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Directed Investment Funds …
Tags: case basis, difs, fund managers, fundraising, general partner, initiatives, investment company, investment funds, lps, partnerships, pipes, pooled investment vehicle, portfolio investments, ppm, private equity fund, prospective investors, sole purpose, target company, vc, willingness,Pages: 3
Language: english
Created: Tue Apr 11 16:59:36 2006
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Directed Investment Funds
Being Big Sometimes Means Starting Small For Unproven Fund Managers
_____________________________________________________________________________
Want to be a VC or PIPEs investor but don' have t on the detailed information provided in the PPM
enough of your own capital or the track record to raise a about both the target company and the terms of the
traditional fund? Consider starting and building your proposed investment by the fund into that
track record through the use of "Directed Investment company. Getting prospective investors to commit
Funds" or "DIFs". What is a Directed Investment to such an arrangement, therefore, is a lot easier
Fund? Sometimes referred to as a "pooled investment" because they need not actually "commit" to
or "pooled investment vehicle", it' essentially a fund
s anything more than a willingness to consider deals
just like any other venture or other private equity fund, as they come along and are presented to them on a
but it' sole purpose is to invest in a single deal only.
s case-by-case basis. In this regard, they need not
Rather than the general partner (GP) raising one large have to be convinced to trust the fund managers to
fund which then invests in and thereafter manages any make their ultimate iMnvestment decisions for
number of portfolio investments, separate limited them; if they like a deal, they can invest. If they
partnerships (LPs) are formed, and separate fundraising don' they can take a pass. And what makes this
t,
initiatives are pursued, for each target company an even more attractive to these prospective
investment. While, in practice, many of the same investors, and therefore an easier sell for unproven
investors participate in the various funds of a single GP, fund managers, is that, even if they don' like a
t
they are not usually identical. given deal and decide to take a pass, they can still
get a look at the next one when it comes around.
Directed Investment Funds are a particularly useful tool They don' have to participate, in other words, in
t
for aspiring fund managers. This is because the DIF every deal that the GP invests in. They can cherry
structure provides the GP with the same basic economic pick their deals on their own out of those
deal that it would get if it were managing a large, presented. And all the while, the GP' are building
s
traditional (i.e. multi-investment) fund (typically a 20% the track record that they' going to need to
re
carried interest and a 1-2% annual management fee), matriculate at some later date to a more traditional
but it affords the following distinct advantages over a fund structure.
traditional structure for the unproven fund manager:
s Allows Funds To Be Raised Over Much Longer
s Much Easier to Sell . The DIF structure makes it a Period. A traditional VC, hedge, or other private
lot easier to sell by an unproven fund management equity fund with a well-established GP will
group. This is because it provides a framework in ordinarily fully subscribe its fund over a 3-6 month
which prospective investors in each case are able to period, even if the fund is raising a billion dollars
decide for themselves what deals they actually or more. It just doesn' take them that long to sell
t
invest in, rather than blindly leaving that decision their deal because they have an existing reputation
to the unproven fund management team. What and network of well-known investors to go to, and
they' presented with in each case (that is, each
re they' raising money in very large slugs from
re
newly proposed deal) is a full-blown private institutional investors that have a compelling need
placement memorandum (PPM) for a prospective to keep their money fully invested. Since first-time
investment into a fund that has been specifically fund managers, in contrast, not only are going to
formed for the purpose of, and that has pre- have a much harder time raising funds generally,
negotiated a certain investment into (in terms of but are also necessarily going to have to be doing
type of structured security, valuation, amount, so from high net worth individuals who will almost
registration rights, warrant coverage, board seats, never invest any more than $500K at a time (and in
consent rights, etc.) a target company. Although most cases a lot less), the fund-raising process is
the GP in the fund maintains responsibility for going to take a long time (particularly for those
managing the investment during the holding period who are not starting with a strong Rolodex of these
(which, for these types of deals, can involve types). By using the DIF structure, the fund-
execution of any number of value-enhancing raising process becomes something an ongoing
strategies along the way, and, eventually execution aspect of the fund operation that the GP' just s
of an exit strategy), it' up to the limited partners
s continue to work at indefinitely.
themselves whether they want to participate based
1
s Avoids Having To Provide High Returns On s Smaller Deal Sizes . As a direct result of having
Uninvested Funds. One of the biggest problems to rely on high net worth investors, fund
faced by large VC, hedge, and other private equity managers that utilize the DIF structure are
funds is that they need to generate very high limited as a practical matter to relatively small
returns for their limited partners, even when much deals. Since, as noted above, none of these types
of their money is at times sitting on the sidelines of investors are likely to ever invest any more
uninvested in any given deal. The DIF structure than $500K at a time (and in most cases will
completely eliminates this issue because the fund invest considerably less), it is much more
generally only raises exactly the amount it needs to difficult for a Directed Investment Fund to make
make the target investment and pay the annual a sizable investment into any given target
management fee. The only exception is when the company. Except in the most unusual cases,
fund goes out to the same investors and raises more investments made by Directed Investment Funds
money for the same company for a later round. In will generally range from $250K to $10MM.
that case, too, though, only the exact amount
required is raised (including the management fee). s Challenge in Selling Structure . Even solely in
relation to high net worth prospects, it is
It is worthy of note that, for some, the DIF structure is definitely a challenge to get investors to
desirable for a somewhat different reason: it allows understand and appreciate the Directed
them to effectively go out and raise money for Investment Fund concept and structure and to be
companies (effectively acting as investment banker) willing to invest their money into a company,
without running afoul of the requirement of being a even if they like it, through something other than
registered securities professional and/or being a direct investment of their own. This is
associated with an NASD member firm (i.e. a registered particularly true when they learn that 1-2% will
broker-dealer). This is because, in doing so, such be taken out of the investment proceeds to pay
individuals are actually raising capital for their own the management fee to the GP, and 20% of the
venture (the fund, in which they are a principal) rather upside will be taken out and paid to them as
than for the account of others. well. The most effective way to overcome this,
however, is to emphasize the much greater
Notwithstanding the advantages cited above, Directed leverage afforded by the combined strength of
Investment Funds definitely have certain drawbacks as the fund (as compared to any single individual)
well. Consider, in this regard, the following: in making and controlling the investment, and
the continuing role of the GP in bringing to bear
s Highly Unlikely to Attract Institutional Investors . value-enhancement over the life of the
As noted above, use of the DIF structure means investment, protecting it from diminution in
that the fund-raising process will necessarily be value, and maximizing return on investment
focused (pretty much entirely) on high net worth upon exit.
"angel" type individuals, including doctors,
lawyers, investment bankers, senior executives, s More Work / More Management . Without
entrepreneurs, and other country club types. question, the DIF structure is considerably more
This is because institutional investors are highly burdensome and expensive in terms of legal and
unlikely to invest in a company through such a ongoing administrative management because
fund, either because they (i) are simply each investment requires a new fund and each
prohibited from doing so under the terms of their fund, at least potentially, has a different set of
charter or LP agreement, (ii) do not want to have investors. While there is not much,
to absorb the expense associated with the unfortunately, that can be done about this, it is
management fee or the dilution associated with important to note that the expenses associated
the carried interest, or (iii) are uncomfortable with this are generally passed along to the target
with the degree of control retained by them company at the time of investment (i.e. payable
inherent under such an arrangement. And out of closing proceeds).
although there are a number of so-called "funds
of funds" out there these days, none of them are s Impossible to Compete With Traditional Funds .
likely to consider a DIF because they invariably Like it or not, it is virtually impossible for
rely very heavily on the track record of the fund Directed Investment Funds to compete for deals
managers involved in making their investment with any of the big VC or PIPE funds, or even
decisions. any other big single (non-institutional) investor,
2
because Directed Investment Fund operators can management fee is sufficient to cover their
not possibly move as quickly as those other overhead and pay them a reasonable salary while
players can. Once they decide they like a target they wait to reap the rewards of their carried
and negotiate a term sheet that they are interest upon maturity and liquidation of their
comfortable with, the established funds can portfolio investments. Most traditional VC or
pretty much have their lawyers send over their hedge funds have at least $50MM under
documents with a check they cut. In sharp management, and, at 1%, that' a $500K annual
s
contrast, with a Directed Investment Fund, if you management fee. Many, of course, have half a
have your circle of go-to investors in place, billion dollars or more under management.
putting your fund PPM together and going out to Because the aggregate management fees from
them to get subscriptions in each case will Directed Investment Funds is unlikely to be
inevitably take some time. And if you don' t significant, at least for some time, most DIF
happen to already have your circle of investors in managers need to keep their day jobs until they
place, well ... it' going to take that much longer
s are able to harvest some investments and realize
(at least the first few times). any carried interest to which they may be
entitled.
s Frenetic Pace . It' a real scramble as a Directed
s
Investment Fund a lot of times because, after you In the final analysis, and despite these disadvantages,
have identified a target, and negotiated and for an unproven management group, the DIF structure
documented a term sheet, you have to prepare provides a practical and realistic opportunity to build a
the fund PPM and documents and go out to sell track record and reputation with investors for picking
the deal to your go-to investors as quickly as good investments, managing them effectively and
possible (at the risk of losing the deal if not generating strong returns, thereby eventually putting
locked up somehow in the meantime, which can them in a position, if they are successful, to move on
be very difficult or impossible), all the while and raise a traditional fund.
having to simultaneously conduct your due
diligence review on the target company and So, then, how does one get started with Directed
negotiate the definitive investment agreements. Investment Funds? As a practical matter, it usually
This process can become extremely unwieldy if begins with a good target company. Once identified,
not managed effectively because, further the would-be GPs will typically pull in legal counsel to
complicating matters is the fact that, many of the negotiate the terms of a structured investment and
go-to investors are likely to want to meet the prepare the documents involved, including the fund
target company management to size them up and PPM and the others to be used in the fundraising
ask questions directly. And you can only process. From there, it' about selling the deal to
s
imagine how crazy this can all get when GPs are prospective investors and, once closed, managing the
trying to tee up several deals at a time. investment through to a profitable exit. After doing this
a few times, and being able to evidence aggregate
s Never-Ending Sales Process . Finally, and while historic returns of 30+% per annum, it might be time to
perhaps obvious, for those that are far more consider moving on to the big leagues.
interested in analytics, deal structuring, _________________
negotiating, creating value, and the like
(common characteristics of effective fund Michael M. Membrado is a principal in the law firm of
managers), another disadvantage of the DIF M.M. Membrado, PLLC in New York, which specializes
structure is that it does actually require having to in corporate finance and securities and which
sell each deal to investors individually. This can represents private and public companies as well as
be very frustrating for those who feel they are investors. The firm' Website can be found at
s
worthy of being entrusted with that responsibility www.mmmembrado.com.
and who could happily do without the sales
process at all. For investment banking types
© April 2006 Michael M. Membrado
who thrive on sales, however, this might not be
considered a disadvantage at all.
s No Meaningful Current Income . Traditional
fund managers have the advantage of being able
to focus their efforts full-time on building and
managing their portfolios because their annual
3