During an initial client consultation with fund managers, one of the first questions we ask is deceptively simple: “How large do you want the fund to be” or “How much are you raising?” When we ask why, the conversation can quickly become very interesting as the target set by the fund manager can be driven from several different motives such as the manager’s anticipated pipeline, competing funds, working backward from the management fee, and sometimes even because a larger fund feels like a more successful fund. For an emerging manager, the last motive can be the most dangerous as fund size is one of the most fundamental components of the strategy itself. If the target raise is an aspirational target that is not tailored to the strategy, then portfolio construction, investment pace, check size, reserves, economics, and ultimately, the manager’s ability to execute the investment plan can all be negatively impacted. Furthermore, in a difficult market, the largest number you can theoretically raise may not be the right number to pursue.
Your Target Raise Should Start with the Target Portfolio and Investor Base
Before deciding to launch a $100 million fund, it is important to think through why $100 million is needed. As such, you should think through the following questions:
- How many investments do you expect to make?
- How many investments can you realistically identify and manage in the current market?
- What is the anticipated check size per investor?
- How many investors do you expect to invest and is there a limit on how many you can accept based on your exemptions?
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What portion of committed capital will be available to deploy into investments after accounting for management fees and fund expenses?
Additionally, from a practical standpoint, some states charge blue sky fees and some service providers (such as fund administrators) set fees based on your target raise. If your offering documents say you’re raising $100 million when you can only realistically raise $25 million, you might have higher operating expenses that do not actually make sense.
Overly Large Funds Create Strategy Drift or Can Blow Your Exemptions
When investors invest, they make their decision based on the stated thesis as well as the manager’s experience, sourcing capabilities, and competitive advantage. While a sponsor with extensive experience acquiring $5 million to $15 million multifamily properties in a particular geographic area may have a compelling reason to launch a fund around that strategy, raising significantly more capital does not necessarily expand the number of attractive properties that fit the sponsor’s stated investment criteria. At some point, additional capital may require the manager to change what it buys, which may conflict with investor expectations and cause them not to invest next time.
In the non-real estate fund context, an overly large fund can blow your exemptions. For example, a hedge, private credit, or other alternative investment fund relying on the 3(c)(1) exemption set forth under the Investment Company Act can only admit up to 100 beneficial owners (or 250 if a qualifying venture capital fund). Therefore, a $150 million fund with only a $50,000 minimum investment requirement would not really make sense and the fund manager might potentially accept more investors than it should, thereby violating its exemption.
For these reasons, we always encourage fund managers to pressure test their target fund size before launching the offering. The question sponsors should ask is whether the manager can deploy their target raise while remaining disciplined to their strategy, rather than if they could raise the full target raise.
Bigger is Not Necessarily More Institutional
Emerging fund managers sometimes raise concerns that a smaller raise makes the fund appear less sophisticated. However, in practice, institutional investors tend to care much more about whether the strategy makes sense. For example, a disciplined $30 million fund can be much more attractive than a $75 million fund whose fund manager cannot clearly explain how the additional $45 million will be deployed. This distinction is particularly important given the current state of the capital raising market where capital has become increasingly concentrated among large, established managers. For smaller private funds, specialized managers (such as those targeting a market it understands uniquely well, a proprietary sourcing network, specialized operating expertise, or access to transactions too small for larger funds) tend to have far greater success than managers trying to imitate the scale of an established manager. Ultimately, your fund size should reinforce your advantage rather than dilute it.
Takeaways
Most successful fund managers start small and raise progressively larger funds as their track records, teams, and investor bases build. For emerging managers, a thoughtfully sized first and second fund can establish the credibility, track record, discipline, and foundation you need to launch larger funds in the future while raising more capital than the strategy supports can do the opposite. Before launching a fund, it is imperative that you build the portfolio on paper by modeling the investment pace, determining realistic check sizes, and accounting for fees and expenses.
Our securities team works with emerging and established sponsors to structure private investment funds around the realities of their investment strategies. From portfolio construction considerations and fund economics to offering documents and ongoing compliance, we help managers build fund structures designed to raise capital and operate successfully after the capital comes in. If you are preparing to launch a new fund or evaluate the structure of your next vehicle, reach out to discuss how the fund’s legal and economic terms can support your investment strategy from the first closing through final liquidation.