Flying feeless

Given the brimming coffers of so many private equity firms these days, the idea of operating without a management fee may seem, at best, quaint, or at worst, evidence of less than convincing investment case.

But many successful private equity franchises begin life without the safety net of a management fee charged to a committed, blindpool partnership. These types of firms have gone by several different names, ?pledge fund? among the most well known.

Pledge funds, which raise capital on a deal by deal basis, pride themselves on the discipline bred of forgoing a fee. Firms raising their first fund will often mimic their pledge brethren until they've established a track record to secure a traditional fund close. Whether by choice or necessity, operating this way frequently requires putting the partner's personal resources at risk until such time as a deal closes, it is a situation not for the faint hearted.

With personal capital at risk, proper budgeting is vital. Regardless of the firm's rationales for raising funds on a deal by deal basis, partners should look beyond their own finances and tally how they may leverage current relationships. Fostering the right rapport with service providers and investors can minimize upfront costs, but in the end, certain charges, such as compensating talent, can't be avoided. There are ways to recoup some fees prior to closing a deal and over the lifespan of an investment, but they don't cancel the risk entirely. Deals that fail to close can break the best-laid budget, so streamlining diligence and approval processes are crucial for staying solvent.

?For those funds executing a few deals on the path to a traditional fund, it may be better to tap some of the early investors for overhead costs. But for those willing to draw up a term sheet, there are ways to charge small-scale management fees.?

Know thysel
In budgeting for deal by deal activity, partners should adequately assess their reasons for pursuing deals as a pledge fund or deals prior to a traditional close. Are there broader market conditions interfering with the fundraising drive? Are LPs anxious about the partners' track record outside of the big brand firms they've spun out of? Or is the firm planning to operate on a long term basis as a pledge fund, preferring the flexibility of going without a fixed fund agreement? General partners should assess whether they are looking to operate as pledge funds temporarily, say for the first one or two deals, or for considerably longer, to determine how best to deploy resources.

New York based Arsenal Capital never planned on operating as anything but a traditional buyout fund. The partners were veterans of Thomas H. Lee Partners and wanted to apply that firm's ?core growth buyout strategy? to the lower middle market. The first $50 million was raised with relative ease in the first half of 2001, but the fallout of 9/11 slowed fundraising. ?Commitments to new funds were few and far between at the time,? recalls Terry Mullen, a managing director at the firm.

Arsenal decided to take advantage of the market downturn, and acquired two deals at an attractive valuation in March and May of 2002. ?We felt that if we executed a few successful transactions, we'd be that better poised to convince LPs,? says Mullen. The pair of deals did perform well and won the support of such high profile investors as Adams Street Partners, JP Morgan and Wilshire Associates, and Arsenal eventually closed on an oversubscribed vehicle.

Unlike Arsenal, Laud Collier & Company didn't have the luxury of an initial infusion of capital. ?We'd run CIT's private equity business for twelve years and spun out from there in 2002 so we were confident we had the experience to do deals,? says Paul Laud, a founding partner of the Chatham, New Jersey based firm. Despite having executed 36 deals at CIT, the partners found LPs hesitant to back the team.

?In many cases, they couldn't determine how much our track record could be attributed to our talent, and how much to the institutional brand of CIT,? explains Laud. With the support of a few investors, Laud Collier began to operate as a fund-less sponsor, gathering commitments on a deal by deal basis. ?We were after a track record, not a few hits that could be dismissed, so we settled into operating this way for a period of time to dispel and doubts investors may have,? says Laud. ?In time, we might shift to a more traditional fund structure, but for now, we're not short of deals or investors.?

Circle Peak Capital built fundraising on a deal by deal basis into the DNA of the firm. Founded in 2002, the New York firm continues to operate as a pledge fund, with deals of increasing size as investors became more comfortable making larger commitments. The firm appears to be performing well, having closed on six buyouts in the past two years alone.

?We were after the agility that comes with foregoing a traditional fund structure that may lock us in to narrowly defined parameters in terms of targets or exits,? says Adam Smith, president and founder of Circle Peak. ?Certainly that agility comes at the price, as we have to be pretty disciplined on costs to operate this way, but our LPs and targets appreciate that.?

Bare essentials
?In some ways, these pledge funds are treating management fess as they were originally intended,? explains Joseph Bartlett, an of counsel in the New York office of the law firm Fish & Richardson. ?It was meant for basic overhead costs, such as office space, travel and modest salaries so the partners could eat, not a source of profit, as you see in the top tier funds today,? he says. However frugal these pledge funds may be, there are real expenses that can't be trimmed any further.

?You can't skimp on people,? says Arsenal's Mullen. ?You have to provide salary and structure some traditional compensation which includes severance and other benefits.?

Mullen admits that some Arsenal professionals shared the startup risk and were willing to forego some aspects of compensation, which in Arsenal's case was a short term proposition. ?People believed in our strategy and were willing to share the risk in exchange for being part of this idea. That said, we still set aside one to two million dollars for staffing, though for us, it was a simple decisionthe strategy required the right team to make it work,? he says.

Firms that decide to operate as a pledge fund on a permanent basis likewise treat compensation a necessary expenditure, worth the initial outlay of capital. While Circle Peak's Smith noted that in addition to the upfront compensation, there's some upside for partners working this way.

?As a fund-less sponsor, compensation can be multi-faceted. Partners don't wait for year-end bonuses. There are rolling payouts on the closing of deals, and we often fold a portion of our transaction fees back into equity on a deal, allowing for a more significant share of the upside in a given deal,? says Smith.

The other cost where there isn't much wiggle room is travel. ?I'd say after compensation, travel is our second biggest expense,? says Jonathan Blue, the founder of Blue Equity, a pledge fund based in Louisville, Kentucky. Mullen echoes the sentiment, though he explained that travel expenses weren't too onerous, as their strategy targeted the East Coast and Midwest exclusively. Other pledge funds cited a narrow enough geographic focus that travel didn't dominate the budget.

Finally, there's general overhead including real estate, though this can be negotiated in a number of ways. ?We outsource most of our back office, which keeps our administrative costs fairly lean,? says Laud. Mullen notes his firm was able to manage a month by month sublet, and most pledge funds find that they can find quality real estate options by tapping their personal network, either through working out of an associate's office or using the offices of service providers, in exchange for guaranteed business once the deals start to close.

Deal expenses
Dealmakers know that success in sourcing and closing deals requires more than keeping the lights on. The due diligence process involves legal fees and often includes commissioning specific intelligence reports from outside accounting or research firms. How much of these fees can be postponed until a deal actually closes depends on the type of relationships a pledge fund has with their service providers.

?We go back to the same service providers over and over again, so there's enough trust to be flexible with their terms,? says Laud. Smith makes it a priority to insure his relationships with intermediaries and outside experts remain robust and reciprocal. ?We make our service providers true partners in the process, and build trust by demonstrating repeat business to them,? says Smith. Many of the partners at these funds noted the generous amount of good faith they enjoyed when they were launching these vehicles.

?Time and time again, the relationships that my partners and I brought to the table came to the rescue,? says Mullen. ?Our first few investors and our personal networks would often vouch for our viability when it came to pulling off those initial deals.? Several GPs stress when the costs for a broken deal process comes out of their own pockets, any goodwill on behalf of vendors is priceless.

The greatest risk of a fund operating without a management fee is the dead-end deal, where the legal and accounting fees have accrued on a transaction that doesn't happen. Closing fees can recoup a great share of the cost incurred in pursuing a given deal, and once the company is part of the firm's portfolio, many pledge funds charge a small management fee for its role in steering the company. However, when the deal fails to happen, the partners are often forced to pay for all costs related to these aborted transactions.

For this reason, the partners are extremely cautious about how far they're willing to chase a given opportunity. ?The discipline of operating this way requires that we look at opportunities, first and foremost by their potential as an investment, but then you also gauge the likelihood of winning the deal, which involves no small amount of intangibles,? says Smith.

One of the toughest decisions for partners appears to be when to draw on outside resources. ?You really want to strike the right pace when it comes to tapping outside expertise, and that's not easy to do,? says Laud, though he does note his firm enjoys a 100 percent closure rate.

Beyond a rival offer or a reluctant seller, a substantial risk to closing a deal for pledge funds is a prolonged approval process among investors. ?Pledge funds usually involve five or six key investors, but even that few can stifle a deal if they take too long to deliberate on a given transaction,? says Bartlett.

Bartlett advises streamlining the approval process among investors as much as possible. He suggests that the terms sheet should define the time frame from when the LP is notified of the opportunity to their final chance to make their commitments. He recalls watching a few pledge funds lose auctions for being too slow to secure investor approval.

Fees for the committed
For those funds executing a few deals on the path to a traditional fund, it may be better to tap some of the early investors for overhead costs. But for those willing to draw up a term sheet, there are ways to charge small-scale management fees to tackle start-up costs and some upfront deal costs (see ?Bridging the gap?).

However, partners at the pledge fund should be warned that while investors may be willing to pay a minor management fee, they don't want to see those fees used in the launching of a standard private equity fund. ?These investors don't want their funds to be used to simply ramp up a traditional vehicle,? says Bartlett. This reiterates how vital it is for the partner to know how long they plan to operate as a pledge fund, whether it's a stopgap measure before a fund's first close or a more integral part of the firm's modus operandi. Either way, a smart budget for operating this way requires some savvy in stretching a dollar, just shy of its breaking point.

Bridging the gap
If you are looking to formalize a pledge fund with your investors, there are some market terms for charging a management fee. Joseph Bartlett of the law firm Fish & Richardson offered these parameters in a recent client memo entitled ?Pledge Funds: Commentary and Model Term Sheet.? Start-up expenses: The vast majority of LPs cap fees for the start up of a pledge fund partnership at $300,000. Investors usually divide this cost evenly among themselves.

Ongoing expenses: LPs may agree to provide a minor monthly fee to the pledge fund partners, in the range of $20,000 per month. Investors also divide this cost evenly among themselves.

More investors, same fees: In many term sheets, the addition of new investors does not increase management fees. Most term sheets allow for the cost of start-up and monthly fees to be recalculated to insure that ever investor contributes equally to these costs.