider.
Let’s review the different components that can help you design your own deal strategy and the advantages and disadvantages of each alternative.
What is the average size of the company you want to invest in? And what average investment ticket are you considering?
Defining the size of the investment and the companies you are targeting will help you figure out the size of the market you are in. There are significantly more companies doing sub $50m in revenue than companies doing over $500m.
The bigger the companies you want to invest in, the fewer investment opportunities you'll have.
Fewer deal opportunities can also mean that the market becomes mechanically more competitive. However, this depends on the state of the private equity market and the number of funds in your specific industry. For instance, in the SaaS market, many more institutional investors are investing in companies doing over $5m in annual sales than below that threshold.
On the flip side, the bigger the average deal size, the bigger the payout for you as a fund manager. Since private equity investing, like Merger and Acquisition, is very scalable (in the sense that it does not require twice as many human resources to close deals twice as big), the bigger the size of the investments, the more significant the funds under management and the bigger the potential earnings for the fund management team; both through management fees and carried interest.
Another consideration is that the smaller the company, the more disorganized it is. If you plan on being involved post-acquisition operationally, or even if you expect clean reporting from the companies, you'll likely have more work to do after investing in micro or small-caps companies than you'll have to invest in $100m+ companies.
Also, on average smaller companies have been in business for less time than more prominent companies. They have fewer historical results to showcase and are generally riskier, which you need to consider depending on what type of LPs you would like to pitch to.
Will you restrict your investment to defined geography? How wide will your investment footprint be?
When it comes to the geography of your targets, sometimes it makes sense to be specific – but it doesn’t have to be. Some fund managers target a whole continent or part of a continent (e.g., JP Morgan has a dedicated southeast Asia-focused fund), a whole country, or on the opposite side of the spectrum, just a state or a county (like the Ohio Capital Fund).
The wider the geographic footprint, the easier it is to get the word out that you are a serious player in the field, which can help boost recognition for a new fund manager. It is also a great way to leverage a local network to know all the deals in your market. For instance, a serious VC fund investing solely in Lisbon and Porto-based start-ups are much more likely to see 99% of all the deals.
A broader geographical footprint can allow a fund manager to look at opportunities in underserved markets. One of the significant advantages of investment opportunities in developing markets is that you can likely invest in the company at a lower valuation than a similar but US-based company. Then by relocating headquarters to the US and increasing North American operations, you can benefit from a good uplift in valuation multiple at the exit.
On the other hand, developing countries bear certain risks that you may not be aware of if you are not deeply familiar with the country. For instance, countries like Bangladesh restrict the cash firms can take out of the country.
The country can also have political instability, corruption, unreliable internet connectivity, electricity, etc. All these components are susceptible to impacting the performance of your investments.
We should also note that while on paper, investing across different geographies could look like a diversification strategy that benefits limited partners, LPs may not necessarily respond to this argument as they can quickly diversify their portfolio geographic exposure by themselves.
Do you want more than 51% and be in charge, or would you leave the reins to management?
Investors' type of equity position is a significant differentiation between private equity funds. It depends on what type of skills investors bring to the table. PE professionals from the corporate finance and consulting world (ex-Investment bankers or Transaction Services professionals) tend to be more hands-off, take a seat at the board and help with build-up strategy. Contrarily, ex-business operators and entrepreneurs turned investors with time to spare may want to leverage their operational knowledge to run the companies more effectively.
Taking the majority can be reassuring and make you feel like you're in complete control of the outcome. You know your team and what you are capable of, so based on your past successes and failures, you may bring invaluable insight and expertise to portfolio companies and create value through your input.
However, this often means that you also need to convince LPs that you have what it takes to lead the management of several portfolio companies. It should be an easy sell if you have an excellent reputation as an operator. But if you are an emerging fund manager attempting to raise money from LPs that do not know you, it will feel more comforting for them to know that you will keep the existing founders in place and create a good incentive plan to push them to deliver their vision.
Additionally, being operationally involved in targets post-acquisition is time-consuming. More time spent running companies means less time spent doing deals. The more deals you can do, the more money you can invest. It comes down to the trade-off between where you think you deliver the most value to your investors and your personal goals regarding assets under management and raising subsequent funds.
What will your average deal structure look like? Will you do 100% equity-based buyouts, LBO, or maybe a combination of equity + convertible instruments?
There are several ways to structure and finance a deal. The list goes on: earn-out, deferred cash payment, seller notes, convertible notes, SAFE, and preferred shares.
When talking to prospective LPs, ensure you are familiar with all these mechanisms and do not get caught off guard by technical questions.
It is also essential to ensure that your intended deal structures align with current market conditions. For instance, don’t pitch a highly leveraged investment thesis right when credit is getting restricted and expensive unless you already have the relationship and commitment secured with lenders.
There are two main axes to consider when assessing what strategy is right for you: level of complexity vs. attractiveness for the seller and level of risk vs. reward.
Using different financial instruments generally fits the purpose of de-risking your investment to make the deal sound more attractive to the seller. For example, taking preferred equity with liquidation preference allows you to collect 100% of the proceeds until you have reached a specific multiple). Another purpose might be to incentivize management (eg. Creating a two-level investment structure with a Management Co and providing convertible notes financing at the Manco level to make managers benefit from more leverage and own more equity with a lower initial investment).
However, the more financial instruments you use, the more complex the deal and the harder to negotiate. And if you want to add debt instruments to your deals, you will need to secure the financing from banks on a deal-by-deal basis which brings more uncertainty to the table and makes for lengthier processes.
It's imperative to understand how your structure increases risk/rewards. For instance, highly leveraged LBOs (with over 5x annual EBITDA raised in debt) have often led to disastrous bankruptcy.
Of course, if everything goes well, debt is a great way to increase the ROI you return to investors and can help you do bigger deals, but it requires you to be extra cautious about the quality of the deals you pursue and the price at which you make the deals.
What is your timeline for the life of the fund?
Regarding IRR (internal rate of return), time is of the essence. If you double the size of a company in one year but stay flat for five more before exiting, the IRR that you return to your LPs will be less attractive than if you had exited after the first year.
The main things to consider are:
The typical private equity fund works on a 5+5 year model where the first five years are dedicated to investing and the last five years to exiting.
Evergreen funds, however, aim to hold the portfolio companies forever.
You will typically want to invest the money as quickly as possible to make quick progress. But you also need to be realistic, and if you need to invest the funds into at least ten companies, it may be hard to do it under 3 or 4 years. While timing is necessary, the quality of your deals should be a top priority.
It would help if you also remembered that exiting some of your portfolio companies may be more complex than anticipated. A mediocre investment often stays in a PE's portfolio for more than five years. The 10-year horizon that most PE funds have adopted is also there to manage LPs' expectations and account for events that are outside your control.
Pitching a fund where you intend to return LP's money faster is attractive on paper. Still, you're also taking the risk of underdelivering and having unpleasant conversations with your LPs down the line.
The evergreen model can have its advantages as well. In this case, you need to make sure you have a consolidation strategy and that you are clear about how you will bring ROI to your LPs and potentially offer a secondary market for their LP shares.
Will you run a generalist investment fund or a specialized one?
As a fund manager, you can decide to focus on a specific niche or a wide array of companies. If you want to specialize, you can focus on a specific industry (e.g. biotech, agriculture, manufacturing, etc.) or a particular revenue and business model (e.g. marketplace, subscription business, long-term contract, enterprise client base, etc.)
To be relevant as a specialized investment fund, consider who is on your team and whom you can showcase. If you want to focus on biotechnology, you will need at least one biotech expert or even someone with a doctorate to have credibility.
The advantages and disadvantages of each solution are similar to the ones we discussed regarding geographical footprint. The larger the net, the more fish you can potentially catch, but having a specialized approach can help you be recognized in a specific industry, especially if it is a technical one.
For instance, if you are known for your team's expertise in robotics or space travel technology when you decide to invest in a new target, it will immediately benefit from your team's recognition of its potential.
Even if you are not focusing on technical industries, being specialized can be part of your recognizable brand. A good example is Vice Venture which purposely chose a provocative name and only invested in what is commonly perceived as “vice” focused companies (Cannabis, alcohol, gambling, etc.).
Are you looking to position yourself as a community, gender, or social impact-oriented fund?
Over the last few years, several types of purpose-driven funds were raised, claiming that their mission goes beyond the pure pursuit of profit. A good example is ForPurposeCo, the fund created to finance the operations of OzHarvest, Australia’s leading food rescue charity.
The most common impact funds we currently come across aim at investing only in women-led companies, under-represented ethnicities, or companies that generally positively impact the planet.
Launching an impact fund has to do with your core belief and what you would like to achieve from a social perspective as a fund manager.
The economic argument is that impact investment vehicles have strict restrictions on what type of companies they can invest in, which statistically reduces your chances to invest in the best deals, which may make it harder to pitch to prospective LPs.
However, impact investing is increasingly popular, with a more extensive base of wealthy individuals looking to have their money positively impact our world. For example, we can look at companies like Patagonia and see that some can indeed be ethical, social, and highly successful.
Are you seeking to do deals by yourself or collectively?
As a young or a first-time fund manager, you might ask yourself if you are experienced enough and have enough deal flow to lead all your investments. Would you rather play it safe and invest in deals where other funds have already done the work and vetted the target?
Co-investing would be less cumbersome than taking the lead on the target and negotiation relationship. However, if you are not the lead investor, chances are that target won't hear your voice as much, and you will have to compromise on your vision of how you should structure the deal.
By leading deals, you’ll likely get more recognition in the market. Potential targets might reach out to you directly if they know you can execute the deal by yourself or at least come in and motivate your network of co-investors to join in.
To pursue a co-investment fund strategy, you will need to build and maintain a good relationship with the lead investors in your market. This is essential if you want to be offered a seat at the table for the hottest deals.
Also, keep in mind that deals, where several investors co-invest may also mean more conversations, negotiations, and messier governance post-deal - so the process needs to be well run and clear to all parties.
What company stage and growth profile are you interested in?
Even when you have sorted out all the points above about your fund strategy, there is still one crucial parameter to clarify. What is the ideal company profile you would like to be involved in?
We already talked about revenue/company size. The next point to consider is how many months, or years of historical data you want your targets to have before getting involved. Do you want to focus on profitable companies, or are you okay with cash-burning start-ups? Are you looking for hyper-growth companies? Flat revenue? Distressed companies you will turn around?
The trade-off regarding the company profile is mainly related to the level of risk/reward you are willing to take. The younger the company, the riskier it is. But also, it is much easier to double the revenue of a company doing $1m a year than a company doing $100m.
The faster a company is growing, the more it seems that the company has hit market fit and is doing something right. But the more growth, the bigger the valuation at the entry, which means that if growth significantly slows down, even if you exit at a higher revenue level, you may still exit the company at a lower price than what you paid when you got in.
The state of the global economy is also essential. While over 2020-2021, all the focus of investors seemed to be on fast-growing software companies, investors' focus seems to have switched mid-2022 towards more stable and profitable companies.
If your fund’s strategy is not yet finalized, go through each point listed above and discuss with your team to decide what is the best course of action for you. Also, talk to your investor friends to get their opinions.
By considering the skillset, experience, and reputation of your team, the psychology and personality of the LPs you already have in your network, and your macroeconomic understanding of the market, you can decide on the right course of action and investment roadmap.
Once you are clear about your investment strategy, it is time to shape it, market it, and pitch it to your prospective investors.
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