Funds are generally raised with the overall objective of generating returns. But how do funds generate returns, what's their leverage and how are returns distributed? Understanding these mechanisms is essential if you are considering starting your own fund or working in one.
Like companies, products and trends, funds go through a life cycle. In each life cycle, the fund manager has different duties to successfully manage the portfolio and make investors happy. Every fund goes through the following 4 stages:
While fundraising is the foundation that allows you to start investing, returns are mainly generated in the investment and management phases. Selecting the right companies and helping them to create value over the holding period is the basis for any successful return generation.
In the final stage, by exiting the portfolio company, you realise the returns you have generated, for example through an IPO or sale, and then distribute the returns to your investors.
Each phase can last for years, and they often overlap. It's important to understand how to use the investing and managing phases to achieve exceptional returns.
At this stage, your general objective is to find interesting target companies. For private equity funds this means finding significantly under-managed companies with unrealised potential, and for VC funds it's finding startups with huge potential. Finding and analysing them properly is a skill that every fund manager should have.
Pricing these targets is, of course, a critical issue at the investment stage. As Robert Kiyosaki said, “Profits are made in buying, not selling”. Paying the right price not only reduces risk, but also increases opportunity. But just getting a bargain is not what you should be looking for. Your new portfolio company must have enough capital to realise its potential or, in the case of VC funds, enough milestones to raise another successful round.
If you think about it, running out of money is the number one reason why startups (or businesses in general) fail. So providing enough capital and helping with future fundraising initiatives is essential for the success of your investment and your fund.
At this stage, fund managers need to create value in their portfolio companies. How value is created and growth is realised depends largely on the target company and its business model. Understanding the business model, and the drivers behind it, is therefore essential to successful portfolio management.
Having your fund as an investor must be a competitive advantage for your portfolio company. At this stage, extensive experience and in-depth market knowledge are necessary for your success and credibility.
Once you've exited your investments and realised your returns, it's time to give your money back.
Typically, fund managers invest alongside investors in the fund. The reason for this is to ensure that the interests of both parties, the investor and the fund manager, are fully aligned and to avoid any potential principal-agent conflict over the holding period.
Note: Principal-agent conflict refers to the phenomenon that people who manage money for others tend to be more reckless and take more risks than those who invest their own money. By requiring general partners to invest their own money in their fund, they have "skin in the game" and therefore have aligned interests.
The general partners typically invest 1% of the target fund size themselves.
To recap, funds raise money from investors and general partners, and both receive returns from the fund accordingly. So do the general partners get 1% and the investors get 99% of the returns?
It's not that easy. But also not much more complicated.
Fund managers invest more than money. They invest time, network, expertise, and experience in the fund. To be rewarded for their additional investment, fund managers typically charge a performance-based fee, called a “carry”, of, 20%. So instead of just getting the 1% invested, the fund managers get 20%, with the remaining 80% going to investors.
Example: The ABC Fund raised 100 million. Investors put in 99 million and the managers 1 million. In the following years, the fund managers had a good eye for investments, added a lot of value and were able to double the amount to 200 million.
After the holding period, the portfolio companies are sold. Investors and fund managers get back their initial investment of 100 million.
Now the additional returns are split 20/80, so the investor gets 80 million (80%) and the fund managers get 20 million (20%).
In the end, investors get 179 million (99+80) and fund managers get 21 million (1+20). So while the fund managers got 20 times their investment, the investors got 1.81 times.
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Our example assumes that the exits take place all at once, whereas funds typically exit their investments gradually over a number of years. Funds don't usually wait until all portfolio companies have been sold to start distributing returns. Typically, after each exit, returns are distributed directly to investors in what is called a "liquidation event".
This, of course, makes the actual return calculations much more complicated. Fund managers always need to know how much they have invested in each company, what the returns (or losses) are on each deal, and what they have or have not distributed to their investors accordingly.
The fund managers don't manage the fund alone, they have a team of smart and experienced managers and operators to help manage the fund. To pay the team, the fund managers charge a management fee of 2% of the assets under management (AUM).
Typically, invested capital is not transferred directly to the fund from the outset. The fund managers make capital calls when the investment in a new target company is in the final stages. From this point, the invested capital is under the management of the fund and the 2% management fee is charged.
While generating returns is different for every fund, depending on the fund managers, distributing them is mostly the same:
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