So, having now been managing your deal flow and building up a pipeline of potential investments for your new fund, you have identified what you feel is an attractive first investment. What considerations should you keep in mind when making this first investment? And how will you fund it?
Building up a portfolio of investments quickly has the benefit of providing a more fully-formed story to sell to investors in later closes, as you will have proven the ability to execute the strategy, and prospective LPs can see the type of investments that have been and are about to be made – always important in blind pool investing.
This can be especially helpful for those emerging managers that lack a lengthy track record of prior investments, but it is important to bear in mind that the due diligence of investors looking at second and subsequent closes of a fund will be focused on this new portfolio, along with your materials and/or existing track record. Therefore, new investments need to be tightly aligned not only to the strategy of the new fund, but also to any previous investments made and track record.
If we accept that sooner is better than later when it comes to making a first investment, there is also a need to remain cautious. The first deal in a fund should be carefully considered, as its impact on a fund’s IRR is always disproportionately large (for good or bad). It is better that the first deal is a solid 1.5x – 2x, rather than a risky “swing for the fences” deal with a risk that it could “blow up”. If the first deal goes sour, it may be extremely difficult, if not impossible, to achieve a decent IRR on the fund and continue to market the fund.
However, assuming that the deal you have identified is both a good fit for the investment strategy of this and previous funds from your track record and is not inordinately large or risky, there are other obstacles to overcome.
Normally, an investment is only possible when one has held a close on the fund and capital from your investors is accessible for deployment. But you may find that the preferred timetable for a deal means that there is considerable pressure to complete before your fund is closed. In cases where the transaction cannot be put into a prior fund (because your previous fund’s investment period has finished, or there simply is no prior fund), a few options exist. Aside from the obviously unpalatable idea of letting the deal go, the manager can:
- Manage the deal’s process in such a way that its timing can be put back until the fund can hold a close; or
- Bridge the gap between the deal’s completion and the closing of the new fund, using specialist bridge financing, with a view to then transferring the deal into the fund upon closing.
Managing the timing to suit one’s own ends in a competitive process is a difficult matter and requires strong negotiating skills, outstanding relationship management and often a genuinely differentiated offering. Given that these are core skills for running a successful fund, it may not be so far-fetched to imagine a successful conclusion to a strategy somewhat reliant on deferring the fund investment, but the situation remains challenging: there is no guarantee that an investment target will be patient, so bridging strategies of one kind or another have become increasingly popular with GPs and, today, the lack of a fund does not necessarily mean a lack of capital. Aside from direct financing through one of a number of specialist finance providers, an anchor or cornerstone investor could fund the deal prior to the fund’s closing and, similarly, one or more existing LPs (or even prospective new LPs that are very likely to commit to the new fund) may fund the deal on a co-investment club basis. The legal process of then transferring the deal into the fund post first closing is relatively straightforward (and is well-trodden ground), although there can be tax implications for the de facto ‘selling’ investor or investors.
Aside from the issues noted above, there are further reasons to prioritise the synchronisation of first close and first investment. Ideally, as discussed, the first close of a fund and its first investment align well, in that a closing is held at the same time or just before capital is required for one or more new investments. This allows a single drawdown notice to be issued to first close investors to cover both fees and any initial investment. Remember, the process of drawing down capital in response to capital calls can be a pain for investors. They only want to draw down when necessary (and most LPAs allow for ‘just-in-time’ capital calls), but this means unpredictability for investors, some of whom (HNWIs, for example) may not find it easy to meet short-notice calls. Whilst this can to an extent be mitigated by allowing some investors to be pre-drawn, this leads to a situation where different investors have different IRR profiles, which is not an ideal position to be in.
Of course, having a deal and no fund close is not the only timing problem a manager can face. The opposite can also be true: a manager might find itself having held a fund closing but without having a deal ready to go. This is far from ideal, of course, and, if you have been properly managing your deal flow and investment pipeline, you should be able to avoid it, but the world is not perfect and it can occur. In such an instance, a manager would be well-advised to ‘dry close’ and not execute a drawdown until it has a deal ready to go. Drawing down just for fees can look bad for a fund’s first quarterly report and really impacts the net IRR.