In life some things are important… And some things are not.
In funds, you’ve got to nail structure. If you don’t, you’re screwed.
I want to dive in to how I structure my funds, and just how I use that to pitch investors.
We’re going to break down several different variables that go into building your successful fund.
Basic LP/GP Structure
The LP/GP structure is the very common in funds.
It gives you the freedom to determine exactly how to pay back your investors, and eventually, yourself.
Let’s clarify a couple of things.
LP refers to the Limited Partners, or your investors who are putting their capital into the fund.
The GP is the fund itself, which includes you as the fund manager.
Some fund managers will charge an upfront management fee, which basically allows a GP to make a certain chunk of change for overseeing the day-to-day operations of the fund, regardless of how it performs.
In my experience I have observed that most management fees range from 2-5% of the total AUM that the GP is overseeing.
If you are just getting started, I would STRONGLY recommend against this.
Investors are not going to want to agree to the payment of a management fee with someone who has little to no track record, and does not fit the stereotypical criteria for a fund manager.
The solution for this situation is a performance fee.
Using a performance fee and structuring your fund with a pref, catch up, and carried interest is going to attract significantly more investors because the only way you are making money is due to the fact that your fund is delivering results.
Observe;
Pref
The pref is the first part of the structuring process.
Let’s say that your fund is going to make a 30% return on a given investment/project.
As the fund performs, your LPs will make back their initial investment first, and then they will receive a “pref” from the deal.
This basically means that the entirety of the first X% of the return on your particular deal is going to go directly to the investors.
I typically recommend somewhere around 8%, that’s what I did on my first funds.
This basically shows the investors that barring a complete failure of the fund, they are guaranteed at least an 8% ROI before you – as the GP – ever get paid.
The pref is subject to change depending on what you do with the next steps, but again, I wouldn’t go below 8%.
Catch Up
The Catch Up is a chunk of the return that goes directly back to the fund itself, to help reimburse certain operations.
This is usually a small percentage that isn’t really where you’re going to make much money.
Its primary purpose is to help cover the expenses of the fund.
I personally used a 2% catch up, which I would say is standard.
So for the purposes of our example the first 10% of the fund’s return is now assigned, 8% to the LPs and 2% to the GP.
Carried Interest
Next up, and arguably the most important for you as the fund manager, is carried interest.
There’s a lot of different variations that you can implement here so I’m going to try and keep this as clear and concise as possible.
Carried interest refers to the division of the remaining return that the fund garners.
Most of these splits are going to look something like an 80/20, or 70/30 divide.
What does this mean?
Simply put it’s saying that for all the remaining return – until forever – 80% is going to go the LPs and 20% will go to you as the GP.
In our hypothetical situation we are saying that we are going to make a 30% return.
We have already factored out the first 10% with our Pref and Catch Up, which leaves us with 20%.
Therefore, using our 80/20 split, 80% of that 20% is going to go to your investors, or 16% of the return.
Meanwhile 4% will go to you.
This is where you will make the majority of your money, and your investors are going to love it.
A lot of funds will put benchmarks in place to transition more and more of the carried interest back to the GP.
For example, let’s say the IRR of 30% will have the 80/20 split, but everything after 30% will have a 50/50 split.
The principle is simple, but there a million variations that you can implement.
Conclusion
I hope you get the main idea of this post and use it to your advantage to draw in potential investors and put yourself in a great position with your fund.
I have personally seen just how mutually beneficial this fund structure can be, and the potential that it possess.
I would experiment with the percentages and do numbers that make sense for you.
Perhaps you do a significantly larger pref, with the confidence that you can then enforce a more favorable split with your carried interest.
The decision is yours, but this knowledge should really help all you Wall Street Rebels out there get going.
Take Care,
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DISCLAIMER: This content is for educational and informational purposes only. It is not to be taken as tax, financial, or legal advice. You should always consult a legal professional before taking action. Furthermore, this is not a recommendation to buy or sell any security. The content is solely just the opinion of the authors.
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