What Makes A Good Fund?

Welcome to this week’s edition of Cape May Wealth Weekly. If you’re new here, subscribe to ensure you receive my next piece in your inbox. If you want to read more of my posts, check out my archive. Disclaimer: Apologies for this week’s delayed newsletter. The last weeks before Christmas have been very busy, paired with admittedly a bit of a lack of inspiration - but more on that next week in the final newsletter of 2024.

“Hey Jan, can you maybe spare 30 minutes this week? We’re [raising a new fund / launching a new strategy / kicking off our fundraise] and would love to get your view on what we’re planning.”

That is a request that I have in my inbox multiple times a week. Without thinking of myself too highly nor thinking that I am particularly wise, I would assume that people reach out to me because I might give them insight from the view of one or multiple of the following roles:

The Family Officer. Having worked for a family office, and by advising a number of them, people think they can get a better feeling for what family offices - by some standards, the source of capital to target - are looking for today. (Unfortunately, many, if not most, misunderstand them.)

The Multi-Asset Investor. People know that I invest (or at least have some knowledge) in more than one asset class. Especially in today’s day and age, where interest rates have stabilized above zero and fundraising seems difficult for most asset classes (except maybe high-flying AI start-ups), GPs know that they need to build understanding why multi-asset investors might or might not consider a ticket in their asset class.

The Wealth Manager. Perhaps somewhat an extension of the Family Officer point of view, but a bit more transactional: Investors and GPs looking to raise capital want to tap into the ‘wealth channel’ by using advisors to help them reach clients that might not be worth reaching out to individually - and often are willing to pay a finder’s fee or similar for their work.

I generally like having these conversations, as more often than not, I learn something as well. I’m also a big believer in paying forward, often receiving referrals down the line from GPs that I helped before. So in today’s newsletter, let’s try to share the knowledge that I generally pass on during these conversations - and hopefully, you can learn something, no matter if you are a GP or LP.

The Multi-Asset View

Today’s economic environment is fundamentally different from recent years. As interest rates have come down yet stabilized above zero, fundraising does not come as easy anymore for all but the most sought funds and companies. Firms that have previously demonstrated good but not great track records now have to take fundamentally longer to raise capital, might not hit their fundraising goals, and/or might decide to wind down strategies that are not worth the effort and focus.

One part of this challenging environment is clearly the change within individual asset classes, for example venture capital suffering substantial write-offs in previously hyped topics such as quick commerce or crypto, or real estate firms struggling amid substantially higher refinancing costs. Even ‘favored’ asset classes such as private credit have weak spots.

But more importantly, it’s also that the dispersion between risk-return expectations of those asset classes has changed substantially. Back in 2020 with interest rates around or below, every risk asset seemed like it would go up, whether it’s simple public equities, venture capital, real estate, or crypto. Today, this ‘landscape’ of asset classes is fundamentally different, with some asset classes (at least in my view) in favor while others are substantially out of favor. Why invest in real estate at record-low yields and sky-high interest costs if you can buy ‘safe’ publicly listed debt? Or even within a single asset class, why invest in a venture capital fund with a 10-year wait for liquidity if you can bet on the AI boom in public markets? Simply said: The risk-free return is much higher than it used to be.

Hence, GPs should be primed to get a cross-asset perspective. A question that I field frequently from clients these days is why they should look at private equity when public markets have delivered the same, if not better returns over the recent years. It is a very valid question, and I pass it on to the GPs. How should they respond?

A bad answer is when a GP tells me that they don’t care about public markets at all, instead stating that they’re focused on just delivering great returns (IRRs, not cash-on-cash, of course). A slightly better answer is when they have a public market equivalent (PME) calculation on hand. Ideally, they can show that they outperformed their publicly listed benchmark over time. 

But a great answer is being able to explain how they see them relative to their public counterpart - in general, and in the light of recent returns. A fund of funds I recently spoke to explained it beautifully: They gave us an indication what excess return over public equities they aim for in general (2-4% p.a.), but also explained how they expect for this excess return to take place relative to the life of a cycle: Often underperforming in early years, before starting to match the public benchmark around years 5 to 7, before eventually overtaking them in the later years, thus crystalizing the target excess return. Lastly, they were also able to give a satisfactory answer of how they felt in the current environment, outright admitting that their strategy (which tended to be less tech-exposed) was likely to be in-line or maybe even underperform if the ‘risk-on’ environment continues across their investment period.

A proper, balanced, and well-informed answer - GPs, take note.

The Asset-Class View

Let’s say the LP you’re talking to has already done their work. Staying with our private equity example, a LP is choosing to invest in private equity despite the asset class’ challenges today. So how do you differentiate yourself from your fellow peers?

The most obvious differentiator, of course, is good performance. If you have top-quartile, repeatable performance, you probably don’t have to spend a lot of time pitching LPs at all - rather, they will be knocking on your door. Just recently, a famous growth fund hosted a multi-billion dollar “one and done” closing - from what I’ve heard, only accepting tickets starting at 50M$ and above. Performance comes in many shapes and forms: High returns are probably the most obvious ones (i.e. high multiples on invested capital or outstanding IRRs), but many LPs also value consistency. Knowing that a fund has a specific strategy that can deliver above-average (or sometimes even outstanding) returns on a consistent basis, rather than being exposed to the ups and downs of the market, also is a fantastic selling point to LPs.

There’s also other quantitative KPIs. There’s a good degree of diversification - particularly something that I look out for in the fund of funds world, where I don’t want to dilute returns through unnecessary over-diversification. There’s reliable capital call and distributions, fueled both by discipline in deployment and perhaps also some ‘tricks of the trade’ when it comes to DPI, whether it is clever structuring, early divestments of non-core divisions of a portfolio company, or in some cases, the responsible use of fund-level financial engineering. Some LPs are also very keen on a fund’s risk-related KPIs, for example a very low (or even zero!) loss rate.

But in the end, all of those things (except perhaps outstanding performance) aren’t the deciding factor. And that is where, in my experience, many funds that tick some of those boxes (good strategy, above-average returns, institutional setup) actually tend to lack. 

I personally put very high emphasis on a fund clearly communicating their value proposition and/or differentiating factors. In my family office jobs, it was the task of the team and I to identify attractive funds that can fit our fund portfolio. One big part, of course, were the quantitative KPIs that I have mentioned, such as performance or a reliable drawdown scheme. But using those KPIs, you are still looking at more funds than you can commit to in a given year. And at that part, you don’t get around also looking at qualitative aspects. 

There’s many ways in which funds can differentiate themselves from one another, whether is the profile of company they are targeting (i.e. a growth, ‘value’ or even turnaround asset), a certain industry (industrials, healthcare, etc.) or their way of creating value (a particular sourcing mechanism such as carve-outs, a buy & build strategy, or a way of driving organic growth). And in practice, most funds can be categorized along those various criteria. But not all of them actually communicate well. I remember meeting a European fund a few years back that we talked to several times. Their returns were above-average, their team had worked together for a while, but despite numerous calls, I could simply not place their strategy. They were doing some buy & build, had done well on a few growth assets, and were focused on a few industry trends. But even when asking our investor relations contact about how they thought they differentiated themselves, all I got was “sales talk.” In the end, we passed. 

Hence, if you are a fund, new or established, make sure that you can clearly define your strategy - even if that means being passed on by LPs who might not be looking for what you do. If anything, it might do the opposite, when a more sophisticated LP is looking exactly for what you are offering. All in all, it gives your fund a hopefully positive and clearly identifiable brand. On the megafund side, a clearly defined name to me is Apollo Global Management, who have clearly established themselves as a financial engineering-savvy, value-oriented fund (if you haven’t read it, I very much recommend The Caesars Palace Coup). But there’s also smaller, more specialized funds that have built great brands. Here in Berlin, the first name that comes to mind is Flex Capital - a small-cap buyout fund focused on (often bootstrapped) software businesses that has also managed to make their way into the (VC-dominated) fund portfolios of local entrepreneurs.

The Structural View

Whether you are a GP in private equity or venture capital, competition has become much more of a topic over the recent years. Even if you had a great track record as a SaaS-focused business angel, raising yet another SaaS fund is a tricky endeavour, seeing yourself in competition for LP dollars against both global Tier 1 funds as well as local champions. Typically, you can’t compete on fund size (especially as an emerging fund manager), nor can you compete easily on differentiation (i.e. value-add services that might require a larger fund’s management fee to sustain). 

And as a result, many fresh GPs think about how they can innovate on fund structure or strategy. Staying with our SaaS example, it might be moving away from a typical fund structure, instead trying to raise some sort of permanent capital vehicle (a ‘HoldCo’). Or it might be a deviation in terms of strategy, i.e. extending your fund lifetime from 10 to 20 years or combining debt and equity investments in one. 

Some of those ideas admittedly can make sense: One topic that I spent a lot of time on earlier this year was FOAK (first of a kind) financing for innovative greentech companies, and I definitely agree that we need funds that are able to offer a more hybrid approach to financing. If you can find a niche that the market wants to invest in but where there are not (yet) any notable GPs, it makes sense to jump on that opportunity, even if it might mean having to convince some other investors why that gap hasn’t been filled yet, and why you’re the best person/team to do it.

But be very cautious when it comes to creative structure, whether that is a HoldCo, a 20-year fund, or some other creative idea. Look back at what I had said about being specific in your strategy and brand: Even if it might be boring, some LPs are just looking for a run-of-the-mill industry/geography-specific small-cap fund, and if you can offer that, there’s a good chance they might consider you for that ‘bucket’ of their portfolio. But if you offer something for which they don’t have a specific bucket, things get much more tricky: Especially in today’s day and age, where LPs have the upper hand in picking from many, many GPs knocking on your door, a truly differentiated fund structure doesn’t make their eyes shine - it just means that they don’t have a fitting ‘bucket’, and are very likely to just move on to the next opportunity.

Admittedly, things are a bit different once you have built a track record and a standing. A great example is Blackstone’s ‘Blackstone Real Estate Income Trust’ (BREIT): After many years of tremendously successful real estate investing (including its acquisition of Hilton, one of private equity’s largest returns based on a dollar basis), they decided to innovate on structure, moving from their traditional closed-end product into an open-ended (semi-liquid) product that was also accessible to non-institutional investors. Or take a look at what Apollo has been building with Athene, and more recently, the launch of their ‘AAA’ fund. It’s not impossible to start with a creative structure from day one, I know some GPs that managed to pull it off - but admittedly, it makes it much, much harder.

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