Making ends meet

There’s a part of the private equity market where the launch of new funds sees investors scrambling to sign on the dotted line, in their wild-eyed enthusiasm barely pausing to take note of the section where the information memorandum seems to be referring to escalating fees and carried interest. Yes, for LBO firms the good times truly are rolling. It’s a pity that the same can’t be said for venture capital firms.
Summing up the dire state of venture capital in the UK, for example, Invesco Private Capital general partner Ray Maxwell describes investors as being on a “detox diet” in which “having gorged on venture during the bubble, they now won’t touch it”. Of course, for a select coterie of venture GPs with established track records, the situation is very different.
But what is life like for those brave enough to launch first-time venture funds? Even in a positive climate, getting investors on board early and being able to pull together sufficient resource to see you through the perilous first phase of existence—often seen as the first year to 18 months—is a tough ask. Amid a nadir in the cycle, how do newcomers to the fundraising trail manage to ensure their survival?
One straightforward answer to that question is that you should avoid being a newcomer. Explains Kelly De-Ponte, a partner at San Francisco-based placement agent Probitas Partners: “If you’re launching a start-up fund, a lot of investors will not back you, full stop. Others will, but they will not back first-time managers. In most cases, the managers must be experienced investors—and, if they are, they’re likely to have a degree of wealth already. You can’t just wake up one morning and say ‘I want to be a venture capitalist’ from scratch.”
But when your personal wealth just won’t quite stretch far enough to see you through to a first closing, what then?
The answer to this conundrum often involves seeking to hook an anchor investor. In one fell swoop, this will bring on board the benefits of credibility, expertise and—most important of all—a substantial slab of capital.
Jason Glover, head of the fund formation team in the London office of law firm Clifford Chance: “Having
an anchor investor is very important, and there are relatively few start-up funds that don’t have an anchor of sorts. They will account for a significant amount of the total capital raised by a debut fund and it will take a long time to raise the money without one.”

Avoiding the long haul
Glover says that having a core sponsor on board at the pre-marketing stage can be invaluable in terms of getting other investors in early, particularly if the supposition is true that most investors in today’s private equity market are more inclined to follow a trend than start one. Without an anchor, the pressure is on to get respected names into the fund by the first closing. A failure to do so could mean a long haul from first close to final close, with all the concomitant strain it will place on the GP’s budget.
However, DePonte highlights one major drawback with anchor investors – their tendency to push for preferential terms and conditions. These special favours might take the form of any or all of the following: lower management fees than other investors; a seat on the fund’s investment committee; a slice of the carried interest; or a stake in the management company. For example, Capital Z Investment Partners, a regular sponsor of first-time funds, says on its website that it seeks to take a “meaningful minority interest in the management company”.
Because of this, says DePonte, a lot of LPs don’t like to invest in a sponsored fund. “If they feel the sponsor isgetting too many preferential terms, they may feel there is not sufficient alignment of interest. They might be worried that a seat on the investment committee, for example, may lead to investment decisions being taken that are in the interests of the sponsor but not necessarily the fund.”
GPs in fear of this kind of negative reaction from investors might instead seek to draw on any existing personal wealth mentioned earlier by DePonte together with the backing of family and friends to help them through the vital early period of their lives before other, higher profile investors come on board. “You need a certain war chest in order to pay staff and bankroll the costs of fundraising, among other things,” says DePonte.
For the fund that takes this route, keeping a close eye on the cents and dollars really is an imperative—much as it would be for any young business that the fund ends up investing in. Such a fund might start at home rather than in an office, and often will not have secretarial staff or administrative staff, or at least not senior back office employees such as a CFO (who will often be hired only once a first closing has been completed). The focus in the early days is likely to be on a core team of two or three investment professionals, who will be tasked with notching up a deal or two and beginning to establish a track record, i.e., something tangible for would-be investors to take into account when considering whether or not to make a commitment.

Favorable fees
Once investors have been lured, the good news for venture funds is that they are generally happy to agree to generous fee structures. Even first-time funds can normally get away with charging a 2.5 percent annual management fee, say industry sources. “Investors [in first-time venture funds] realise that a critical mass needs to be reached in terms of building the company’s infrastructure. They will also tend to have a pragmatic attitude when it comes to charging expenses to the fund,” says DePonte.
Glover adds that such funds will also often have an establishment fee built into the limited partner agreement.
This retrospectively covers the cost of setting up the fund and used to be typically set at one percent of total commitments. According to one source at a venture fund, investors tend not to be quite so generous in today’s market. “These days,” he says “it tends not to be a flat fee. Rather, you keep a record of all your costs and it gets paid back up to a maximum limit of one percent.”
Maxwell says that the fee structure also seems generous in the context of deal costs. “If you’re an LBO fund and you’re trying to buy and merge companies, you have quite high acquisition costs. In venture it’s different—you bring other investors into the initial deal and share the costs. And then, as the company gets bigger, these same investors commit further amounts. It’s not directly comparable.” On the other hand, though, sources point out the deleterious effect of write-offs on venture funds’ income when the management fee is related to total funds under management (a typical venture fund could see at least half of its portfolio crash and burn).
They also say that certain investors in such funds will often seek a precise breakdown of all incomings and outgoings from the GP—which is something the GP normally has to agree to, especially if any of the terms and conditions are ‘above market’.
As with any new business, the start-up phase for a venture fund is perilous and the cloth must be cut according to the means. However, once such a fund is up and running, it is more likely that investment decisions will make or break the fund rather than a lack of income and resources.