How to Structure a Private Equity Fund

Colin and Brent discuss discuss how to structure a private equity fund after speaking with LPs.

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Colin Keeley: [00:00:00] Hello, and welcome back. This is Colin Keeley. Here

Brent Sanders: [00:00:03] And I'm Brent Sanders.

Colin Keeley: [00:00:04] we are two guys buying and building wonderful internet companies.

Brent Sanders: [00:00:08] Yes, sir. Yeah. And today I think we want to talk about, different deals, not deal structures, but like fund structures. Like how do we intend to, or I guess a transparent view into what we've been kicking around for as we look at additional deals. How we want to structure them. Cause we do want to involve outside investors.

We want to come up with a way to attract good investors that ,  can be helpful, but also, not create a bunch of work for us and work for like legal work. So it's this world is esoteric, but it's simple from a ,  a fundamental perspective you're trying to get. Money in and then figure out how you're going to pay these people out.

And then we also have a certain strategy. And how does it fit within that strategy?

Colin Keeley: [00:00:55] Yeah. So we've been looking at all these different ways. I wasn't super familiar, but we've talked to a bunch of a couple in-person LPs this week and got feedback and then like other LPs last week and how other people are structuring things. So we did the constellation podcasts and we talked about that.

That is basically. A holding company with committed capital. So it's not two and 20, there are fees that are like equivalent to that. But it is not a traditional private equity fund. So this is where you basically get a committed pool of capital and then you deploy it over some number of years, and then you ,  use the cashflow to purchase more businesses going forward.

And that is what the goal of the law. Multiple of invested capital ,  instead of IRR or something. And so that I think is interesting, not going to be the easiest thing to raise on. Our initial plan was more independent sponsor, so this is raising money on a deal by deal. Okay.

You can take some management fee, like a percent of revenue ,  you get some carry and people structure this in all different ways.

You could have no management fee and like high Hikari or higher management fee. You can have closing fees. It's the wild west. You do much different ways.

Brent Sanders: [00:02:05] And when you say committed, committed capital, though, like going back to, Hey ,  you're going to raise ,  let's say $10 million. What it means is like people say, yes, I will give you some amount of money. And then over time you will do a capital call. Which means. You're going to send them an email and say, Hey, you committed to, let's say $150,000.

I'm going to take 20% of it now. And then six, eight months from now, I'm going to take another 20% and so over time, cause you don't really need that money all at all.

Colin Keeley: [00:02:31] Yeah.

this is different than so in the startup world, you raise a seed round. You traditionally get that million dollars and you stick it in the bank and you have a million dollars sitting in the bank ,  for a private equity fund venture capital fund. You get all these commitments, maybe that equal like $10 million or something.

And then you call that capital as you need it ,  as you find deals. So it's not sitting there, basically wasting away for the investor. Venture capital fund, private equity fund, you normally viewed, or judged on your IRR. So internal rate of return.

Brent Sanders: [00:03:01] Versus, we're talking about revenue. So how did the, like the private equity model, which seems like fairly straightforward to me, which is, I've also seen like real estate deals that you'll see where, essentially you're going to say, Hey, I'm going to put this money in. It gets called in over time.

There's a thing called Kerry, which you mentioned, which goes to the, usually the partners in the fund or, those involved in making investment decisions. And like the payout is there's like an end to it. And that's the thing that the constellation model that we talked about last week is there's, there was no, and that was the interesting thing.

It wasn't really clear ,  was that known from the beginning that, Hey, this is just going to keep rolling and ,  yeah. We'll pay you out when we sell a business, but we didn't end up selling any businesses. So he ended up going public is was that his intention? I'm curious. And then is that now, like its own model?

Colin Keeley: [00:03:48] Yeah. So it's, we're saying that traditional, like private equity fund has like a finite life. So buyout funds, you typically hold for five years and then you exit. And so back to constellation, he raised that capital from a largely, from a pension fund OMERS, which was happy to hold that money in company.

Forever or indefinitely, but he also raised some venture capitalists. And when you raised some venture capitalists, it's known that there's like a ticking clock. Like you have to give their capital back because they have to give it back to their LPs. So he took constellation public as a way for the LPs that wanted to exit ,  had the ability to exit basically.

Brent Sanders: [00:04:26] Our goal and I think this is like the right way to, to start with figuring out ,  what is the right structure? Our goal is to hold these businesses for ever and ever as long as possible. So with that, it's like immediately in, in conflict with delivering  people returns, but then again, you can also issue like dividends.

You could say, Hey, once we hit a certain point, we're going to start paying money back. And it's in small installments, either monthly or something like that. And I think we heard of some players in the space that do that, where they just, you know, Hey, we're making some percentage on your capital. Here's a ,  an installment of that.

And I'm wondering ,  does that just go until the capital's in, repaid at some multiple, or like when does that stop?

Colin Keeley: [00:05:12] you can do it all different ways. This is what we've been hung up on is ,  like planning something that is an indefinite amount of time out at the very beginning. And not easy to do so you could have some term that you could buy out. Investors have three times their investment or something like that.

And that three X fund is what, most people would be happy with. And you could do that in different ways. You could dividend, you could just keep it indefinitely and maybe split the dividends like 80, 20, 70, 30, something like that. Forever fact. Or you could have some exit events where you often these buyout funds buy a company and then five years later after improving it, they sell out to another   private equity fund.

And then more recently there's these like evergreen or open-ended long dated funds that maybe stretch that out longer than that. Or you could just raise successive funds. So you have Vern fund one, and then maybe you want to hold that. And it's like many years later and maybe you raise Vern fund four.

So instead of selling to other private equity funds, you sell to yourself because you think there's still room to grow on  those assets.

Brent Sanders: [00:06:17] We were, yeah,   this is like one of the things we're really struggling with, and we got that feedback of having to be a, an amazing turn around at a rolling fund. That's just goes forever and ever, and has no exit date. You go with something more typical and then yeah, just sell to yourself.

And that way, it's almost like an implementation detail. It's from fund one from fund two, and those lasts three to five years or whatever they. The timeframe is, and you're not tied in because the way we were looking at before, it's like, all right, this is what we're going to do for the next 20 years of our lives.

It just seems like a really big decision to make all at once. I would never, there's no other decision. I think ,  you'd make like that other than marriage probably, or, maybe having children. So it's like marriage, children raising a fund that are there that long-term.

Colin Keeley: [00:07:02] Yeah. Our mutual friend had a good point of what were you doing 20 years ago? What are you doing out 20 years in the future, you have no idea where you're going to be. So yeah, definitely took that to heart of I wonder if we're just overthinking it where like perfect is the enemy of good, where you just do something standard, you do 220 or some thing close to that, and then you figure it out in the future.

Like you don't have to have it all planned out immediately. There's outs in the future to do different paths.

Brent Sanders: [00:07:29] Like simplicity is good. Simplicity. And the other thing is that seems like good advice. Cause you can just, again, people may realize oh, there's there has been other funds and these business, technically haven't sold, but you're selling it to yourself. Or you sent the, selling them to them.

You sort of generation and, I think that makes a ton of sense. I think that was my, the way that I'm leaning is let's do something simple that people will understand the LPs will understand. And also, that they have a, because I think the constellation , Example is one that's very good for, the main investor, right?

The pension funds. It's they don't really need the money back. They need to know on paper that it's growing, but they want it deployed and they want it earning as much as possible versus, the LPs your standard LP that you know ,  is trying out, the venture investor or private equity, like they're gonna want that return eventually.

And so the one thing that we heard from another LP, though, that was really interesting. Was in this season of sort of the economy it's like tax efficiency is really interesting there. So it's like being able to keep the money rolling. Here's your return for the year. Do you want to re up or do you wanna, do you want a check and have to pay capital gains or some, sizeable upon a flush to the government on it?

Which I don't know if you can get away with that.

Colin Keeley: [00:08:44] As the wealthy people definitely do. So if you think of, Zuckerberg or whatever, like our ,  Elon Musk, all their wealth is in there, the companies, Right.

So you own a tremendous amount of Facebook stock and you want to buy a house like you own, I don't know, $40 billion in Facebook stock.

You just go to Goldman Sachs and say, Hey, I want a loan of a hundred million dollars on this. And I want it at 0.5%   and they're happy to give that to you, right? Cause it's against this enormously valuable Facebook stock, that's only going to increase the value. So I know some, I think it's venture capital funds.

If you own Airbnb or something, instead of you selling it at the end and taking a huge tax burden, you could just give the people share. And so the shares this rollover, and then there's no sale, right? There's no  taxable. So there's different ways around it. And this all goes to don't try to predict the future, five years out.

If the tax system changes like there's ways, always tons of probably way too smart way too many smart people working on ways to avoid taxes because the tax system is so complicated.

Brent Sanders: [00:09:48] Yeah. And I think the other ,  like piece of interesting feedback that we heard recently was like around  having. Yearly or not necessarily yearly, but like more frequent payout of Hey, here's your investment back? Or here's a multiple honor, whatever it is, but then coupling that with the next fund, right?

It's Hey  we're here with your check, but before we give it to you, would you like to get it back on the ride again? And we just delivered you 20% or whatever the returns were, as long as you're telling a good story, you're delivering good results. It's almost like a mental thing where it's do you want to get back on the ride?

Whereas, Cosmax was saying, do you wanna run with the big boys or you want to be a little bitch? That's the way I was trying to explain this to him. And he was saying to me, that should be your line, just have Collin look at them right in the eyes and say, do you want to be a little bitch?

Or you want to run with the big dogs?

Colin Keeley: [00:10:36] There you go.

Brent Sanders: [00:10:38] No, but in all seriousness, it's I think there, there is an element of if it's working, people will tend to reinvest and ,  I think some of these decisions around tax and  holding these companies forever. I think there's good ways to figure that out.

And it doesn't have to be reflected in the fund structure, which is, I think that's my conclusion. That's what I, my key learning from, some of our conversations are it's you can do whatever you want. And structure it. And that's the interesting thing about this that I've never really put a lot of thought into.

But it is like a compositional mathematical kind of interesting thing to, to figure out. And ,  my sense, just like most things I try to do in my life is just try to keep it simple. That's my takeaway. It's Hey, go with something that everybody understands and that you understand, and you can talk about you understand versus ,  I think the long, really long running fund would, I hate we're going to raise something and it's indefinite.

It's just hard to align the incentives with the investors and us.

Colin Keeley: [00:11:34] Yeah. I, so I feel like we nailed the founder products of clean deals, be super simple to deal with  straightforward, no assholes in this LP product. It seemed like we were coming to a solution in our heads. And then you went and talked to that, like LP customers. And they're like, what are you talking about?

This is really complicated. Why don't you just do something more simple? It's every product you ever designed goes this way, where you have these great ideas in your head, and then it runs into them.

Brent Sanders: [00:12:00] Yeah. And they're like now, no ,  just to do something normal. I think that's, that was a good feedback. Do something.

Colin Keeley: [00:12:08] yeah. Don't recycle fees. That's weird. Do it maybe in the future, but don't have that built in. Was the other kind of feedback around there are recycle ,  like Caslow was our initial idea, but all this leads to like you so start small. And how do you start small and where do we begin with this?

So are you leaning one way or the other.

Brent Sanders: [00:12:27] I'm waiting for a little bit more transparent only, the LP feedback that we've gotten has been really productive, really good. And I'd like to see where those conversations go. But yeah, my sense is like, Hey, let's get more deals under small, do more smaller deals first before trying to raise a larger pool of capital and trying to raise a fund, I think is you have to.

At least show more track record. Otherwise I think you can still do it. It's just gonna be harder. And you'll, you won't get as favorable terms. And that's like my experience with VC. See, just being around the fund there, it's just if you have a good track record, if you have a, you can point to even just three deals, it's Hey ,  these are going great.

And we just want to do more of these. Great. I think it'll be a lot easier than, Hey, we've done one. We've got another on the books. And we're going to close a third in the next month or two, like it's a lot harder to people just say it's very easy as a ,  like sitting at, from a LP perspective, just to say, Hey ,  great.

Let me know how the third one goes and reach out.

Colin Keeley: [00:13:33] Yeah.

I just torn her. Like how many deals do you need to show? So you could acquire deals at good multiples that you think are good businesses. And then are you gonna wait a year or two years to have an exit from those? Do you want to wait that long? Or if there's capital out there, that's interested in this and you have a little bit of proven experience that you could get deals at good prices and closed up.

Does it make sense to scale that up?

Brent Sanders: [00:13:57] Yeah. And there's this other thing that like, it's easy to access capital right now and will that. Will that stay the course, which most people that I talked to were like, there's no way, but we also didn't quite, things happen that you can't really predict the future, but if cash becomes harder to come by and investment com it starts to dry up ,  yeah, you're going to wish you raised eight to $10 million or more, as much as you possibly can to kind of stuff your pockets.

And then you don't have to go back to the trough for quite a long time or wherever.

Colin Keeley: [00:14:27] Yeah. I guess my preference would be to keep testing the waters and keep doing these conversations with LPs. And if we're able to get one to bite, that's a little bigger. I think it's probably downhill. like it's a lot of social proof of one person committed and then you could raise a tiny phone.

Go do something with it. Maybe deploy it like relatively quickly, and then you go out and raise another success of larger fund.

Brent Sanders: [00:14:51] Yeah. Yeah.

Colin Keeley: [00:14:53] and if that.

doesn't work, like you just do independent sponsor deals until you feel ready.

Brent Sanders: [00:14:58] Yeah. Yeah. And I wonder again, if you return good return to people, they're going to tell their friends they're going to want to involve other people. It's if you, but again, it's so hard to know when those returns are going to take a long time. We're the one thing that I really like about this space is that we're not buying businesses that we're going to like.

Turn around and turn into a unicorn. It's like modest growth will actually have great returns. It just takes a little bit of time. And so by the time we're delivering our first set of returns, at the earliest, like a year three, something like that. It's you're not, three years from now.

It's just same thing. What were you doing three years ago? It's you weren't planning on doing that. So it's it's too far out. So timing is, I think probably the most interesting part of this. Timing into market against where investors are at, where the economy's at, and then also like how many deals you've done.

So it's all, trying to coordinate those things together with a structure that, aligns the right incentives.

Colin Keeley: [00:15:51] For sure. Yeah. you really don't want to be trying to time the market. So if the capital's available, I'd say you get away. You can, because you don't know, you don't know if it's going to go up or down or whatever is going to happen in the future. But Yeah.

it's interesting spot to be ,  you just keep finding good deals and, I guess you move forward with it.

Brent Sanders: [00:16:07] One kind of last thing that I was thinking about is that the balance between fees and carry, right? So for those of you out there that are like, what are those two things? Fees are a percentage of the invested capital that I believe on a yearly basis. And a lot of models like goes to. Us essentially.

So it would be going to Collin and I, and our staff and ,  smart people that we'd be bringing into the system, whatever ways to maximize the investment versus Kerry, which can you explain Carrie in a simple way ,

Colin Keeley: [00:16:37] Yeah, so we had this analogy of whaling boats. We talked about this in the past. So it's basically 20% of profits is like the simplest way to think through it. So two and 20 stamps. Brian's kind of alluding to is a lot of people ,  deviate from that. And especially people that have made good money before and don't need like the 2% management, they don't care about the salary that is  care about the equity value, equity increase and paying capital gains.

So like I have my notes somewhere, but benchmark or a lot of other folks I think take close to zero management fee and then we'll take much more than 20% and carry 30% or more.

Brent Sanders: [00:17:15] which is, I think, as an investor, that's where you want them to be. You don't, nobody likes fees and it aligns incentives the right way. However, they're taking, I think somebody had mentioned, I see stuff coming around. That's zero and 35. So no fees. We're going to take 35%. Of that, Carrie.

And does that maximize it's it puts the investors in a little bit of a backseat, right? When it comes to returns, it's like you're getting close to 40% of the profits essentially. That is going to the, the fund manager. Yeah, it just, I think it's an interesting time.

That's awesome. Indicative of kind of what's going on in the space. It's this has been really fun to learn about. It's never been like something I've before, especially working in venture, like never really understood that it existed or, just lumped it in with all the different things I didn't know about.

Colin Keeley: [00:18:05] Yeah, it's an interesting space. I've always loved like portfolio construction, like the real nerds in the venture space and get really into it and how you could play it differently. But yeah, still figuring it out and like people arrive at all different stuff. It's like supply demand, right? So once you're a SU super sought after fund, you could, take a larger pot of flesh.

You could, upper carry up your management fee and do that.

Brent Sanders: [00:18:27] Yeah  so that's my kind of one point going back to Hey, if we just do a couple of these, I think you still raise money, but then when we're, if you're raising from the same people again, and you're just raising more. Broadening the investor base, you can, I think command better terms.

It's just the same thing as like a startup that's raising pre-revenue versus Hey ,  we took six months to get product market fit or a year to start seeing. It's, I'm not saying it's the right thing to do in all cases. I'm just saying you'll get better terms. The more it's flushed out.

Colin Keeley: [00:18:57] so that is an interesting perspective, especially today, because a lot of these, like pre-revenue startups raising crazy amounts of money because there is so much capital out.

there chasing deals.

Brent Sanders: [00:19:07] Yeah. That is always true for San Francisco, but I'm talking about, the Chicago based startup, that's gotta basically show they're effectively profitable and they're going to be unicorn before people invest. But yeah, th that is, I shouldn't say that about all venture, but. It is generally true.

If you see some point to some traction, like you're looking at a deal, those are the deals, at least that I see from people that we used to work with, that they'll share things that, Hey, can you believe this company is doing, $60,000 MRR doing this? And it's still very early and usually  how do I put it?

Like squishy, right? Those deals are generally very squishy, but  it's always helps to have some points of reference.

Colin Keeley: [00:19:46] One last thing before we go ,  My pre-order is alive on my course. So is my ,  website for the new course. It's how to buy, grow and sell small companies. So if you're enjoying the podcast, check it out. Pre-orders are open for $199 right now. Pricing. These like zero marginal cost products is weird.

But my plan is to never discount and then slowly increase the price as I add more and more content. So as far as what's covered, It's basically everything you need from finding a deal is sourcing it different places to find them. And I'm including all my scripts and templates that we use over here at Vern.

And then after you find a deal, how do you Is it, how do you negotiate the deal? Different ways you could structure the deal. And what I recommend. With real sample deal structures. We have templates for asset transfers for the legal docs, all that good stuff. And then after you actually close. Yeah. How do you grow the thing?

And what we recommend there a playbook that we're using and then our ,  recommendations around hiring SEO writers, hiring developers. Brent has a couple sections and then eventually hiring CEOs. And incentivizing them and, doing that whole structure. So check it out. The course is going live in about a week and a half, two weeks.

And so I am working frantically to finish everything up. A good chunk of it's done already, but yeah. Check it out  

take care everyone. Bye bye.

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