|September 25, 2012|
Previously published on Fall 2012
A successful first closing can propel a private investment fund sponsor toward its fundraising target. Key factors that contribute to a successful first closing are planning, patience and, in a difficult fundraising market, creativity.
Planning for a successful fundraising involves properly positioning a fund in the marketplace by obtaining feedback from prospective investors, choosing appropriate fund terms and building a strong team of investment professionals, managers, investor relations and back office personnel, accountants and lawyers.
By speaking with prospective investors before bringing a new fund to the market, a sponsor can obtain valuable information about which investors are most likely to participate in a first closing, the extent to which changes to the fund’s terms, strategies or personnel, as compared to previous funds, would increase the sponsor’s fundraising success and whether the sponsor’s fundraising time line is aligned with investors’ investment time lines. This data can be critical in setting the stage for a realistic time line and a fund structure that is acceptable to those involved.
Once a sponsor has this data, the next step is to set a target date for the first closing and establish a time and responsibility schedule. Getting all of the prospective first closing investors on the same time line and working towards the same date is often one of the most difficult things to do. Laying the groundwork ahead of time and being realistic and fair to those involved helps breed success.
Planning also involves evaluating how the terms of the sponsor’s existing funds fit within the current market environment. Deal terms that were standard several years ago may now be viewed as off-market or inconsistent with current standards, including the private equity principles promoted by ILPA, which have garnered support among certain institutional limited partners. In recent years, changing deal terms have affected economic issues, such as waterfall structures, carried interest calculations, general partner clawbacks and management fee offsets, as well as more general matters such as the role of the advisory board, investment limitations and indemnity matters. Limited partners have been asking that distribution waterfalls delay the time when carried interest payments are made, that carried interest be calculated on a net instead of gross basis, that clawbacks work properly in practice and take into account tax considerations, and that management fees be offset by 100% of directors’, transaction, monitoring and similar fees received by the sponsor and its affiliates.
The investor community is becoming increasingly more sophisticated, and a working knowledge of the fund’s terms as compared to the ILPA principles is advisable. Fund sponsors may or may not need to update terms for a current offering, but a sponsor that is well-versed about the terms of its fund and reasons for why a term may be different from what is perceived to be “market” will be better positioned to successfully navigate negotiations with investors.
Get Your House in Order
Before bringing a new fund to market, a sponsor also should evaluate its personnel and make any changes necessary to ensure that its team has the skills, expertise and bench-strength to attract investors and support the operation of a new fund. A sponsor should make sure that it has the right people assigned to the appropriate tasks during fundraising. Having a leader for the process is critical to getting through diligence, investment committees and negotiations, and hitting target dates.
It is also crucial for the sponsor to assemble a strong team of outside advisors. First and foremost a sponsor must determine whether or not to hire a placement agent to support the fundraising. The choice of a placement agent is highly specific to the circumstances of each sponsor and fund, and a sponsor should interview a number of firms before making its final selection. In addition, experienced fund counsel and accountants, with
in-depth of knowledge in the market, can ease the path to a successful close.
The Long and Winding Road
Sponsors follow a range of paths toward their first closing. Some are fortunate enough to be able to raise their first or next fund with minimal efforts in short periods of time. Most, however, follow a longer path toward their first closing. That path begins with sponsors focusing their marketing efforts on their best prospects which, for sponsors raising a successor fund, are their existing limited partners and, for sponsors of first-time funds, often are friends and family or, as described below, an anchor investor. Sponsors then expand their marketing efforts to new groups of investors, such as investors that have similar characteristics to the sponsor’s existing investors, investors with a particular interest in the sponsor’s investment strategy and investors in other geographic regions.
For the sponsor of a first-time fund or an emerging manager, finding an anchor investor can be invaluable. An anchor investor can provide the sponsor with seed financing required to build its management team, fund the sponsor’s early operations and provide capital for initial fundraising efforts. An anchor investor also can provide the sponsor with the marketplace credibility necessary to continue its fundraising, particularly where the anchor investor has name recognition in the industry or is otherwise expected to support the sponsor through its expertise, deal flow, industry contacts or operational infrastructure.
An anchor investor that takes a chance on a first-time fund or an emerging manager often will request beneficial terms that may include an ownership interest in the sponsor’s management company, a right to receive a portion of the fund’s carried interest, a discount on management fees or some combination of the foregoing.
Early Bird Special
An increasingly popular fundraising strategy, especially for more established firms, is to offer incentives to investors that participate in an upcoming fund’s first or early closings. The most common of these so-called “early bird” incentives are management fee discounts, priority access to co-investment opportunities and, less frequently, carried interest discounts.
The dynamic of private equity fundraising, however, which can last 12 to 18 months or more, makes it difficult to limit early bird incentives to just early closers. We have seen many firms offer early bird incentives at the opening stages of a fundraising period only to end up granting those rights to all investors at the fundraising period’s final stages.
There are times when investors are motivated to participate in a fund’s first closing even where a sponsor does not offer early closing incentives. An investor may be motivated to participate in a fund’s first closing when it is investing large amounts of capital and wants to take a lead role in shaping the fund’s terms or when it wants to secure a larger allocation to an oversubscribed fund.
There are also times when investors are motivated to sit back and let other investors negotiate favorable terms and to evaluate the progress of the fund’s early investments before committing to the fund. If properly implemented, sponsors can use early closing incentives to their advantage in an effort to offset the perceived benefit of participating in a fund’s later closings.
Lighten My Load
A recently popular early closing incentive has been the management fee discount which can take many forms, with the most basic being a simple reduction to the management fee charged over the life of a fund. Sponsors also sometimes offer management fee discounts on a portion of an investor’s commitment amount or during specified time periods, such as during a fund’s investment period or between the time of a fund’s first and last closings.
While offering some form of management fee discount to early investors has become more common in recent years, the practice can yield undesirable results. Some managers that offer management fee discounts to early investors have found it difficult to hold the line with later investors demanding the same discount. Furthermore, a sponsor that offers lower management fees for some or all of the investors in its current fund may find it difficult to increase those fees for successor funds. Sponsors face the risk that a temporary and limited incentive becomes the new baseline for all of its investors.
While investors are very focused on the overall expenses associated with their investment, by and large they are also realistic about the amount of management fee income that is required for a sponsor to support a team adequate to operate a successful fund. “Alignment of interests” between sponsors and investors has been the drumbeat over the past few years and that is expected to continue.
A Piece of the Action
Another common early closing incentive requested by investors is a priority allocation on co-investment opportunities. Offering a priority on co-investments can be a seemingly easy concession for sponsors because it does not affect their management fees or carried interest directly. The risk for sponsors is that they give up some control over whom they partner with on co-investment opportunities, and managing multiple requests for co-investment rights and priorities is often difficult.
Last But Not Least
Other early closing incentives include offering early investors representation on a fund’s advisory or investment committee, providing preferential rights to participate in future funds organized by the sponsor, permitting an investor’s employees to participate in a sponsor-operated secondment program, providing carried interest discounts, providing the early investors with the opportunity to participate in specified co-investments that arise during the fundraising process and providing early investors with a priority allocation in one of the sponsor’s other funds that is oversubscribed.
Achieving a first closing for a new fund can be a difficult process, but with planning, patience and creativity, a sponsor can put itself in the best position possible to successfully reach its fundraising targets in a manner that contributes to the long-term success of its organization.