Private equity investments have proven to be a successful asset class, and the industry keeps growing. According to Investopedia, many investment bankers decided to switch from public to private equity because the latter has significantly outperformed the Standard & Poor’s 500 Index over the last few decades. Also, in contrast to many other asset classes including hedge funds, outperforming private equity fund managers tend to continue to outperform. This further fueled the demand for private equity funds, providing a perfect opportunity for all aspiring entrepreneurs to join the industry and provide investors with new opportunities.
Sean Frank is the managing partner at Cloud Equity Group, a boutique investment management firm specializing in leveraged buyouts of tech-enabled business service providers. What started as an independent sponsor going to market to capitalize each individual investment over time is now an investment manager of discretionary capital on behalf of its high-net-worth individual, family office, and institutional investor clients.
Sean shares some of the basic principles needed to create a competitive private equity fund in today’s market.
Define the investment strategy
The first step to starting an investment management firm is mapping out the actual investment strategy. This can’t just be theoretical but it has to be proven with a verifiable track record. There is no shortage of competing resources and platforms available for investors looking to grow their capital, so you need to show investors that you are able to outperform those.
“You need to outline all the specifics, from investment thesis to historical returns, in advance because investors want to know everything there is to know about your firm’s strategy and performance – particularly when you are first starting out,” Sean explains. “If you are only building a track record for the first time based on some theory, it’s best to start out small using your own money first to develop that track record before attempting to go to market.”
Develop a business plan and set up operations
A business plan should include cash flow expectations for the investment management firm as well as the fund’s timeline, including the amount of time it will take to raise capital and when the fund would be expected to liquidate. Typically, the investment management firm will not receive any income until a fund actually launches, and so there needs to be a plan in place to fund all of the initial operations surrounding the capital raise.
When devising a business plan, it is also essential to plan out in-house operations, such as the office space, furniture, technology, and staff. These are additional expenses that a new investment manager will incur from day one before it’s actually receiving any income. Ideally the owner(s) of the new firm has capital to cover these initial costs until the business starts making money, but if not it’s possible to ask prospective fund investors to help cover these costs in exchange for discounted fees or profit sharing.
Establish the investment vehicle
In the United States, a private equity fund typically assumes the structure of a Delaware limited partnership for legal and tax advantages. The manager of the fund is known as a General Partner and it has the right to decide the investments that compose the fund. Investors are Limited Partners who are essentially silent, non-controlling partners of the entity. Sean recommends hiring a law firm with experience in closed-ended investment vehicles to draft your private placement memorandum as well as all other operating agreements.
Hire third-party vendors to produce financial data
Now more than ever, it is imperative that investment managers utilize third-party vendors to produce financial data. Sean recommends using a third-party fund administrator to do all fund accounting and to issue investor capital statements, as well as a top 10 audit firm to compile the year-end financials. This level of transparency will not only aid in confidence amongst existing investors but will help significantly in the due diligence process of future prospective investors.
Raising capital is the biggest challenge of starting a private equity fund. Sean points out that, when starting out, you must be prepared to invest in your own fund. “We started small by investing just our own capital and that of close friends and family. There is no set amount of money that you need to put in; however, the amount needs to be meaningful to you. No investor will trust you with their capital if you aren’t willing to put your money right alongside theirs,” Sean explains.
For more information and invaluable entrepreneurial advice, you can connect with Sean onhis personal website.