1. Have Sufficient Resources for a Lengthy Fundraise.
Raising a fund takes lots of determination, time and money. Some people rush into raising a fund without considering whether they have the resources to successfully raise a fund. Raising a first-time fund can take a long time, in some cases 18 to 24 months (or more), and can cost over $1 million, which the partners of the emerging manager must pay out of their pockets until the fund has its initial closing, at which time fundraising expenses (excluding placement agent fees, see below) are reimbursed by the fund. The partners must have sufficient resources to finance the costs of fundraising as well as the costs of opening and maintaining an office (with staff). In addition, each partner of the emerging manager must have enough resources to finance that partner’s personal household expenses during the fundraising. Having the resources to fundraise for an extended period of time is critical to the success of raising a fund.
It sometimes surprises me that emerging managers will launch fundraising before they are ready. When an emerging manager launches their fundraising effort, the following materials should be completed and available in a virtual data room: an executive summary, marketing presentation, private placement memorandum (known as a “PPM”), completed ILPA due diligence questionnaire (ILPA is the Institutional Limited Partners Association, and the due diligence questionnaire can be found on the ILPA website at www.ilpa.org), track record spreadsheet, track record attribution letters (more on this later), detailed CVs for each team member, and references.
Additional materials that should be ready to go include investment memoranda for existing investments, examples of quarterly and annual financial statements and reports provided to LPs in prior funds, examples of capital call and distribution notices, a compliance manual, Environmental, Social and Governance (ESG) policy, valuation policy, business continuity plan, and the like. The fund should also have contact information for the fund’s service providers, such as attorneys, accountants, auditors, fund administrators, and bankers. All of this information should be available in a virtual data room. An emerging manager that has all of these items ready to go when the manager starts fundraising demonstrates that the manager is well-prepared for fundraising. Not having these items can make an emerging manager look disorganized, which doesn’t bode well for a fundraising effort.
Emerging managers also should gather as much competitive intelligence as possible before the fundraising starts. Emerging managers should talk to fund formation attorneys, placement agents, accountants, banks, etc., to learn about the fundraising environment, current market terms for funds, the competitive landscape, and to obtain feedback on their marketing presentation. Most are be happy to meet with emerging managers.
3. Consider using a placement agent.
A placement agent can be an amazing resource for fund managers. A good placement agent will work with the emerging manager to make sure that prior to launching the fundraising, the fund’s marketing and data room materials are complete and ready to go, and the pitch is well-rehearsed and polished. The placement agent will handle the logistics of identifying potential LPs, scheduling meetings and following up with potential LPs. Placement agents have relationships with LPs that invest in emerging managers. Yes, placement agents are well compensated for their efforts, but they offer a lot of value. Finally, using a well-known and highly-regarded placement agent can add a level of credibility with LPs.
Even if an emerging manager doesn’t sign with a placement agent, just meeting with a few placement agents can be very enlightening. An emerging manager can learn about LP appetite for emerging managers, obtain feedback on their pitch and strategy, and obtain suggestions on how to improve their chances for success.
How to find a placement agent? The best way are referrals from other fund managers, attorneys, accountants, banks, and the like. Before signing an engagement letter with a placement agent, an emerging manager should do some reference calls to ensure the placement has been successful raising funds of a similar size and strategy. Also, an attorney should review the engagement letter before an emerging manager signs it, to make sure that the terms are appropriate for the situation.
A note on placement agent fees. Placement agents typically paid based on a percentage of the funds raised, and may also require an up-front and/or monthly retainer. The success fee is often paid over several quarters after the fund’s closing. In addition, there are some banks that will finance the placement agent fees.
4. The Strategy Must Be Convincing
Have you heard the term “JAMMBOG”? A JAMMBOG is a term private equity fund LPs use that means “Just Another Middle-Market Buyout Group.” This term highlights the challenge that emerging managers face when raising a fund. How does an emerging manager stand out from the hordes of other funds in the market? It starts with the fund’s strategy.
Emerging managers must be able to articulate to potential LPs a convincing strategy that is clearly stated, differentiated, and consistent with the team members’ investment experience and skills. What are the fund’s investment objectives: stage, sector(s), geography(ies), etc.? How is this strategy consistent with the team’s prior investment experience and other skills (operations, etc.)? How is this strategy different from the other funds investing in the space? How is this strategy unique? Is the strategy repeatable? How will the fund fare in an economic downturn?
Another important part of the strategy is fund size. The target fund size must be appropriate for the strategy. Given the fund’s strategy, the number of investing partners, the pipeline of investment opportunities, the investment pace, the size of the investments, etc., does the size of the fund make sense? Also, there should be a hard “cap” on the size of the fund, which must also be appropriate for the strategy. Two points on the hard cap: first, LPs want the emerging manager to spend its time investing, not fundraising; and second, without a hard cap on the fund size, the emerging manager could raise too much money which doesn’t work for the fund’s stated strategy and leads to “strategy shift” which often leads to poor results.
Emerging managers must be able to discuss the competitive landscape and other funds it will compete with in the space. Emerging managers sometimes say that “there is no one doing what we do,” but this rings hollow to many LPs. Given the hundreds of funds pitching similar strategies, it is highly unlikely that any fund truly has no competition. The better approach is for an emerging manager to know its competition and convincingly demonstrate how its strategy is differentiated from the competition.
Finally, what is the fund’s “plus” factor – the special sauce that will enable this fund to have exceptional performance?
5. What is the Investment Process?
Potential LPs will scrutinize the emerging manager’s investment process. This includes how the manager sources deals, evaluates deals, wins deals in competitive processes, approves deals, adds value post-investment and how the manager manages exiting the investment. Because the emerging manager doesn’t have an established track record over multiple funds, LPs will want to make sure that the emerging manager’s investment process is thorough, successful and repeatable.
Investment success starts with sourcing. I have written a blog post on how VCs source deals, which can be found here: http://www.allenlatta.com/allens-blog/lp-corner-how-vcs-source-deals. Unless the emerging manager can access great deals, then the chances of the manager providing outsized returns to its LPs is slim. One note: virtually every manager touts their “proprietary deal flow”, and when an emerging manager says that to potential LPs, most LPs are pretty skeptical. If an emerging manager is going to tout “proprietary deal flow”, the manager should be able to demonstrate how their deal sourcing is really differentiated and unique. The emerging manager should also have a robust pipeline of deals that are ready to go when the fund’s first closing occurs.
When other private equity firms are competing with the emerging manager for a deal, how does the emerging manager win these deals? Paying the highest price isn’t a great answer. An emerging manager should demonstrate that they are winning deals because of some edge they have – whether that’s having known the company for a long time through their sourcing efforts, or having provided the company with some pre-investment value add such as helping them with recruiting management or engineering talent, introducing them to potential customers or strategic partners, or otherwise. If an emerging manager is able to demonstrate how they win deals for reasons other than price, that can impress LPs.
The investment approval process is also very important. I have met emerging managers who have struggled to articulate the investment approval process. The emerging manager must be able to articulate their investment approval process, including whether unanimous approval by all of the partners is required, or is some lower threshold required. Having examples of investment memoranda is very useful to a potential LPs conducting due diligence on an emerging manager.
After the investment is made, how does the emerging manager add value to the company? Is it by serving on the board of directors? Making operational improvements? Recruiting for key positions at the company? Assisting with customer introductions? Introducing innovation? Acting as a company’s corporate development team for follow-on acquisitions? Potential LPs will want to see concrete examples of how the emerging manager adds value to their portfolio companies.
Finally, how does the emerging manager guide the portfolio company to a successful exit? This is especially important in venture and growth equity strategies as the fund will typically own a minority stake in the company and will not be able to dictate how or when a company has a liquidity event. Buyout funds typically own a controlling stake in the company, and so have greater ability to effect a liquidity event at a portfolio company. Many emerging managers do not have deep experience in guiding companies to an exit, and so the emerging manager must have a clear and convincing strategy about this.
6. Show you Have a “Dream Team.”
Do you have a “dream team?” For emerging managers, having a dream team is critical. To me, a dream team for an emerging manager is a group that has an attributable track record of successfully investing together over a long period of time in the fund’s stated strategy. In the best of all worlds, the team would be spinning out of a well-regarded private equity firm. Teams that are “assembled” – meaning that they don’t have long histories of investing together and have come together recently to form the firm – may not have a track record of working together or investing together – things critical to the success of the fund. Note that having known someone socially for several years is largely irrelevant.
A note on one-person funds. Over the past few years, I have seen a significant increase in the number of funds being managed by a single person. While there are some LPs that invest in one-person managed funds (some family offices and funds-of-funds come to mind), in my experience it is harder to get an institutional LP to invest in a fund managed by one person.
7. Prove That You Can Build a Lasting Firm
When an LP evaluates an emerging manager, they are not only evaluating the manager’s ability to make successful investments in the stated strategy, but also the manager’s ability to start, manage and grow a successful firm. If the partners of the emerging manager haven’t thought through the mechanics of starting and growing a lasting, successful investment firm, how can they expect an LP to invest? Team risk is one of the biggest risks of emerging managers. Established firms have worked out their management philosophy, internal corporate governance, culture, employee development, dispute resolution, internal controls, ownership and compensation schemes, and succession planning. Emerging managers need to be prepared to explain all of these items and more in great detail to potential LPs.
Previously mentioned was the ILPA’s Due Diligence Questionnaire. One of the reasons I recommend this to emerging managers is that the questionnaire has many detailed questions about the firm, including ownership and carry allocation, succession planning, and corporate governance. Emerging managers must have good answers to hard questions about these items.
Emerging managers will also be subject to rigorous operational due diligence. For first time funds, the emerging manager must have strong outsourced service providers. Critical among these are the fund administrator, attorneys, auditor, IT service provider and a compliance consultant (the attorneys may do this if the firm is an exempt reporting adviser). The emphasis on operational due diligence has grown dramatically over the past few years, and emerging managers must be prepared for an extensive review of their processes, controls and policies.
8. Demonstrate a Verifiable Investment Track Record.
There’s a saying among LPs that invest in first-time funds: “We invest in first time funds, not first-time investors.” This is very true. An emerging manager, whether they are raising a first fund or a third fund, must demonstrate a verifiable track record of investing success as a team in the fund’s stated strategy. An emerging manager whose partners don’t have verifiable investing track records will struggle to get traction.
When we review a manager’s track record, we look at the gross portfolio level returns as well as the fund’s net returns to LPs. For more on this, see my post “LP Corner: Gross vs Net Returns”. To that end, we expect an emerging manager to be able to provide spreadsheets for both of those analyses. The portfolio-level returns show the emerging manager’s ability to make investments. The net-to-LP returns show the timing of calls and distributions, and shows the impact of expenses, management fees, carried interest, as well as the impact of a subscription line of credit if one is used.
The track record must also be verifiable. The best situation is when the partners of the emerging manager obtain attribution letters from their former firms. These attribution letters identify the person’s involvement in deals (sourcing, due diligence, negotiation, board member, value add, exit management) and the performance of the deal. However, many firms refuse to provide attribution letters. In those cases, it’s very hard for potential LPs to determine attribution. If an emerging manager can’t provide attribution letters, then there are other ways to demonstrate a track record. The first is to use public information about prior investments (such as being the lead investor, serving on the board, etc.) to demonstrate a manager’s role in prior portfolio companies. The other is the emerging manager can provide references from the CEOs and co-investors of companies in which the manager has invested. In this way, it is possible to determine some level of attribution.
One way to address a lack of a verifiable track record would be for the team to make three to five investments in the stated strategy prior to raising the fund. This can be done through special purpose vehicles or “SPVs”. In this case, the emerging manager finds a deal, finds investors willing to invest in the deal, and sets up an SPV to finance the investment. These individual investments might be rolled into the fund at the initial closing, or remain independent from the fund. These SPV investments must be in the strategy of the fund and made by the team that is raising the fund. The emerging manager should create formal investment memoranda for each investment which are later shared with potential LPs for the fund. Note that personal investments made by a partner that aren’t in the fund’s strategy have little relevance when evaluating a track record, and should not be rolled into the fund.
The track record should also be a “full cycle” track record that demonstrates the team’s ability to successfully source and negotiate deals, add value post-investment, and manage a profitable exit. In my experience, each part of the process is critical to the success of the investment.
9. Offer LP-Friendly Terms
Emerging managers should offer fund terms that are “LP friendly.” What are “LP-friendly” terms? Here’s my view:
- Management Fee. The standard management fee in the industry is 2% per year, but this can be more for sub-$100 million funds, and is often less for funds exceeding $500 million. The management fee should “step down” after the fund’s investment period, which should be no more than 5 years from the date of the fund’s initial closing. No management fees should be paid after the initial term of the fund. Also, consider offering a discount to the management fee if an LP makes a sizeable investment in the initial close. These management fee discounts can be very attractive to LPs. For more on this, please see my post "LP Corner: Fund Terms - Management Fee".
- Carried Interest. Carried interest should be the standard 20%, and should be on a “whole fund basis” (also known as “European carry”). Whole fund carry means that the manager will only receive carry after LPs have received as distributions all of their contributed capital plus a preferred return (discussed below). “Deal-by-deal” carry, also known as “American carry”, is very GP-favorable, as are hybrid carry structures. An emerging manager should not charge premium carry (such as 25% carry). For more on this, please see my post "LP Corner: Fund Terms - Carried Interest Overview."
- Preferred Return Hurdle. The preferred return hurdle should be 8% per year for buyout and growth funds. While a preferred return hurdle isn’t as common in venture capital funds, I believe that venture capital funds should also have a preferred return hurdle to better align the manager’s interest with that of the LPs. For more on this, please see my post "LP Corner: Fund Terms - Preferred Return and GP Catchup".
- Manager Commitment. Emerging managers must be prepared to “give until it hurts, and then give more” when it comes to the manager’s commitment to the fund (this is also known as “general partner commit” or “GP Commit”). The old standard of a 1% GP commit is outdated, and the new standard is that a GP commits an amount equal to 2% to 3% of the total commitments to the fund. I have seen emerging manager GP commit as high as 20%. We don’t focus as much on the actual percentage, but whether the GP commitment represents a meaningful portion of the investable assets of the members of the investment team. Please see my post “LP Corner: Thoughts on GP Commitment” for more on this topic.
- Co-Investment. Co-invest opportunities have become a very important feature to LPs, and so emerging managers should consider offering co-investment to the LPs. Co-investment provides LPs an opportunity to make direct investments alongside the emerging manager in its deals while leveraging the fund manager’s expertise and due diligence. If co-investment is offered to LPs, it should be offered on a no-fee, no-carry basis. Co-invest reduces the management fee and carry paid by the LP to the emerging manager on a blended basis (management fee paid on the fund and the zero management fee on the co-invest), provides the LP with insights as to how the emerging manager sources, evaluates, negotiates and adds value to an investment, and finally, how they manage an exit of their investment.
- Key-Person Clause. Key person clauses are extremely important in emerging managers, as the risk of a firm break-up is higher for emerging managers than for established managers. In my view, a key person clause should be triggered if any of the original members of the investment team stop devoting their full time an attention to the fund. When triggered, the investment period should be suspended for a period of time (usually 180 days), and should be made permanent unless a super-majority in interest of the LPs (excluding the GP’s interest) vote to reinstate the investment period. For more on this, please see my post “LP Corner: Key Person Clauses”.
- No-Fault Clauses. Similar to Key-Person clause, no-fault clauses are especially important to potential LPs when considering investing in emerging managers. The GP should be able to be removed, and the fund’s investment period should be able to be suspended or terminated on a 2/3 in interest vote of the LPs. This gives LPs comfort that if something serious happens that they can take action to suspend all investing until things can get sorted out, or in an extreme case, remove the GP. For more on this, please see my post “LP Corner: Fund Terms – No Fault Divorce”.
Finally, the ILPA has published guidelines on fund terms, which can be found on their website. I recommend that emerging managers review these guidelines and structure their fund terms to be as LP-friendly as possible.
A note on premium terms. If an emerging manager wants to charge premium terms, such as a premium carry, I offer two words: Earn it. My advice to emerging managers is start off with very LP-friendly terms, and if the first couple of funds are very successful, LPs will be more willing to accept more terms that are manager friendly, such as premium carry or a deal-by-deal carry waterfall.
10. Make It Easy on the LP
Because there are so many funds in the market, it is very easy for an LP to pass on a fund. One way an emerging manager can get a “no” from an LP is by making due diligence difficult. Emerging managers should strive to make the due diligence process as easy as possible for LPs. This means providing all documents or information requested by LPs. An emerging manager that declines to provide an LP with requested documents or information risks getting a quick “no” from the LP.
As an example, the virtual data room should contain all of the due diligence documents, be easy to navigate, and allow all documents to be downloadable with a single click.
Another example relates to Non-Disclosure Agreements, or NDAs. We sign NDAs routinely, but occasionally we run across an NDA that is so onerous that we simply can’t sign it unless it is amended to make it acceptable to us. Believe it or not, a couple of emerging managers have refused to allow any changes to the NDA, which can end our interest in a fund.
I believe that all fund managers are nicest to LPs when the managers are fundraising and need the LPs’ money. If a manager is very difficult to deal with or refuses to provide requested information during fundraising, what does that say about the manager-LP relationship after the investment is made?
11. Be Honest and Up Front
Every experienced fund manager has made a bad investment (or two…). For emerging managers, it is better to acknowledge investment mistakes and to turn these into strengths by demonstrating the “lessons learned.” LPs appreciate honesty and transparency. The worst thing an emerging manager can do is to try to downplay a bad investment or to omit it from the track record. If an LP finds out that the manager has hidden something from the LP, not only will the LP walk away, but the emerging manager’s reputation in the industry could be damaged.
12. Follow-Up and More Follow-Up
LPs and their advisors are incredibly busy and will review hundreds of funds each year. Because of how busy LPs can be, an emerging manager must be proactive and politely persistent. For example, if the emerging manager has not heard from an LP evaluating the fund in several weeks, the manager could send a short follow-up email politely asking if the LP needs any additional information, if the investor would like to schedule another call, or to ask for an update from the LP as to where they are in the process. An emerging manager should continue to follow up with an LP until the LP gives an affirmative “yes” or “no.”
If a placement agent is used, the placement agent will do the follow-up. If not, then it is incumbent on the emerging manager to be disciplined and make periodic follow-up contact.
The following are some other thoughts that might be useful in fundraising:
- Build Momentum for an Initial Close. Trying to coordinate an initial closing for a fund is like herding cats. LPs can be slow to move, and so building momentum for an initial close is important. Some ways emerging managers can build momentum for an initial close include offering a management fee discount for LPs investing in the initial close, having an anchor LP (see below), having prior colleagues invest in the first closing (see below), having private equity “luminaries” invest in the fund’s initial closing, and having a deal in the pipeline so that LPs who participate in the initial closing can participate in that deal as a co-investment.
- Anchor LP. Having an anchor LP (also called a “cornerstone investor”), which is an LP that makes a sizeable investment in the initial closing, that will build a lot of traction for other LPs. Anchor LPs typically require some type of economic deal, such as discounted management fees or discounted carry.
- Prior Firm Partners as LPs. If an emerging manager has left a private equity firm to launch a new firm and fund, having partners from the former firm make commitments in the fund’s initial closing sends LPs a positive signal. Such an investment demonstrates that the emerging manager’s investment acumen is respected by the people who know best. It also demonstrates that the emerging manager left the prior firm on good terms.
- Check Your References. One key part of an LP’s due diligence on a fund is checking references. You may be surprised to learn that I have actually received negative references from “on-list” references – the people a manager offers to a potential LP to provide a glowing report on the manager. An emerging manager must be absolutely sure that the references will be positive. Note that many potential LPs will also check “off-list” references – these are people who aren’t on the manager’s reference list, but people the LP knows who may have been a co-investor with the manager, or served on a board with the manager, or was the CEO of a company in which the manager invested. I know of one institutional LP whose goal it is to find a negative “off-list” reference so the LP can really evaluate the character of the manager.
- Background Checks. Many institutional LPs will conduct formal background checks on every partner of the emerging manager’s investment team. An emerging manager must be prepared for this, and be willing to provide LPs with the information necessary to conduct the background checks. I know of a few emerging managers who have run background checks on themselves and posted the reports in the data room. Note that doing this won’t stop an LP from doing its own background checks, but it demonstrates that the manager is confident about their team’s pasts. Key issues that LPs are investigating include litigation, SEC investigations, bankruptcies, sexual harassment claims, and criminal actions (assault, etc.).
- The Best Time to Fundraise is When You’re Not Fundraising. I find this adage to be very true. We take calls with pretty much any credible manager whose fund is within our investment parameters. Many LPs like to establish relationships with emerging managers and watch how their first fund and strategy unfold. Develop relationships with LPs well before fundraising. This can occur at networking events, industry conferences, and over coffee.
- Reputation Matters. If a manager has a good reputation as being an honest, talented, collegial and successful investor, that positive reputation can help with fundraising. Conversely, if a manager has a bad reputation, that can doom the manager’s fundraising effort.
- This is a Relationship Business. An important point is that private equity is a relationship business, and if an LP says “no” to one fund, it doesn’t mean “no” for future funds. Building strong relationships can only help an emerging manager in the long run.
- Roadshow Tips. See my article “Compelling PE Roadshows: The Investor Perspective” on PH Hub for tips on how to have great roadshows. Here’s the link: https://www.pehub.com/2018/08/compelling-pe-roadshows-the-investor-perspective/.
Raising a fund is hard work. With literally thousands of funds in the market at any one time, the competition for LP attention is extremely high. Emerging managers can increase their chances of success by being prepared, having a differentiated strategy, offering an attributable track record of success in the stated strategy, providing LP-friendly fund terms, and being politely persistent. I hope these thoughts are useful. Good luck and good fundraising!
© 2019 Allen J. Latta. All rights reserved.
 Some LPs don’t feel that a PPM is necessary, but I encourage emerging managers to prepare this document. Drafting a PPM takes a lot of time, energy and thought, and I find a well-crafted PPM to be very helpful in my evaluation of a fund.
 A word on legal documents (limited partnership agreement (LPA), subscription packet, etc.). Having lawyers draft an LPA is a very expensive endeavor. Many emerging managers will wait to draft the LPA until they have sufficient interest from potential LPs to warrant incurring this expense. Most LPs won’t have a problem with this.