Fundraising in the private equity markets has been on a tear of late. In 2021, private equity funds raised more than $730 billion. These record-setting numbers are being driven by a heightened interest in private markets and increasing demand for exposure to the alternative investments sector in a low-yield environment.
That’s not to say it isn’t a challenge, especially if you’re an emerging manager just starting a private equity firm. Case in point: one-fifth of the capital raised in 2021 went to the 10 largest funds. And after a couple of years of banner growth, there’s the risk of investors feeling stretched thin:
Fundraising for private equity firms: The basics
The tactical part of fundraising is typically the second stage of the investing in private equity process, following initial conversations with LPs to gauge general interest and, separately, early due diligence on potential investments (such as privately held companies).
During the organization/formation stage, interested LPs will pledge capital commitments. Capital calls are completed when these pledged funds are needed for tangible opportunities.
With so many active PE firms – roughly 7,000 globally, per McKinsey – it’s important to follow strategic steps ahead of these LP conversations so that they choose to invest in you versus one of the many other options.
Step 1: Qualify how you stand out
Before you begin to reach out to potential investors, it’s helpful to develop a value proposition that makes limited partners consider you as an option for their investments. This can be a short, simple statement that indicates what specific benefits your firm has compared to competitors.
Maybe it’s technical expertise, previous experience of your principals, a specific investment strategy, or a niche industry or geographical focus. Focus on what sets you apart (your key differentiators) and why you’re the best at what you do (your competitive advantage). If you don’t stand out, raising the initial capital needed to get off the ground will be challenging.
As part of this process, you should perform your own due diligence. Who are your top competitors that are already up-and-running, and how can you differentiate yourself? If you’ve decided to focus on a specific type of investment (venture capital or fund of funds, for example), what risks are involved and how will you address them? You’ll want to think beyond the obvious risk of market/economic volatility and consider other factors, such as funding, liquidity, and capital risks.
Step 2: Determine the details
Like any other business launch, the devil’s in the details when it comes to starting a private equity firm. Here are some basics you’ll want to decide on before beginning your fundraising discussions.
Key considerations for a new private equity fund
Fund size: Your target investment strategy will help inform your fund size. Review the market cap of your prospective portfolio companies and consider how much you hope to invest. From there, you can calculate how many LPs you want (and how much you’ll need them to chip in).
Fee structure: Typically, GPs charge LPs between 1.5% and 2% of committed capital to pay for overhead costs. As an early-stage manager in the initial rounds of PE fundraising, however, many choose to reduce this fee for prospective partners (taking only 1.25%, for example). Once you have a proven track record, you can always adjust.
Track record: Speaking of your track record, what do you plan to calculate and share with investors? Private equity return measures generally include net internal rate of return (Net IRR), total value to paid capital (TVPI) or total value to paid-in, and distributions to paid capital (DPI). Depending on your stated objectives, these results can be calculated at the port co level, the portfolio level, or the fund level.
You’ll also want to consider your reporting functionality – what will your reports look like, and will they be available to your LPs on-demand? While Excel or QuickBooks might be sufficient as you get started, these solutions are prone to human error and aren’t particularly scalable.
We’ve recognized a clear need among startup and emerging managers – a software package that can scale in complexity alongside a burgeoning firm – and leveraged our experience with enterprise-level clients to build the Allvue Equity Essentials software set. This suite caters to the needs of new and emerging PE and VC firms, providing solutions for accounting, reporting, and investor communications, plus real-time performance metrics to help streamline fundraising efforts.
Step 3: Appoint your team
PE fundraising is ultimately a people business, so you’ll want to have the right team in the room as part of any discussions with potential LPs. Anyone in the conversations should be prepared to confidently discuss their relevant experience, including any past achievements that can be supported by data (deal origination, investment performance, timing, etc.)
Depending on the size of your firm at launch, your fundraising team might include the CEO, COO, Chief Investment Officer, and Chief Compliance Officer, along with any relevant support staff that can speak to your differentiating factors.
Step 4: Find your first investors
Once you’ve set up shop and figured out the above details, you’ll want to consider committing your own capital if it’s possible to do so. Most GPs do invest in their funds, typically 1% to 2%. One benefit to contributing your own capital is that it shows potential investors that you have “skin in the game.”
Then, it’s time to start fundraising in earnest. There’s nothing wrong with starting with trusted friends, family, and colleagues – even if the conversations are just for practice! Your network is the best place to find trusted investment partners.
You’ll eventually want to have a relatively diverse group of limited partners from the following segments:
Patient (long-term) capital: Large institutional investors – such as private foundations, pensions, or endowments — are considered patient capital. These organizations may be more conservative as to what they’ll invest in (leading to longer due diligence periods) but they are typically reliable and have ample cash on hand. Additionally, some pension funds and endowments have launched “emerging manager programs,” allocating a certain percentage of their threshold to smaller or newer managers.
Value-add capital: Value-add capital investors help out behind the scenes with identifying deals and managing them. Often, these are high-net-worth individuals with PE experience.
Flexible capital: Often in the form of fund of funds or family offices, these investors have available cash but typically hope for quick returns.
Step 5: Equip yourself for success
PE fundraising is challenging and frustrating, but a vital (and rewarding) part of starting a private equity firm. These steps are far from the end of the journey, which will also include marketing yourself, tracking your investments, and communicating on a regular cadence with the partners you make. Having the right technology to support and streamline your efforts can make a world of difference
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