Setting up a new PE or Venture fund
17th January 2018
Part 3: Your fund as a business
Up until now, this series of articles has focused on some questions that need confident answers before it is prudent to sink the time, cash and other resources required into launching a new fund. This time we will concern ourselves with just one issue:
How do I run the business side of being a fund manager?
Like any business, your fund management company needs a financial plan. You must have a clear plan as to how you will cover the costs and cash demands of establishing and running the operations of the business.
To start with, you will incur significant costs to get up and running. In the first months’ you will need to engage a number of advisors and you will need to keep the lights on while you identify and secure investor commitments to your fund – which can take longer that you expect. Some private equity funds allow the fund manager to charge set-up costs to the fund, but this will depend on the LPs you attract and the strength of your negotiating position. Whilst establishment costs may include the legal costs of setting up the fund’s structures, they are however unlikely to cover your time nor the marketing costs (for example, the costs of employing a placement agent to raise capital) and in any case set-up contributions are likely to be capped.
Notwithstanding the apportionment of costs, you will need to cover the cashflow demands of the fund management company prior to the first drawdown of investor capital into the fund. Your plan should therefore cover this exposure and an assessment of the period from which the running costs will be covered through the fund management fee or fund returns.
In your first months (in fact, typically, your first years) it’s unlikely that there will be any distributions into the fund from the sale of portfolio companies. Fortunately, seasoned private equity investors will be familiar with the concept of funding your operations through a management fee, usually calculated as a percentage of an investor’s total commitment to a fund, paid quarterly. Note, once the investment period of the fund is passed – say half way through a fund’s life – the calculation will likely switch to a (sometimes smaller) percentage of cash actually invested in portfolio companies – ie a smaller percentage of a smaller number.
Whilst institutional investor scrutiny on all things fee-related has increased since the performance shock of the financial crisis, management fees of ca. 2% for a smaller fund remains broadly stable, although for longer funds there is more downward pressure. Aside from origination and deal fees, your working capital requirements are likely to be within a knowable range (office and associated costs, staff costs, service provider fees etc.). As your management fee will usually be expressed as a percentage of capital committed to the fund, the decision as to the size of commitments you seek is crucial.
The actual costs of running your fund management company will be determined by myriad factors including but not limited to the geographical and sector focus of the fund and the number and types of employees you will need to hire. However, the lists below cover source of the usual items. If you don’t have these items in your business plan, you may wish to consider how you will cover them.
- Staff costs, including salary, bonus, benefits and recruitment costs
- Office costs, including rates, utilities and associated fees
- Travel and other expenses
- Fund administrator and other service providers (e.g. is your fund in the EU and of a size that it needs a depositary?)
- Legal and other specialist advisers
- Transaction fees (although these are often recouped)
- The costs of running a regulated fund manager or accessing an outsourced regulated manager
- Set up and establishment fees – if you have been able to negotiate them.
- Annual fund manager management fees (typically drawn down quarterly)
- Transaction costs recoupment from the target company or from the fund investors (or do you need to deduct these from your management fees?)
- Investee company monitoring or board fees (although these are under pressure)
- Distributions into the fund upon the financial exit from a portfolio company
The nature of private equity funds and the manner in which they are funded means that even an immediately and durably successful fund will require significant funding prior to breaking even and delivering a return.
Next time: PART 4: PERMISSION TO LAUNCH – AIFMD AND ALL THAT
The final steps before you can approach investors – regulatory cover; custodians; legal advisers.
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