How can I develop a successful track record to start a private equity firm?

Private equity PPM example

You can work at a private equity firm for years and make it to a Principal level and more likely Managing Director/Partner.

At that point youll be a partner and/or get pretty decent carry in the fund.

You must source and run your own deals, manage those investments and sit on the board.

Youll need to show successful exits, and thats plural, over a couple of economic cycles.

Investors know that its easy(ish) to make money when the tides rising so they want to see that you dont blow up when shit is hitting the fan.

The issue here is that a funds life is typically 10 years and youll hold investments for an average of 7 years so youll need to get through two of those cycles to really build a track record at the Principal level or above.

Your deals as an associate or VP will show experience but theyre not your deals.

,You need to do self promotion along the way and become a well known investor in the space that you work in.

Speak at industry events, both within PE and within industries that you invest in.

Youll want to speak to your investors and get to know them and be a name that the overall LP community knows.

Speak at their events and network.

Purposefully become close to a few that you know invest in first funds.

A lot of LPu2019s dont by charter and cant change that no matter how much they like you.

,Try to land a cornerstone investor that will soft commit to you.

Youll most likely need to put a team together on the down low because LPu2019s arent going to invest in a single person unless theyre an absolute rockstar and if youre an absolute rockstar youll know it and people will flock to work for you.

Getting other people who work in PE to quit their jobs on the hope that you raise a fund wont be easy.

,Save up a lot of money.

Raising a first fund is expensive and will take longer than youd ever expect.

If you think it will take one year it will be two, unless youre that rockstar.

Youll need money to get nice office space (it doesnt have to be at 9 West 57th but it cant be a class C crappy building), pay employees and other overhead and for a butt load of legal fees youll be paying during the raise.

A PPM from a respected law firm will cost you $250k or more and youll need them to negotiate subscription docs for you along the way for investors.

Youll also need to coinvest in your new fund.

Expect at least 2% of the total raise and the more the better.

LPu2019s want GPu2019s to have substantial skin in the game.

,You can go an alternate route and do a couple of one off deals with LPu2019s then try to wrap them into a fund as a way to generate some fee income and show a track record of acquisitions on your own.

Youll still have most of the above expenses other than legal fees and costs related to raising a fund but youll have to float legal and due diligence fees for these acquisitions and still pay people and rent.

,Now the problem with all of this is that youre a Managing Director at an established fund.

You most likely have job security, already built infrastructure, existing investors who will invest in the next fund as long as your fund performs and you dont have to deal with any of that because you have employees who do.

Its akin to starting up any business but theres a lot of expenses, including big salaries across the board and not just for senior investment professionals (my assistant had a six figure base for example), that are currently fed by your annual management fees that most likely run over two active funds and the fund is making big money as you exit, which should be happening regularly because your active funds are at different points of their life.

If you start up a firm none of that income is coming in and will not for a while.

Its not like starting another business where you slowly start selling a product or service.

All of your money will be going out and even if you do successfully raise a fund youll only be getting the 2% management fee for a long time, and it wont even be 2% because some of your investors will negotiate that down.

,And depending on the size of deals your fund does you personally make a shit ton of money.

Its very difficult to walk away from a job when youre making well into the millions per annum to take a risk opening your own fund thats going to do the exact same thing.

You wont be 25, youll be well into your 40u2019s, most likely have a family and youll lead a rather expensive lifestyle.

Hopefully you live well within your means but your means are giant.

Some of your colleagues may live in $15 million homes and have a couple of multi million dollar vacation homes but youre not like them and live u201cmodestly.

u201d But your modesty isnt going to be a four bedroom house in Jersey City.

Im friends with a guy who used to co-head one of the leading groups at one of the leading investment banks.

Hes a rockstar and for his position he did live a relatively modest lifestyle.

We were talking once over drinks and he said that he wakes up on January 1st and has a $750k nut to crack for the year that hes already commited to.

Thats notprivate jets, exotic travel and sports cars.

That just housing in NYC, private school for three kids and things like that.

,Youre basically your own boss now anyway even though you have someone above you.

If youre considering opening your own shop youu2019re more than performing so you make your own hours, which will pretty much be 24/7 anyway, your boss most likely likes you at least professionally and youve worked with the same core group of people for a couple of decades and since you spend more time with them than anyone else on Earth theyve become like family.

It will be very difficult to give up your income, accept the risk and the headaches that come with starting any business, go out hat in hand to raise money and leave a comfortable and extremely well compensated professional life to possibly and hopefully make slightly more in 7u201310 years when you start exiting your first fundu2019s portfolio.

,I wont even get into how tough it is to raise a first fund and the LP communitys current outlook.

Thats another topic entirely.

Most private equity firms are at least 15u201320 years old and theres a reason for that.

Returns for LPu2019s are still there but the space is much more crowded than it used to be and investors arenu2019t as keen on the 2/20 as they used to be.

Private equity fund offering memorandum

Private equity firms have been a historically successful asset class and the field continues to grow as more would-be portfolio managers join the industry.

Many investment bankers have made the switch from public to private equity because the latter has significantly outperformed the Standard & Poors 500 over the last few decades, fueling greater demand for private equity funds from institutional and individual accredited investors.

As demand continues to swell for alternative investments in the private equity space, new managers will need to emerge and provide investors with new opportunities to generate alpha.

,Todays many successful private equity firms include Blackstone Group, Apollo Management, TPG Capital, Goldman Sachs Capital Partners, and Carlyle Group.

However, most firms are small to mid-size shops and can range from just two employees to several hundred workers.

Here are several steps managers should follow to launch a private equity fund.

,Define the Business StrategyFirst, outline your business strategy and differentiate your financial plan from those of competitors and benchmarks.

Establishing a business strategy requires significant research into a defined market or individual sector.

Some funds focus on energy development, while others may focus on early-stage biotech companies.

Ultimately, investors want to know more about your funds goals.

,As you articulate your investment strategy, consider whether you will have a geographic focus.

Will the fund focus on one region of the United States? Will it focus on an industry in a certain country? Or will it emphasize a specific strategy in similar emerging markets? Meanwhile, there are several business focuses you could adopt.

Will your fund aim to improve your portfolio companies operational or strategic focus, or will this center entirely on cleaning up their balance sheets?,Remember, private equity typically hinges on investment in companies that are not traded on the public market.

Its critical that you determine the purpose of each investment.

For example, is the aim of the investment to grow capital for mergers and acquisitions activity? Or is the goal to raise capital that will allow existing owners to sell their positions in the firm?,Set up the Business Plan and the OperationsThe second step is to write a business plan, which calculates cash flow expectations, establishes your private equity funds timeline, including the period to raise capital and exit from portfolio investments.

Each fund typically has a life of 10 years, although ultimately timelines are up to the managers discretion.

A sound business plan contains a strategy on how the fund will grow over time, a marketing plan to target future investors, and an executive summary, which ties all of these sections and goals together.

,Following the establishment of the business plan, set up an external team of consultants that includes independent accountants, attorneys and industry consultants who can provide insight into the industries of the companies in your portfolio.

Its also wise to establish an advisory board and explore disaster recovery strategies in case of cyber attacks, steep market downturns, or other portfolio-related threats to the individual fund.

,Another important step is to establish the firm and fund name.

Additionally, the manager must decide on the roles and titles of the firms leaders, such as the role of partner or portfolio manager.

From there, establish the management team, including the CEO, CFO, chief information security officer, and chief compliance officer.

First-time managers are more likely to raise more money if they are part of a team that spins out of a previously successful firm.

,On the back end, its essential to establish in-house operations.

These tasks include the rent or purchase office space, furniture, technology requirements, and hiring staff.

There are several things to consider when hiring staff, such as profit-sharing programs, bonus structures, compensation protocols, health insurance plans, and retirement plans.

,Establish the Investment VehicleAfter early operations are in order, establish the fundu2019s legal structure.

In the United States, a fund typically assumes the structure of a limited partnership or a limited liability firm.

As a founder of the fund, you will be a general partner, meaning that you will have the right to decide the investments that compose the fund.

,Your investors will be limited partners who dont have the right to decide which companies are part of your fund.

Limited partners are only accountable for losses tied to their individual investment, while general partners handle any additional losses within the fund and liabilities to the broader market.

,Ultimately, your lawyer will draft a private placement memorandum and any other operating agreements such as a Limited Partnership Agreement or Articles of Association.

,Determine a Fee StructureThe fund manager should determine provisions related to management fees, carried interest and any hurdle rate for performance.

Typically, private equity managers receive an annual management fee of 2% of committed capital from investors.

So, for every $10 million the fund raises from investors, the manager will collect $200,000 in management fees annually.

However, fund managers with less experience may receive a smaller management fee to attract new capital.

,Carried interest is commonly set at 20% above an expected return level.

Should the hurdle rate be 5% for the fund, you and your investors would split returns at a rate of 20 to 80.

During this period, it is also important to establish compliance, risk and valuation guidelines for the fund.

,Raise CapitalNext, you will want to have your offering memorandum, subscription agreement, partnership terms, custodial agreement, and due diligence questionnaires prepared.

Also, marketing material will be needed prior to the process of raising capital.

New managers will also want to ensure that they have obtained a proper severance letter from previous employers.

A severance letter important because employees require permission to boast about their previous experience and track record.

,All of this leads ultimately leads you to the biggest challenge of starting a private equity fund, which is convincing others to invest in your fund.

Firstly, prepare to invest your own fund.

Fund managers who had had success during their careers will likely be expected to provide at least 2% to 3% of their money to the funds total capital commitments.

New managers with less capital can likely succeed with a commitment of 1% to 2% for their first fund.

,In addition to your investment track record and investment strategy, your marketing strategy will be central to raising capital.

Due to regulations on who can invest and the unregistered nature of private equity investments, the government says that only institutional investors and accredited investors can provide capital to these funds.

,Institutional investors include insurance firms, sovereign wealth funds, financial institutions, pension programs, and university endowments.

Accredited investors are limited to individuals who meet a specified annual income threshold for two years or maintain a net worth (less the value of their primary residence) of $1 million or more.

Additional criteria for other groups that represent accredited investors are discussed in the Securities Act of 1933.

,Once a private equity fund has been established, portfolio managers have the capacity to begin building their portfolio.

At this point, managers will start to select the companies and assets that fit their investment strategy.

,The Bottom LinePrivate equity investments have outperformed the broader U.

S.

markets over the last few decades.

That has generated increased demand from investors seeking new ways to generate superior returns.

The above steps can be used as a road map for establishing a successful fund.