Addressing Issues in Smaller Private Equity Fund Capital Raises

Since Kalorama Capital’s SEC-licensure in 2000, we have discovered that it is much easier to raise $1 billion than $100 million. Many challenges face smaller funds in capital raises. The following are 5 considerations for overcoming issues in smaller private equity fund capital raises.

1. How does size impact a private equity fund’s capital raise?

The problem arises when a General Partner seeks to raise a fund that is too large for high net worth investors but too small to attract large amounts of institutional capital. Many institutions prefer to not be more than 10% of any fund. With frequent institutional minimum investment sizes of $10 million per fund, a capital raise will have a much harder time if it is not seeking at least $100 million. (At $250 million to $500 million, it will become substantially easier.) Beyond concerns as to concentration, even institutional investors may have limited investment staffs. As a result, there is a practical limit to the number of funds they can diligence, invest in and follow for the long private equity life cycle for each fund. In addition, since many small to mid-size institutions use outside consultants, they, too, may not follow many funds that are much smaller than $100 million.

2.  How does periods of marked illiquidity impact small private equity fund capital raises?

The starting point begins with looking at the team’s performance. Smaller funds, by their very size, lack the existing capital to have invested in large numbers of portfolio companies. In an illiquid market, exits are harder leaving data based primarily on unrealized rather than realized investments.

3.  How do rising costs impact small private equity fund capital raises?

With funds relying upon management fees to cover costs, the tally for a capital raise continues to be a constraint. As state, federal and international securities and tax laws become more complex, the legal and accounting bill will grow accordingly. Add-in to the mix, travel costs and on-going administrative expenses.

4.  How does the length of time required to complete a capital raise become a factor for small funds to consider?

For many funds, especially newer entrants to the market, capital raises can take more than one year. As a result, there are demands on managers’ time as they address the capital raise and legacy investments.

5.  What should private equity fund managers consider where seeking to raise under $100 million?

Where managers are considering a raise under $100 million, the following can be key:

-Taking a realistic appraisal of the dollar figures that will likely come from returning LP’s, friends and family.

-Approaching strategic investors and corporate venture partners.

-If a first-time fund, looking at the merits of a pledge fund or similar structure.

-Completing additional exits before approaching a broader market.

Each of the above can be addressed. Therefore efforts at overcoming issues in smaller private equity fund capital raises can be successful after recognizing the time commitment and expenditures required.

May 4, 2016

Strategies Addressing Challenges in Small Cross-Border Private Equity Fund Raises

Strategies addressing challenges for small cross-border private equity fund raises must overcome a myriad of issues. Merely approaching sovereign funds is no solution as most are too large to be a fit. In addition, smaller funds may lack a lengthier performance history with multiple exits and as a result be passed by in favor of more mature funds IV-V and above. Nonetheless, after gaining traction at home, there are opportunities to successfully raise funds cross-borders. It is key to first consider and develop a strategy to address four significant stumbling blocks before expanding abroad.

Issue 1:

Strategies Addressing Challenges in Small Cross-Border Private Equity Fund Raises:

Understanding and complying with foreign securities regulations:

As in the United States, both national and state/provincial laws can govern at the same time. For example, Canada has substantial differences in its provincial securities laws while there is no de minimis exemption for infrequent institutional fund raises. Ontario province is especially stringent requiring placement agents to register rather than merely make a notice filing for an exemption. In addition, fund raisers, whether successful in closing or not, incur ongoing 6 years of filing requirements/ fees for agents for service of process. This can run into thousands of dollars per year.

The Alternative Investment Directive governing the 28 nation European Union creates a second significant legal issue for foreign funds to address. As often happens, certain of the requirements such as appointments of custodians do not distinguish between cash-rich hedge funds that trade securities and private equity funds that receive commitments only for prospective capital calls.  Add to the uncertainly the fact that member nations can also impose their own local restrictions.

Strategy: The best approach is to target specific countries with those having the most likely traction rather than treating the EU or Canada as one monolithic entity.  The easiest avenue is likely to be where there is existing cross-border business that fits the fund’s targeted niche. For example, if raising a clean tech fund, consider the environmental initiatives already ongoing in the Nordic region.

Issue 2:

Strategies Addressing Challenges in Small Cross-Border Private Equity Fund Raises:

Dealing with tax issues:

Taxes incurred cross-borders represent not only a monetary outlay and time deflected from core business. They also can create concerns about submitting to a new jurisdiction for the first time. What impact will this have going forward? Is the potential reward worth the risk?

Strategy: Consider parallel limited partnerships for domestic and foreign usage from the start. Beyond looking at off-shore options, it is important to understand how structure impacts taxation and whether valid exemptions exist. The US FATCA law raises most frequent concern. However, it was originally enacted not to ensnare foreign investors but prevent US citizens abroad from avoiding income tax at home. For more details see, for example, and subsequent amendments from 2014 forward.

Issue 3:

Strategies Addressing Challenges in Small Cross-Border Private Equity Fund Raises:

Responding to investor concerns as to illiquidity compounded by regional solvency requirements:

The typical 10-year projected life of private equity funds has helped to create investors’ interest in a private equity market for secondaries, exchange-listed funds and other innovative solutions.

From the regulatory side, the European Union’s Basel 3 and Solvency 2 require categories of institutional investors to maintain set liquidity ratios. This limits the amount of private equity funds in a portfolio. Add to the mix that national laws within the EU can impact whether a company or its financial products fall into that of a pension fund or more stringently regulated insurance company, Although France and Sweden have been in the press recently as seeking some relief, these regulations continue to inhibit private equity fund capital raises.

Strategy: First, identify classes of institutions not constrained by the regulations. Among these would be new entrants to the asset class that previously have focused on listed securities and therefore have a strong liquidity ratio. In any case, small funds actually have an advantage here over mega-funds. Why? The former generally seek investments below the threshold of institutions, such as pension funds and insurance companies, which are most impacted by these liquidity requirements.

Issue 4:

Strategies Addressing Challenges in Small Cross-Border Private Equity Fund Raises: Managing the practical side of an extended cross-border capital raise:

The first issue is the capital outlay during a 1-2 year offering period. Costs fall into two categories: 1. Professional fees from law firms to accountants and marketing service providers. 2. Travel expenses for meetings

Strategy: There are 2 basic ways to do this.1. Limit the scope of the capital raise by geography. 2. Identify the largest region with an overlay of uniform laws, such as the EU. This can cut down on the need to meet conflicting legal and accounting requirements which increase costs.

Secondly, investors need to get comfortable with initial diligence and following investments at a distance. Without the ability to “kick the bricks” and get a real feel for the risk/reward apart from document review, investors may opt instead for local opportunities.

Strategy:  1. Seek investors, such as corporate venture investors and corporate pension funds with a link to the investment region. 2. Look specifically to Identify potential strategic partners engaged in, or seeking to expand into, the market sector the fund addresses, such as medtech.

Lastly, remember the market is a continuum, albeit an ever changing one. As a result, between capital raises, general partners should develop a strategic plan for follow-on funds to be in touch with the marketplace.  Four ways to do so include: 1. Publishing a well-optimized weekly blog, 2. Sending periodic newsletters . 3. Attending conferences and 4. Serving on panels. Such a long-range approach builds deep relationships rather than relying upon making contact intermittently during subsequent fund launches.

Jun 7, 2016

How to Successfully Raise Smaller Green Private Equity Funds

Raising private equity funds of $1 billion and up is far easier than smaller funds. One practical reason is that larger funds generally have mature teams that have lengthy and substantial performance data.  In addition, they would have some existing limited partners that reup. Lastly,  larger funds are a better fit for investors deploying significant amounts of capital and looking to be no more than 10% of a fund.

The last decade has seen a growth in interest in investing in funds to address environmental concerns (“green funds”).  Smaller green funds face certain challenges which can be addressed early on in structuring and marketing their capital raise. From the viewpoint of US funds, there are five potential stumbling blocks.

How to Successfully Raise Smaller Green Private Equity Funds:

Issue One:

Much of the interest in environmentally-focused investment is centered in Western Europe. The Alternative Investment Directive covering the European Union imposes restrictions that include non-EU private equity funds.  Certain of these provisions are not too onerous. For example, the required disclosure statements are similar to the Private Placement Memoranda used in the US.  A custodian is required but apparently can be centralized in the US rather than abroad. The difficulty? The challenge is two-fold. First, individual countries can impose additional regulations. Secondly, filing requirements in each country must be met prior to marketing the fund. (There is an exclusion for “reverse solicitation”. That is, if an investor asks to see your offering, you can comply.) One of the most onerous regulatory structures is in Denmark which can result in jail time for violations.  That is a daunting prospect.

How to Successfully Raise Smaller Green Private Equity Funds:

Issue Two:

Geographic focus can be a deal breaker for investors. The reason may be two-fold. The first may be a legal restriction or a policy concern requiring investments be domestic not cross-borders.  Secondly, other investors may simply prefer to mitigate risk by diligencing and monitoring funds and portfolio companies that are close by. This can alleviate finding out too late that a deal or investment is performing poorly.

How to Successfully Raise Smaller Green Private Equity Funds:

Issue Three:

In forming and raising the fund, the green strategy selected can range from clean tech to individual renewable energy or be narrowly focused, for example on a solitary solution such as solar energy.  For investors, clean tech may imply too much early stage technology risk. As a result, venture capital investors are a more likely fit for clean tech funds.  Renewable energy and project finance offerings attract a larger market sector, later-stage investors who may be looking to maximize return or seek income.

How to Successfully Raise Smaller Green Private Equity Funds:

Issue Four:

For green funds, raising capital as part of Socially Responsible Investing or SRI appears a logical starting point. The dilemma there is that many SRI investors are working with smaller bite sizes. In addition, they may have specific geographic or other mandates that must be met and are not necessarily a fit for the fund.

How to Successfully Raise Smaller Green Private Equity Funds:

Issue Five:

Sovereign funds have been active investors in green funds. However, they have tended to be among the largest investors. As a result, the fund must be at least $500,000 if not $1 billion to avoid exceeding the sovereign fund’s typical 10-25% maximum investment in one fund. They, too, are likely to have geographic and other constraints in order to be a fit.

How to Successfully Raise Smaller Green Private Equity Funds:

The best strategy for a successful capital raise:

-Approach first investors in the geographic area you will address.

-Identify and engage SRI investors that share the same objectives.

-Reach an initial first close before approaching foreign investors.

-Expand your fund raise more broadly in the US while beginning to file in the European Union under the Alternative Investment Directive.

-If the fund is large enough, consider fund raising in Australia.  However, many Australian pension or “superannuation” funds have $50+ million bite sizes. As a result, like sovereign funds, most superannuation funds are unlikely to look at funds under $500 million.

-Lastly, really understand your competition and how to successfully differentiate your fund’s edge.  At any time, there may be 1,000 other funds in the market. To be successful in its capital raise, a fund must be able to quickly convey the key points that make it a compelling choice over its competitors.