Someone tell me why starting a PE fund is "hard"

It seems ridiculously easy. All you need is a few years of deal experience to be able to handle the actual technical side of things. (Granted your resume may need to be better to raise capital). But basically if you have rich contacts who will front the capital and know a few bankers for the dealflow, what is to stop you from raising a 10-20mm fund at 30 years old and start putting deals together? Is there something I am missing?

 

I hope you are kidding. Are you planning to do all of the work yourself? The fixed fees from a $10-20M fund (if you are even able to raise $$$) would be barely enough to cover your overhead let alone your salary. And this doesn't even factor in salaries and bonuses for those that might be part of your team. Performance fees could help make up the difference but you won't see any $$$ here for a number of years.

More importantly, with a fund of $10-20M its hard for to see how bankers could be a credible source for deal flow. The average deal size for a fund like the one you describe (especially with the credit markets in the tank) would barely command the attention of a regional IB.

Raising a fund regardless of type is difficult. Even some of the most accomplished individuals have a hard time starting a fund because they lack true investment acumen/experience or business building skills or both. These are key ingredients to getting any new investment firm off the ground.

 

not worth starting such a small PE fund, the fixed costs are way too high, not many attractive targets in that range that you will see, will have to raise expensive debt, and just not much deal flow (very small banks pitching bad businesses to small funds). Any good company will be sapped up by VC/hybrid funds that have better access to deal flow in the small range. Also, good chance you won't be making much $$ for a long time, usually funds under 50mm or so, raise the startup capital for a specific deal or two and if that's a bang up job, go from there. But in general, most larger PE funds are started by reputable PE guys or senior bankers. If you are set on this, you really need to have 2-3 sole sourced ideas and than go raise the capital from family and friends and a few other places. In general, the monetary payoff is just not worth it (you will make a lot, and I mean a lot, more $$ working for an established PE fund and working your way up to get carry-at this point you can try leaving and starting a much larger start up fund)

 

I have a relative that started his own venture firm with some buddies. He told me that it was nearly impossible to raise a fund without an MBA from Harvard. As a result, he had to have a number of successful transactions prior to raising a fund. This was in addition to his Fuqua MBA and years of industry experience.

It just isn't that easy to raise money. Why should someone give you their money when there are so many more experience funds that will take their money???

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HF guy, you make good points (that I had not thought of) on everything but the "fixed fees". Assume that you arent going into this business with zero of your own startup capital. Its a business, like any other, and you need to front your own money. Given that you, if you are starting a fund, have been fairly successful in this industry, putting up $2-3mm of your and maybe one partner's capital isn't out of the question. Living modestly and in less than extravagant offices, I would think this is pretty possible (also since your dealflow is extremely small, assume its 2 partners and an admin).

Also, assume you have contacts with rich people that, for some reason or another, will give you money. I certainly dont have these contacts as I am just tossing this idea around, but there must be enough trust fund babies out there with daddy's friends who are loaded. With a little industry experience, a halfway decent resume, and contacts with people who are trying to get in the good graces of daddy, raising capital shouldnt be an issue.

The market competition for the good deals would be an issue, especially within the last few years. Just food for thought anyways..

 
Best Response

You are correct about start up capital but it may be difficult to line up a person willing to bank roll the operation in its early years. And, in exchange for the $2-3M, a smart seed investor/partner would seek to take a significant majority of the equity in the management company, especially if his/her partners weren't contributing all that much. You would be forced to live modestly in this situation because, as Napoleon pointed out, your $$$ generated from the business would be quite small in the early years.

Your point about having contacts with rich people is somewhat off base. While rich people have a lot of money to throw around, many of them have worked hard to build the wealth they have. Many are generally interested in wealth preservation rather than further wealth creation. They are not going to throw around money to a new start up when they can make allocations to bigger more established players or smaller niche groups that may have deeper teams and more experience. You may get lucky with a "trust fund baby" but the $$$ they are going to commit will likely be small meaning you will have to find a group of these to make your target of $20-30 million.

My point with all of this is that while raising a PE or HF may sound easy on the surface the reality is that its not that easy. You should check with some of your banker contacts and see what they have to say about the difficulties of the fundraising process.

 

The original poster is obviously very young and naive (as am I relatively speaking). Those of us in our early 20's have been involved in the greatest buyout boom in history with cheap debt, a ton of liquidity, and investors eager to throw money at any alternative investment shop that could provide outsized gains. We have gotten so used to cheap debt and highly leveraged LBO's that we think any moron can start a PE shop. I work for a PE shop that was created by several wealthy individuals and we have taken down 3 multi-billion targets in the past year and half (with limited resources and a small team). This success speaks volumes about the type environment that we have been in, which unfortunately for all of us in PE no longer exists as deal flow and financing has come to a screaching halt.

Note that many large players (i.e. KKR, Apollo) got started in a back room with very limited resources.

 

... that nobody has mentioned yet is the requirement that you have a significant track record. All the fancy degrees, white shoe firm names, and connections in the world will do you little good if you don't have a track record of strong returns to LPs. Obviously, building that track record requires that one first get in to a firm that can serve as a platform for the realization of that type of experience (not easy) and then deliver the returns.

The idea that a few rich contacts willing to front a few mil each will give you a credible start is inches short of pure fantasy. Even if you knew a few rich people willing to make a wild ass bet on your ability to drive returns, you then have to drive returns! With the industry at an all-time competitive high, and the trend of fund size going straight up and to the right, a smallish no-name fund managed by an inexperienced team has a snowball's chance in hell of being able to source and close good deals.

Allow me to tell an anecdote. The smartest friend I have went this route about eight years ago. He was a valedictorian at Princeton (economics), worked at a BB and was easily top 10% of his class there, graduated with highest honors from Stanford GSB, then went to work as a VP at one of the top middle market buyout funds, and decided at 29 years of age that he wanted to start his own fund. It took him two years to raise a $25M fund, another two years to invest that money, and then another two years to exit his investments. The result: a 1.5x fund. During the tail end of that first fund, he used that experience to raise a $70M fund, which took him another 18 months to raise. Four years later, the result: a 2.25X fund. He just finished raising a $125M fund and has done his first two deals from that fund.

Meanwhile, two of his GSB classmates, nowhere near as smart, hard-working, connected, or ambitious, work at my firm. One has made partner and the other is a principal. They former makes $3-4M a year in cash comp and the latter 1.5-2.5M, and then there's carry (we have a better than 40%+ IRR over the past 10-year period on all our funds).

Being a former entrepeneur myself, I am all for going for it. So I don't mean to discourage anyone from venturing on their own. However, dive in with your eyes wide open.

 

Toro,

Thank you for bringing this discussion back to reality...

The original poster has obviously spent too many late nights at the printing press getting berated by his VP. He has obviously never been involved in a road-show process and seen how difficult the fundraising process can be. LPs are extremely skeptical of fly-by-night operations even if they have previous relationships with the exisiting principals.

Dija you are missing the better half of your brain

 

Let's do the math. A typical PE firm gets 2% in management fees and carry is 20% with a 7ish% hurdle rate. Smaller funds often don't have the hurdle rate, and my friend's doesn't.

2% of a 70M fund is a 1.4M a year for salaries, T&A, lawyers, accountants, consultants, etc. Keep in mind my buddy has to have a team. If you assume he has 10 people, that should give you an idea of how that pool of operating capital is split per year.

A 2.25x result in 5 years or so means he returned 157.5M total. He gets 20% of 87.5 (take out 70 which is the original amount invested), or 17.5M, which he has to share with his team. Assuming he as the founder gets half of it, that's about 9M over a 5-year period plus whatever he pays himself in cash comp per year. Net net: he's not making much more than 2M a year and that was after much less than that when he started (remember he started with a 25M fund) and after incurring a very high amount of risk to get to where he got.

Meanwhile, his dumber (obviously a relative term used somewhat in jest) classmates at my firm are making that in cash comp alone, never mind the carried interest. They out-earn him by 3X+.

However, the nice thing about my friend's situation, and PE in general, is that success builds upon itself. His next fund is 125M, the next one after that could very well be 300M, the next one after that could be a billion, and so on. If he keeps delivering results, which I'm confident he will keep doing (he is definitely one of the smartest people I've ever met), he will be way ahead of his currently higher-payed former classmates in the long term. Just look at how quickly Schwartzman built astronomical wealth at Blackstone to use but one example.

But... As I cautioned, it is a very tough road to hoe and the attrition rate is quite high. Branching out alone early in your career is a very high beta approach to wealth creation but if you have the smarts, the contacts, and the balls, by all means go for it. Just be realistic and realize that you are much more likely to fail than to succeed at the level you need to to break even had you stayed on your regular track at your firm.

 

minor points...at $70M I would think you would only need, or want, 1-2 other deal professionals and maybe 1-2 admin. All deal related expenses: accountants, lawyers, etc. should be reimbursed from the fund, as well as the fund operating expenses, e.g. audit, tax, fund admin. The $1.4M should pay for some office space, to keep the lights on, and for salaries. That means you're still getting to split about $1.2M b/w the deal professionals...so you pay 75-150k to an analyst/associate, 150-250k to an associate/vp and keep the rest. You'd probably have to give away a good amount of carry to keep the professionals around at those rates, but I don't think it would be more than 30-40%.

However, as you say the opportunity cost of working as a partner at a larger shop is indeed expensive for your friend.

 

Unless you are like Peterson and Bonderman when they started and are connected as all hell, you will need more people to source. A big part of running a successful small fund is getting proprietary deal flow, which you'll have to work for, i.e. hire associate-level junior deal guys to cold-call, sell, etc.

10 is about right. 2-3 senior deal partner/principal level pros, the rest junior, 1 admin or so.

 

Toro - good posts. What the OP is suggesting isn't impossible at all, the biggest issue is raising the capital obviously. There are a lot of funds launched with just 2 guys and enough commitments to do one small deal a year as they ramp up, but as many have mentioned the road is long and tough. You charge 1-2% fees on the equity capital which doesn't cover much and as soon as you close your first deal you can start charging the portfolio company a management fee to help keep you afloat (and each additional one). That's basically the only cash flow you can expect for a while until you can do a dividend recap or have an exit.

Again, not impossible to do if you can raise the capital - the deal flow is there. Also worth mentioning is the search fund concept (line up investors w/ commitments, identify target, acquire, install yourself as management team) which would get you experience and a track record to raise more $ (though not really a scalable model and ripe for failure).

 

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