On this episode of Deal-by-Deal, host Greg Hawver and fellow McGuireWoods partner, fund formation lawyer Rick Starling, discuss considerations and alternatives to raising a committed fund, analyze what’s going on in today’s market, and share insights on the phases of raising a fund.

The episode also explores fund structures such as the "proof of concept fund" for emerging managers, highlights key differences between traditional fund economics and deal-by-deal economics, and briefly discusses operational shifts such as building out the back office and investment adviser registration.

Meet Your Guest

Name: Rick Starling

Title: Partner, McGuireWoods

Speciality: Rick is a fund formation lawyer with over 20 years of experience representing investment managers in the establishment of private funds and related products and representing institutional investors with respect to alternative investments.

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This podcast was recorded and is being made available by McGuireWoods for informational purposes only. By accessing this podcast, you acknowledge that McGuireWoods makes no warranty, guarantee, or representation as to the accuracy or sufficiency of the information featured in the podcast. The views, information, or opinions expressed during this podcast series are solely those of the individuals involved and do not necessarily reflect those of McGuireWoods. This podcast should not be used as a substitute for competent legal advice from a licensed professional attorney in your state and should not be construed as an offer to make or consider any investment or course of action.

You are listening to Deal-by-Deal, a McGuireWoods Independent-Sponsor podcast. Deal-by-Deal invites you to conversations with experienced independent sponsors and other private equity professionals. Join McGuireWoods partners, Greg Hawver and Jeff Brooker, as they explore middle market private equity M&A to provide you with timely insights and relevant takeaways.

Hi, and welcome to Deal-by-Deal, a podcast for independent sponsors and others in the private equity community. Today, we are going to be talking about raising a committed fund. I'm Greg Hawver, your host. I'm a lawyer here at McGuireWoods in the Chicago office. For today's topic, I'm excited to be joined by my partner in our Charlotte office, Rick Starling. Before I get too far into the topic of what we're going to be talking about today, Rick, do you want to give a quick intro to yourself and your practice?

Sure. Thanks, Greg. It's good to be talking to you today. And hello to all the listeners out there. Again, as Greg said, my name's Rick Starling. I'm in the fund formation practice here at McGuireWoods. I've been practicing fund formation law for 20 or 25 years now. Most of my career at a different firm, but I joined McGuireWoods roughly six months ago to help lead the funds group here. I think the hallmark of our practice is really our focus on emerging managers and also independent sponsors, helping people really get their fund businesses up and running from the start and helping them with all phases of that and all aspects of it. I'm excited to be here talking to Greg today about considerations and alternatives to raising a committed fund and what's going on in today's market and what we're seeing.

Great. Appreciate that, Rick. Just to set the stage here a little bit and to provide a little context, so Rick and I we're just down in Dallas with a bunch of other McGuireWoods lawyers and 1500 other attendees at the McGuireWoods Independent Sponsor Conference. The attendees there were either capital partners or independent sponsors. It was a fantastic conference. One of the topics that we discussed, which is kind of a crossover topic, is raising a fund. If you are an independent sponsor thinking of raising a fund, what are some of the pitfalls there? What are some of the considerations.

In addition to that initiative we have at McGuireWoods, we also have our Emerging Managers initiative, which is actually another conference that we have in Dallas in the spring. Rick is one of the leaders of that initiative in that practice and works with people raising their first fund or their second fund. The idea here is if you are an independent sponsor, if you're currently with a fund and have moved up the ranks quite a bit and are thinking about what would life be like raising my own fund, we're going to try to talk about all things to consider on that front. With that, Rick, you want to give an overview of what is the current fundraising market like for those out there seeking to raise a fund right now?

Well, sure. I'll do that. Before we do that, I'll just want to chime in on these conferences. The work that McGuireWoods does in the independent sponsor and emerging manager space is really exciting, and it's a real value add for clients and even non-clients in this space. It's honestly maybe the biggest driver of my decision to leave where I was and come to McGuireWoods. It's really exciting stuff. If there are any capital providers out there listening that have an interest in investing with independent sponsors and emerging managers, please look these things up and consider attending. If you're an investment manager, whether you are working as an independent sponsor or as an emerging manager or somewhere in between, find out about these things and please do... We encourage you to come and attend. The events are really more about putting capital providers together with people that are looking to raise capital than they are about anything else. It's a lot of that, and then very little actually interaction with McGuire voice lawyers, frankly, but they tend to be really great and exciting events that I've been excited to be able to attend those.

Back to your question, Greg, as we all probably would imagine, fundraising is a little bit tough right now. 2023 has been a rough year. 2021 was gangbusters. It was gangbusters on beginning of 2022, but the back half of 2022 and the earlier part of 2023, it has been a little bit harder. LP's allocations, in particular with respect to new relationships with new managers, are a little lower than they were in the last couple of years. I think at this point in 2023, a lot of LP's allocations are frankly used up, so they're already starting to think about 2024, which means if you're trying to raise money in 2023, it's going to be that much harder. I ran a panel on this topic at our Independent Sponsor Conference, and that was the gist of what the panelists who are on the LP side were relaying to us. Although they did say that they thought it would probably look up hopefully as soon as sometime in 2024.

Got it. Not the ideal time to raise a fund, but if you do decide to go down this road, what are some things that you should be thinking about right now? If you make the decision in fall of 2023 that you're going to raise a fund, what's the timeline like and what are some key considerations to think about?

Well, there's a few different questions in there. The timeline for raising the fund can really vary. If you're thinking about engaging counsel and other service providers and what their timelines might be, they're usually not going to be the gating factors. I mean, the gating factors usually is how long is it going to take you to work your network, to meet new investors, and get these investors comfortable with who you are and what you're doing, and to sign on the bottom line. The reason I point that out is because we have clients... By the way, even though the 2023 market is a little tough, we have clients that are out there raising funds successfully and reaching their targets and even their caps. It is not like it can't be done. Somebody who comes to us that already has good relationships with investors, who are aware they're raising a fund and interested in raising a fund with them, can raise the fund in 60 or 90 days.

That's the bare minimum time when getting it done. More realistically, you're probably looking at a six to 10 month process from starting to do work on it to holding an initial closing. You only want that initial closing to be maybe half of your target, give or take, and we can get back to that. There'll typically be a fundraising period that follows your initial closing, where once you have an initial closing on your fund, you've got 12 to 18 months to get your final closing, where you then have to wrap a bow on the fund and get down to the work of investing, not that you're not investing during that period as well.

Got it. Got it. Maybe talk to me a little bit about track record and the importance of track record. When do you want to make the... This assumes we're talking about independent sponsor. How many deals do you see people close or how many deals do you see people exit before they're turning to raising a fund?

Great question. Track record is certainly important. Now, that track record can be from a prior firm. We see a lot of emerging manager clients who are people that have worked at larger private equity firms for some period of years and have their own track record or a track record that they can point to as more or less attributable to them. Some folks like that can actually go out and raise a fund maybe without doing any deals on their own, but usually, it helps to be able to do one or two or maybe even three, which is really less about maybe your track record per se, because you've got a track record if you were at another firm, but it's more maybe about just showing that you can, in fact, source and execute deals on your own, which I guess the sourcing and execution of deals is part of your track record, just like your performance is.

It can be as few as a couple. Maybe that's not where you're coming from. Maybe you are more of an operator and you don't have the experience of having worked in a private equity firm before, a slightly longer track record might be relevant and critical. You might need to show that you've got... You actually might even need to exit some investments and show that you can actually generate returns. It varies by firm, but it certainly is an important thing that the people need to have.

Got it. I've got a question. I hear hear a lot about attribution. If I'm with Committed fund, what are the dynamics between whether I can get attribution for deals I've closed? Can you tell me a little bit about that? How do those discussions work?

Well, there's a few different angles to that, but at the end of the day, from a legal standpoint and maybe even also a commercial standpoint, I think it boils down to two things. One, of course, is whether you have the right to use that information. People who are leaving private equity firms oftentimes are subject to restrictions on their ability to use their track record, have to run things by their former employer. Some people don't have any restrictions and some people have a lot, but anybody who's leaving a firm and hoping to use a track record from that firm needs to make sure they're doing it right by the prior firm. Equally, and perhaps more importantly, but a little more complicated to think through, is how you can use whatever track record you have, because certainly, somebody who's coming out of...

Say somebody who worked as an analyst for a few years at a firm and then graduated from being an analyst to being a higher up and being a partner or an MD, their track record or their involvement in the deals they worked on will have evolved over time. Their role in each deal is a little bit different, so you do have interesting questions about, well... Also, these people presumably worked on teams. You worked on a team of people where maybe you had peers, maybe you had people above you, maybe you had people below you. We certainly talked to people about whether to what extent they can use that track record, but in most cases, I think you can. It turns into a question of just being accurate and disclosing whether to what extent those deals are attributable to you. At the end of the day, the SEC would say that you can't use a track record that is not yours or that is materially misleading to investors.

They would say that a track record from different types of deals, or where your involvement in the deals was arguably not that significant, or where the team of people you were working on, [inaudible 00:11:05] working with, is so different from the team of people you're working with now that that track record is almost not usable. We have had situations where you have to tell people, from a performance standpoint, that you can't give those performance metrics on those deals. I'll also say that when we talk about track records, there's kind of different elements to it. One is the types of deals you've done and what your roles in those deals were. The other is how those deals did. The former is a lot looser than the latter. In other words, it's pretty much always going to be fair game to talk about what you've done, what kind of deals you're involved in, what your role was, as long as you're honest about that. But where it gets a little trickier is where you want to talk about the returns on those investments.

That's where we get into things where we sometimes get into advising clients that, "Look, that team, that track record, your role there, the types of deals you are doing, whether it was size or industry focus, is just too different from what you're doing now." Or, "It's so different from what you're doing now that you frankly can't use that track record and marketing materials." Maybe orally, you can do a little more orally in one-off meetings and in response to specific requests from specific investors than you can in written marketing materials, but there's a lot of considerations to be thought through when you're thinking about using your track record in terms of MOIs, IIRs, and written materials that you're providing investors.

Got it. That's really helpful and that's a good transition to the next phase of raising a fund. We talked about building the track record, being a great investor. At some point, you need to give smart fund formation lawyer, like Rick Starling, a phone call, or someone a phone call to start thinking about, I assume, what type of fund are you going to raise, a typical fund or some variation on that. What are going to be the terms that you're going to go out to the market with to LPs? I want to touch later on anchor investors. But when does that occur? When do those discussions happen with a fund formation lawyer? And then what are some initial very high level considerations about the types of funds? Not to throw seven questions into one, but what are some differences between fund economics than independent sponsor deal-by-deal economic?

Well, we may have to come back, Greg, and address some of this [inaudible 00:13:31]. Let's put it this way. If I forget one, [inaudible 00:13:33] me back.

I'll let you off the hook.

Few different ideas there. One is it's never too early to engage helpful counsel. People shouldn't be worried that talking to fund formation lawyers all of a sudden going to lock them into tens of thousands of dollars of legal expense. There's a lot that we can do with clients on the front end where it's just minimal consultations to get them pointed in the right direction, whether that's in terms of thinking about fund structures, thinking about timing, thinking about preliminary marketing materials, like a pitch book or something like that, and what a big picture summary of terms would look like. People should never hesitate to reach out to the fund counselor early in the process. Here at McGuireWoods, we do a lot of early planning and advising like that for people without even charging for it upfront. The idea being that if you retain us help you with your fund formation, we'll probably not charge you until your fund closes. Never too early to start those conversations.

Another question you didn't exactly answer but I want to touch on the answer to, what you asked it is what would a fund structure look like and are there maybe alternatives to a traditional fund? Something we got some consistent feedback from LPs on my panel at the Independent Sponsor Conference was the idea of this concept that the traditional 10-year, 10 to 15 investment fund hasn't gone by the wayside, but for emerging managers, it may be always the best idea. What I mean by that is a lot of... Historically, people launching funds have backed into an investment period, a term, and a fund size based on their typical investment size and frequency, and this idea that a normal fund would probably have 10 or 15 investments in it for diversification purposes. What I mean by that is if you think, "Okay, well, I typically make 20 to 30 million investments. I make one or two investments a year.

A fund should hold maybe two investments a year. The fund should hold 10 investments." You can do some easy back of the envelope math and back into a 200 or $300 million fund with a four or five year investment period in a 10-year life. That's more or less how people have designed funds over the years. Now, for an emerging manager who does 20 to $30 million deals, it might be tough to go raise 200 to $300 million, and have people entrust that much money to you and entrust the idea of making 10 or 15 investments with their money to you. One thing we are seeing a fair bit of these days is what we sometimes call a proof of concept fund, where instead of raising enough money to do 10 to 12 or 15 deals, you raise enough money to do three or four deals, go do those deals, show that you can execute, and then come back and do it again.

Or maybe by the time you do it again, the economy's in a little better position or maybe just makes sense. You'll just have more investor appetite for what you're doing, and that point in time, be able to raise your traditional 10 year, 10 or 15 investment funds. Back to this example of somebody who does say 20 to $30 million investments, instead of raising two or $300 million, raise $80 million or $100 million dollars. Raise enough money to get you through of years and to get you through a handful of investments. It gives investors an opportunity to test the waters with you without making too big a commitment and maybe tide you over into a better economic time.

Great. The proof of concept fund is super interesting and probably very applicable to our audience. Maybe spend one more minute on just what the traditional fund structure looks like from investing horizon or investing period perspective, and then just quickly how that differs from deal-by-deal economics.

Yeah. I think, Greg, your question probably, what I hear, is maybe think talking about how the economics of a commingled fund or a traditional fund would differ from the economics of operating as an independent sponsor, which there may be a lot of people... Most people who are listening to this may know this or this may be obvious, but I think it is worth repeating and bearing out. Somebody operating as an independent sponsor is presumably putting together the money for each deal they do on a one-off basis and getting a carried interest on each investment on a one-off basis. We also see a lot of independent sponsors able to get tiered carry where maybe it's, and a lot of times, what I would call super carry, carry over 20%. Now, in the independent sponsor world, we see a lot where you don't get the 20% until you maybe reach certain hurdles or thresholds.

Maybe it starts at 10 or 15, goes to 20, it goes to 25 or 30 if you hit certain multiples or other performance metrics. But in the fund world, two and 20 still is the standard. What that means, there are two important aspects to that. One is you're probably not going to get super carry as an emerging manager. It's not unheard of, but it's going to be tough. Secondly and more fundamentally, whereas when you're operating as an independent sponsor, each deal stands on its own two feet. If you have some deals underperform and some deals overperform, you get benefit of the outperformance on your deals that do and your carrier isn't necessarily hit. Your carry on those deals certainly is not hit by how the other deals perform. But in a fund, you of course have a commingled group of investments where the carry is going to be calculated across the whole pool of investments.

Also, you get into questions about how that gets paid out, where you get... That's when you start talking about American waterfalls versus European waterfalls and when you can actually get that carry. To make a long story short, a commingled fund, if your first deal does really well, you may or may not actually be able to take carry on it depending on your distribution waterfall. The other thing that people in the independent sponsor space need to be aware of is the difference in how fees... Other fees they can earn commingled fund. In the independent sponsor space, sponsors are used to charging management fees, diligence fees, and other portfolio company level fees, and getting to keep that compensation to keep their businesses running.

In the fund space, you will get to charge, in almost every instance, a management fee based on the capital commitments of your fund from day one, which obviously is a real benefit. The flip side of that is investors and commingled funds expect their fund managers not to charge and keep fees on the portfolio companies that they're managing. To the extent, fund managers collecting monitoring fees or due diligence fees, there's almost always a dollar for dollar offset to management fees. That's just another thing that independent sponsors need to bear in mind, is from an economic perspective, as they're thinking about this shift from being an independent sponsor to running a commingled fund.

Great. Great. That's really interesting. This has been a really good overview, Rick. I guess a parting question, any other considerations that you see as far as how the world shifts once you move from whatever you're doing, whether it's deal-by-deal investing or working at a fund to raising your own fund, whether that's administrative items and building out a larger back office, whether that's additional registrations with the SEC, et cetera?

It is an interesting question because I thought about that and asked people about that and gotten different answers. A lot of independent sponsors already have well-built out teams, internal back offices and well-developed network of service providers, but there are also independent sponsors who are more one or two man shops that are making investments and just using accountants and may or may not have a fund administrator or any other service providers helping them. Certainly, when someone like in that latter camp is transitioning to being a fund manager, it's a good idea to start thinking sooner rather than later about building out your back office and maybe even also building out your investment team. If you're going to raise and manage a 200 or 300 or $500 million fund, or even a $100 million fund, and especially if you're going to have any institutional investors, you probably need to be able to show them upfront that you've already thought through the administrative aspects of running your fund.

Now, that doesn't necessarily mean that you need to staff up internally, because there are a lot of really good service providers that you can outsource a lot of this too. We do have emerging manager clients that almost still operate as one-man or two-man shops without any other employees. But those that do that, you need to have a qualified fund administrator. You probably want to have a compliance firm helping you with investment advisor registration and compliance. You want to make sure you have the right auditors and accountants helping you and all that. That aspect of running a fund is important and institutional investors look at that and want to see that. You alluded to investment advisor registration. Look, whether an independent sponsor needs to consider registering as an investment advisor is an interesting and complicated question that independent sponsors will be well-served to talk to their council about.

Whether a fund manager has to register as an investment advisor is a much simpler question. If someone is managing funds and has over $25 million in assets under management, they need to, at a minimum, begin filing with the SEC as an exempt reporting advisor, and when they hit $150 million in assets under management, will have to register as an investment advisor with the SEC. Now, that is a one sentence, very high level overview of investment advisor considerations. That leaves out a whole lot of details. There are situations where people in that 25 to $150 million range would still need to register. There are situations where people above one 50 would not have to register.

Take all this with a grain of salt. But certainly, I guess the way I would sum that up is by saying that investment advisor registration is an issue for all investment managers, but is particularly acute for people that are raising the fund in the sense that, look, generally speaking, unless they're a venture capital fund manager at $150 million in assets under management, they will have to register with the SEC. Not the end of the world. I mean, since Dodd-Frank, thousands of fund managers have registered. There are thousands of people out there operating as registered investment advisors that manage funds. It's not the end of the world, but it does add a layer of administrative and regulatory complexity to your business.

Great. Well, don't worry, Rick, we do have a disclaimer at the end of this podcast that makes clear this is not legal advice, but I will just highlight that again, and definitely worthy of conversations with a lawyer, not on a podcast, about those topics. Well, this was super informative and interesting, Rick. Thank you for your time. This was not meant to be a sales pitch for raising a committed fund. Most of our listeners are really bought into the deal-by-deal model and we'll continue to follow that model. It's growing as evidenced by our conference. We just wrapped up in Dallas. For those interested, we did bring in Rick, we brought on other partners into our fund formation group and have been expanding this emerging managers initiative significantly such that I think that Rick and his team are really in a great position to advise people on these preliminary type of matters that are exciting for people as they're out there thinking about raising the fund. Rick, again, thanks for your time. Really appreciate it.

Thank you, Greg.

Thank you for joining us on this episode of Deal-by-Deal, a McGuireWoods Independent Sponsor podcast. To learn more about today's discussion and our commitment to the independent sponsor community, please visit our website at mcguirewoods.com. We look forward to hearing from you. This podcast was recorded and is being made available by McGuireWoods for informational purposes only. By accessing this podcast, you acknowledge that McGuireWoods makes no warranty, guarantee, or representation as to the accuracy or sufficiency of the information featured in the podcast. The views, information, or opinions expressed during this podcast series are solely those of the individuals involved and do not necessarily reflect those of McGuireWoods. This podcast should not be used as a substitute for competent legal advice from a licensed professional attorney in your state and should not be construed as an offer to make or consider any investment or course of action.