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The Truth About Fund Management (And Raising Capital)
There’s a lot of misinformation parading around as authoritative expertise. On a scale of one to ten, this “expertise” runs with a bullshit factor of about eight out of ten.
Here are a few things investors and asset managers need to know about investing and fund management:
To start, no matter how much is spent on fund legal documents, by themselves, they’re not worth the paper they’re printed on….
People talk about the banking system creating money out of thin air as if it’s backed by nothing. This is simply not true.
The monetary base created by central banks is backed by the GDP of their respective countries and enforced with the full might of their militaries.
Money created through fractional reserve banking is backed by borrowers’ willingness and ability to pay on promissory notes that are backed by collateral.
Fund docs can also be thought of as a form of money, but to be useful, they must be backed by something of value too: the risk-adjusted performance of the underlying strategy.
Are there people who start funds and succeed at raising capital based upon little more than a story? Yes, but they are successful because they have close relationships with affluent people who like them. That’s not a sound business model, and it’s one that’s not even possible for most people.
To successfully raise money for a fund at scale, asset managers must be able to compete in the capital markets based on merit.
Despite what most retail financial advisors say, within the capital markets, the ruler for measuring the quality and value of a fund is its accurately measured and verifiable risk-adjusted performance.
When starting a fund, step one is not paying a lawyer; step one is engineering a strategy with risk-adjusted performance good enough to successfully compete in the capital markets.
Step two is engineering the optimal capital and fund structure that accounts for the risk-adjusted performance and liquidity characteristics of the strategy (e.g., maximum drawdown duration required to achieve the expected return informs the lock-up period) while meeting capital market demand.
Once that’s done, then it’s time to start thinking about which regulatory exemptions to operate under based on how much capital can be deployed, then getting legal docs drafted around the strategy, structure, and appropriate regulatory exemptions. This is where terms like “PPM”, “Reg D” and “506(b)” or “506(c)” start to come into play. They say nothing about the quality of a fund… they’re just terms that pertain to the exemptions being utilized.
In short, legal docs don’t give a fund value; they just translate what the asset manager is doing into compliant legalese. Again, the accurately measured and verifiable risk-adjusted performance of the strategy is the fund’s source of value.
So what if an asset manager doesn’t have a track record?
First, it’s a myth that starting with syndications is the best way to build a track record.
Syndications just make the story easier to communicate. So if an asset manager already knows people who are willing to give them money, it can be easier to raise money by syndicating individual, tangible projects.
For those who want to be serious players, though, forget syndicating deals on a one-by-one basis.
Develop a scalable strategy that can perform across market cycles; distill that strategy into a set of objective rules; then plug actual historical data into those rules to create a credible theoretical track record.
You can think of the theoretical track record as a pro forma in retrospect. Because this process requires the strategy to be effectively converted into an algorithm, there is no opportunity for data fitting or cherry picking. When executed rigorously, the risk-adjusted performance measures of the theoretical track record are as reliable as the measures of an actual track record.
How do asset managers get paid running a fund?
The two basic components of fund manager compensation are management fees and performance fees. 2% of assets under management (“AUM") per year and 20% of the fund’s annual gains, or “2 and 20”, with a hurdle and high-water mark is the traditional fee structure for private equity and hedge funds.
Real estate and some private equity funds may have a slightly different compensation structure that includes a waterfall to account for the various activities required to run them.
In short, asset managers can get paid in many different ways, but the greater the risk-adjusted performance of their strategy, the greater their compensation can be—and vice versa—as should be the case.
Despite what others may say, fund managers don’t need a license to earn a management fee on a fund out of the gate. Once a fund hits $150 million in AUM, the manager will likely need to register with the SEC as an Investment Adviser, but until that time, no license is needed.
For those not in real estate, a performance fee probably can’t be taken unless all the fund investors are Qualified Clients, but that’s a topic for another time…
While the powers that be would like everyone to believe otherwise, people don’t have to be super rich to do these things. Anyone can create an institutional-grade fund from scratch with a little hard work and know-how.
Knowledge is the key…
When an asset manager has only observed the conventional capital raising experience, the underwriting and financial engineering required to affect capital formation at institutional scale while preserving autonomy can often seem dauntingly complex and potentially demotivating. The desire for the goal can get lost in feelings of overwhelm.
That is why we have stripped the process down into two palatable steps…
We measure the risk, return, and liquidity of your strategy.
We introduce you with the risk, return, and liquidity measures of your strategy to the over 100,000 accredited investors and 10,000 financial institutions in our ecosystem.
From there, whatever incremental steps—if any—that are required to raise the capital you need to reach your goals will present themselves at the appropriate time and with the context required to understand why those steps need to be taken. The ultimate solution is necessarily bespoke per each firm’s circumstances, and we’ll do the heavy lifting.
Alternatively, the process could simply end with capital introductions.
The one commonality I’ve seen in all the asset managers I’ve spoken with—without exception—is that to have a productive conversation, they must have first either read The Shadow Banker’s Secrets: Investment Banking for Alternatives or watched the book’s companion masterclass. Those who have tend to wrap their minds around the ostensible complexity with relative ease, and the discussion progresses to individual-specific solutions rather quickly. Those who haven’t tend to force the conversation into frustrating dead-ends characterized by conventional questions seeking conventional answers with an inability and unwillingness to recognize anything that deviates. This is the reason I insist that asset managers get through The Shadow Banker’s Secrets before scheduling a call with me: it protects my time and yours.
To get introduced to the 100,000+ accredited investors and 10,000+ financial institutions in our ecosystem and scale to institutional-level AUM, take The Shadow Banker’s Secrets: Investment Banking for Alternatives Masterclass (upgrade your free book order) to learn the technical fundamentals you’ll need, then schedule your free private consultation.