Global private equity has delivered stellar results in the past decade, outpacing other alternative investment asset classes.
According to McKinsey, private market Assets Under Management (AUM) growth reached $13.1 trillion as of June 30, 2023, with private equity accounting for the most significant growth, especially in European markets, where fundraising surged more than 50%.
Although fundraising has slowed since the first half of 2022, much dry powder is still available in North America and Europe, and many ambitious private equity investors are looking to launch their funds.
One of the core tenets of raising capital for a private equity, venture capital, or other investment fund is having a well-thought-out answer to prospective investors or limited partners' “Why should we invest in you?” question, especially during the current times of higher interest rates, lower valuations, and difficult market conditions.
If you don’t have a convincing answer – or any answer potential limited partners are bound to abandon you for any of the thousands of more well-known buyout funds or other private capital asset classes they evaluate, such as hedge funds, real estate, etc. Thus, correctly answering this question requires extensive research and an in-depth understanding of your fund’s investment strategy and thesis.
We’ve put together this private equity fundraising guide to help your fund’s general partners articulate an excellent answer to this question. Go through these categories and ensure you have a compelling answer for each.
Determine Your Strategy and Competitive Advantage
Investment Strategy: The Core of Your Fund
Before diving into the complexities of fundraising, the most crucial element that requires articulation is your fund’s investment strategy. This isn’t just about selecting a type of investment but rather involves constructing a comprehensive plan that details the fund’s objectives and the steps you’ll take to achieve them.
Types of Focus and Asset Allocation: The first layer of your investment strategy is the type of businesses your fund will target. The choices range from early-stage startups, known for their higher risk and potentially higher returns (venture capital), to established companies that promise consistent, albeit sometimes smaller, returns (growth equity). Alternatively, you might opt for a fund-of-funds model, where you invest in other funds, essentially diversifying your risks and rewards. Traditional buyouts, where you acquire controlling stakes in mature companies, offer yet another avenue.
Geographic and Industry Scope: Once you know what type of company you’re interested in, the next step is to identify your fund’s geographic focus. Will it be domestic, international, or even localized to a particular region or sub-region? Similarly, is there a specific sector that aligns with your fund’s vision? Technology, healthcare, and renewable energy are just a few examples of industry-specific funds.
Competitive Advantage: What Sets Your Fund Apart
In the crowded arena of PE funds, having a clearly defined competitive advantage isn’t a nice to have; it’s a necessity. If your fund doesn’t offer something unique, attracting the capital and investor confidence needed to get off the ground will be challenging.
These competitive advantages include a solid deal-sourcing network, operational expertise in a specific industry, a successful track record, brand recognition, technology and data analytics, etc.
Unique Selling Proposition: More than High Returns
It’s not enough to promise high returns; most funds aim to do that. You need a unique selling proposition (USP) that separates you from the crowd. Whether it’s specialized expertise in emerging markets, a proprietary investment algorithm, or exclusive partnerships with industry leaders, your USP should be central to your fundraising pitch.
Proven Track Record: While a new fund may not have the luxury of a long track record, the individual experience of the General Partners (GPs) counts. A history of successful exits, high IRR (Internal Rate of Return), or other notable accomplishments can be a compelling differentiator.
Before starting the fundraising process, ask yourself why a multi-billion dollar pension fund should decide to invest with my firm instead of the hundreds of other options available.
Comprehensive Plans: Short-term and Long-term
Limited Partners (LPs) will expect to see what your fund aims to do and how you plan to do it. Your strategy should be broken down into actionable short-term and long-term plans.
Short-term Plans include immediate fundraising targets, initial investments, and operational setup tasks. Clearly defined milestones for the first 1-2 years can instill confidence.
Long-term Plans: What does success look like five or ten years later? Outline how you aim to scale the fund, possible exit strategies, and how you will adapt to market changes across the fund’s lifecycle.
Risk Management: Planning for the Worst-Case Scenarios
A comprehensive risk management plan is non-negotiable. From market downturns and regulatory upheavals to cyber-attacks to default on a capital call, you need to have a plan for how your fund will respond to various threats.
Actionable Steps: Each identified risk should come with a mitigation strategy, whether diversification to reduce market risk, cybersecurity measures, or even insurance coverage for extreme cases.
Building a Team and External Support
Advisory Board: Leverage Industry Wisdom
An advisory board is a crucial asset for any private equity fund. It provides strategic guidance, industry expertise, and valuable networks that enhance the fund's credibility and operational effectiveness.
By selecting advisors with a proven track record, deep industry knowledge, and strong connections, you can aggregate insights that help you navigate complex challenges and seize opportunities.
Regular engagement with the advisory board ensures that their advice is integrated into decision-making processes, adding significant value to your fund's strategy, fundraising efforts, and portfolio management.
Their involvement bolsters your fund's reputation and opens doors to new partnerships and investment opportunities.
Professional Assistance: The Unsung Heroes
Don't underestimate the value of external consultants or in-house professionals. An experienced attorney can help navigate the legal landscape, a regulatory expert can ensure compliance, and an independent accountant can bring transparency into the fund's financials.
Depending on the type of fund, you may need experts in fields like technology, healthcare, or renewable energy to provide deep industry insights. Consider working with a placement agent if this is your first fundraising round.
Figure Out Your Fund Structure and Model
Fund Size and Fees
The size of your fund should relate to your investment strategy. Consider the market cap of potential portfolio companies, how much you plan to invest in those companies, and the number of LPs you'll recruit during the PE fundraising process. It's usually wiser to set a conservative fund size to generate demand so it is easier to meet your funding objectives.
As a first-time fund manager, you'll want to set friendly terms for your limited partners. Keep your fees around 1.25%- 2.00%. As you develop a track record of success, you can raise your fees and shift your terms in your favor.
Private Equity Metrics and Reporting
In the Private Equity (PE) world, transparency isn't just a buzzword; it's a necessity. Limited Partners (LPs) aren't just passive spectators; they are deeply invested stakeholders who require clarity and context regarding the performance of their investments. Let's delve into why specific metrics matter and how to contextualize them.
Contextualizing Projections: Liquidity and Timing Differences
First and foremost, it's essential to understand that PE differs from other asset classes like equities or bonds. The irregular timing of cash flows—both inbound from LPs and outbound for investments and distributions—makes measuring and projecting returns complex.
Liquidity Concerns: PE investments are relatively illiquid, meaning they can’t be quickly sold for cash without a significant loss in value. As such, the return metrics are more intricate.
Benchmarking Challenges: Comparing PE returns to other asset classes is more complicated. While the S&P 500 might serve as a general performance benchmark for equities, finding an analogous measure for PE is more complex, often requiring specialized indices or peer group comparisons.
Must-Have Metrics: What to Include in Your Reports
Net IRR (Net Internal Rate of Return): This is the annualized effective compounded return rate, accounting for the time value of money.
TVPI (Total Value to Paid-in Capital): A holistic measure that reflects the fund’s realized and unrealized value compared to the total amount of capital paid in by the LPs. It provides a picture of total growth or shrinkage.
MoIC (Multiples of Invested Capital): MoIC indicates how many times the original invested capital has grown or shrunk, providing a quick snapshot of performance.
DPI (Distributions to Paid-in Capital): This indicates the ratio of the capital that has been returned to LPs relative to the total paid-in capital.
RVPI (Residual Value to Paid-in Capital): This metric shows the value of the remaining portfolio if it were liquidated today relative to the amount of paid-in capital. It offers insights into potential future distributions.
Loss Ratio: Often overlooked but immensely informative, this metric indicates the proportion of deals where capital was realized below the cost. It serves as a barometer for the risk management effectiveness of the fund.
Transparency and detailed reporting are not optional; they are fundamental to your relationship with your investors. By offering context and clear metrics, you are not just sharing numbers but building a narrative of trust, performance, and future potential. This comprehensive approach to metrics and reporting can significantly improve the attractiveness of your fund to discerning LPs.
Identify Your Target LPs
Identifying the right limited partners to reach your level of committed capital is a critical step in the fundraising process of a private equity firm. Once your attorney has drafted your offering memorandum, partnership terms, subscription agreement, and other documents, you can begin to identify LPs and fundraise actively. It is also important to have gathered feedback from trusted friends and contacts before venturing out and engaging with potential LPs.
Before looking for potential investors, we recommend that you and other GPs invest in your fund. New managers typically invest 1%- 2% in their first fund. Fund managers not having "skin in the game" can be a deal-breaking issue for some LPs.
Each investor you bring into your fund has its own goals, requirements, and concerns. On the one hand, you want a diverse group of partners so unexpected dropouts don't cripple you. On the other hand, you want LPs whose goals are similar enough so that everyone buys into the mission and strategy of the fund.
Generally speaking, there are three types of LPs, and depending on your fund, you want a healthy mix from each group:
- Patient capital: Large institutional investors (like foundations or university endowments) can meet their capital commitments and usually aren't easily influenced by business cycle swings. They might have a lot of cash but can't deploy it quickly due to strict investment policies.
- Value-add capital: These investors don’t just contribute cash. They also assist in finding deals, winning them, and getting through the management phase. These LPs can be a significant advantage and are often high-net-worth individuals.
- Flexible capital: Typically comes from funds-of-funds, which have the resources for fast due diligence and capital deployment. However, they usually look for quick returns to cover their double layer of fees.
Where do you find LPs for your fund? Through your network. The strength of a relationship can be the deciding factor when raising private equity funds. Leveraging your network requires a deliberate approach to relationship management with the right processes and tools.
To get started finding LPs, here is a list we have compiled.
Co-Investment
Consider if you're willing to permit co-investment at a later point. Many LPs seek co-investment because it offers higher returns by avoiding PE fund fees and carried interest. In addition, it lets LPs investigate or "try out" fund managers before formally allocating part of their capital to the fund. According to a Preqin survey, fund managers view co-investment opportunities as necessary for successful fundraising.
Naturally, these kinds of arrangements complicate things. There's always more complexity when you involve more people, especially with unique needs and goals. Nevertheless, co-investment could be a valuable way to bring more capital as needed.
Determine Your Fund’s Marketing Strategy
Your network will likely be your most significant funding source, and even though private equity has the word private, it does not mean you will not need to market the fund actively. For example, when meeting with potential LPs, you need certain documents and marketing collateral to provide potential investors with the information they need. Additionally, you will want to leverage the power of content and social media to position your fund as a leader and build its brand.
Elements such as subscription documents, due diligence questionnaires, team background information, slide decks, and other documents should include your firm's branding and be kept in a virtual data room. Then, as you take more meetings, refine these documents to address the concerns and objections voiced by potential LPs.
A professional website and profiles on X and LinkedIn where you articulate your fund's investment strategy and expertise and share relevant content can showcase your firm as an industry thought leader and attract more partners and deals. In addition, as the fund grows, you can host events and webinars to raise your firm's profile and subsequent funds.
Management Team
Having the right management team for a new fund can mark the difference between success and failure. Potential LPs will want to meet the team and learn about their professional background, credentials, and achievements. In the world of alternative investments, where little data is available, the management team's quality and network are crucial for securing funding.
Make sure that anyone involved on your end has a proven track record of success, experience within the industry, and the ability to identify opportunities, mitigate risk, and pivot if necessary. Break down your track record (or whoever is managing the fund) by actions of the investment cycle:
- Deal flow origination: Discovering companies, recruiting investors, and negotiating terms.
- Investment performance: The actual financial returns of your managed deals and funds.
- Hiring: The talented people you have hired and their successes.
- Timing: Your ability to enter and exit deals at the correct times.
The size of your team will vary depending on the size of the fund and investment strategy, but consider having the following professionals: a CEO, Operations Officer, Investment Officer, Financial Officer, Compliance Officer, and investor relations professional, among other support staff.
Executing and Iterating on the Fundraising Process
Fundraising is an iterative process. By meeting with more potential limited partners, you will refine your pitch and learn what specific investor groups are looking for in a fund.
To ensure productive meetings and get the most out of them, you should incorporate the right technology tools, including an intelligent relationship management platform like 4Degrees, specifically built from the ground up for PE firms.
4Degrees leverages your network's power to find introductions to limited partners, streamline fundraising, deal origination, and due diligence, and provide you with the data you need to make better investments.
To learn how 4Degrees can streamline your fundraising and deal-sourcing process, Request a free demo today.
Going Forward
This guide covers some of your primary considerations when raising private equity dollars. Use this advice to prepare yourself, but be flexible and transparent with prospective limited partners.
Of course, they have their own goals and mandates that don't always align with your strategy. However, if you and your team are experienced dealmakers and present potential LPs with a well-thought-out and sound investment strategy, chances are you will have some good conversations with potential partners.
If you are looking to learn more about private equity fundraising, check out these PE podcasts.
