Bible for the Emerging Private Equity and Venture Capital Manager
By Ron Geffner and Paul Marino,
Partners, Sadis & Goldberg
October 30, 2018
Chapter Two: Deploying TLC to KYC (Know/Your/Client)
Knowing your customer is not just about compliance. If you want to raise capital, you need to raise your game to the next level by knowing the specific needs of your client/customer.
First, as an investment manager (“Manager” or “Managers”), you need to know what your investor (client) is seeking and/or needs from its investment. As an example, there are (generally) two types of investors in venture capital and private equity firms—institutions and high net worth individuals; and within each vertical there are subsets of investors.
Institutional Investor Vertical
Most Managers would love nothing more than to have access to and receive investment allocations from institutions. The money is generally sticky and usually comes in larger amounts (than, say, a high net worth investor’s money); and, equally as important, an investment made by an institution is usually viewed by other institutional investors as a seal of approval in considering their potential investment. However, not every institution seeks the same return on capital, and certainly each institutional investor has its own risk/return parameters and requirements.
Municipal Investors (“Municipals”), such as The New York State Teachers’ Retirement System, manage the pension funds for state and/or municipal educators or other state or local employees’ pension funds on behalf of their members and are backstopped by the tax-payers of the state. Municipals usually have actuarial assumptions for the pension funds they manage. In recent years, the investment returns of many pension funds have failed to meet such actuarial assumptions. This has resulted in many pension funds being underfunded (i.e., the current assets are not expected to meet future liabilities), and has compelled Municipals to seek above-market returns in hopes of maintaining, at minimum, current pension benefit payments. In furtherance of this objective, many Municipals have turned to alternative assets (e.g., hedge funds, private equity funds and venture capital funds, or separately managed vehicles pursuing similar strategies) for the potential to achieve returns greater than those associated with more traditional investments, such as public equities and fixed income. To that extent, while some Municipals do have emerging Manager platforms, internal resource constraints or prohibitions on the percentage of total AUM that can be allocated to a single investment (i.e., most Municipals do not wish to be more than 10%-15% of the total AUM of any Manager) prevent Municipals from being able to allocate relatively small(er) dollar amounts to emerging Managers.
There are also other considerations for Municipals (and most other tax-exempt investors), including, but not limited to, the following: (i) effectively connected income (ECI) and unrelated business taxable income (UBTI), both of which are often toxic for many tax-exempt funds, and (ii) certain socially acceptable investments (ESG).
In short, while Municipals have greater risk tolerance than their Taft/Hartley Pension Fund brethren, most do not have the infrastructure to invest in smaller, emerging Managers and/or the ability to allocate smaller amounts, thereby creating capacity constraints for their investments.
ERISA investors are comprised of employer-sponsored pension funds that are funded by employees and employers. Your 401(k) is an ERISA plan, and, while it could invest in alternative investment vehicles, generally 401(k)s do not have enough assets under management to make investments big enough to meet investment minimums of such vehicles. However, some ERISA investors, such as Taft Hartley funds (think electrical workers union or united auto workers union), run a pooled employee pension plan and therefore have larger pools of capital to invest. While the foregoing plans are subject to ERISA, they do have large pools of capital to invest. Nevertheless, ERISA investors have strict mandates and restrictions, such as liquidity mandates (e.g., with very few exceptions, most funds must invest in highly liquid investments, such as publicly traded equities). Due to these mandates and restrictions, many funds are ultimately not suitable investments for ERISA investors.
ERISA investors rely mostly on their members to fund liabilities (i.e., if there is a default and/or underfunding, ERISA investors cannot turn to municipalities to fund the difference). While the Pension Benefit and Guaranty Company will, when necessary, take on the oversight and administration of certain benefit plans, it does not guaranty funds nor does it make a contractual promise to pay out all benefits owed to members. As stated above, ERISA investors are also prohibited from investing in certain businesses and are subject to some of the same prohibitions as tax-exempt funds.
Foundations come in many shapes and sizes—generally public and private foundations—and are focused on principal preservation rather than aggressive growth. However, larger foundations may allocate a certain portion of their portfolios to alternatives, but generally they are adverse to illiquid investments that do not have a current yield component (i.e., throw off cash on a monthly or other periodic basis). In short, most foundations are focused on meeting the current needs of the charities supported by their benefactors/grantors and generally lack the timeframe and risk tolerance for alternative investing.
While foundations and endowments differ in a number of ways, one of the biggest differences is that a foundation is generally established by a donor with a lump sum of money while an endowment generally raises funds in perpetuity. The best example of an endowment is a college endowment (e.g., Yale or Harvard have multibillion dollar endowments). In the foregoing scenario, multiple donors give money to a not-for-profit vehicle on an ongoing basis. Accordingly, since the endowment continuously raises capital and generally has one beneficiary, its margin for error is greater and, therefore, endowments generally have a greater tolerance and even appetite for risk. For Managers looking for dollars from endowments this simply means that endowments have a greater risk tolerance for investing.
Notwithstanding the foregoing, endowments, like foundations, still seek safety in investments and invest in alternatives—but generally in alternatives such as timber and other natural resources, with smaller allocations to alternatives such as venture capital, private equity and hedge funds. With that being stated, the size of the allocation is usually directly correlated to the size of the endowment (duh); however, a large endowment will likely not have the ability (due to size and percentage constraints) or the acumen to invest in smaller Managers. Nonetheless, smaller or emerging Managers should not eliminate endowments (large or small) from their targeted list because many endowments offer emerging Manager platforms, and smaller endowments (just like smaller pension funds) are generally more accessible. You should keep in mind that endowments are more flexible than foundations but are still guided by their mandates, which means that Managers seeking capital from them should know the specific endowment’s mandate.
Family Offices and High Net Worth Individuals Vertical
The last group of investors includes family offices and high net worth individuals. In most simplistic terms, a family office is an organization that assumes the day-to-day administration and management of a family’s financial affairs. Most family offices are controlled by the family head (usually the family member who actually made the money); however, as the space has evolved in recent years, family offices have moved to hiring COOs and CFOs with greater sophistication to run their businesses. Further to that point, some wealthier families have structured entire professional/wealth management companies to care for and manage such families’ money. Those families which require that level of sophistication use such professionals as gatekeepers to screen potential Managers and limit their access to the inner sanctum of the family.
For a Manager to successfully raise capital from a family office, the Manager needs to understand: (i) how the family made their money (i.e., most families will invest in areas that they know well—especially families who have only been wealthy for one or two generations); (ii) how much liquid net worth the family has (e.g., families who derive their wealth from real estate or manufacturing often have their wealth locked up in illiquid assets and therefore do not have as much liquidity to invest in alternative investments); (iii) who makes the investment decisions in for family (it could be the gatekeeper—e.g., C-level person such as CFO/COO/CEO, but more often than not, it is the family member who made the money); and (iv) whether the family is more focused on wealth preservation or wealth accumulation (in other words, whether the family is looking to simply maintain their wealth or also grow their capital base—this will guide their investment thesis and determine the risk tolerance).
High net worth individuals are similar to family offices but without most of the formalities. Generally, like family offices, high net worth individuals will invest in areas that they are familiar with and/or have had previous success investing. A Manager seeking an investment from a high net worth individual should essentially be focused on the same considerations as a Manager seeking an investment from a family office, except that the gatekeeper is usually a trusted advisor of a high net worth individual (e.g., accountant, lawyer or financial adviser). While the trusted advisor is an important person in the process, the most important person is the actual investor. In the end, the Manager will have to determine if the investor has the liquidity (i.e., you do not want money from an investor who is not willing to lock up his capital for an extended period of time and/or cannot afford to lose his capital investment).
Today’s capital raising environment is competitive, complex and fractured. Investors that once perceived alternative investment funds as scarce now have a multitude of options. However, the one thing that has not changed is that fundraising is, and likely always will be, about building relationships. It is about knowing who your target audience is and how to identify which investor base is ready, willing and able to invest in the product you are offering. Ultimately, while fundraising is often unpredictable, what is predictable are the objectives and concerns of your target audience, and what they seek to achieve with their investments.