Intangible Capital Value

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Investment in unlisted companies: private equity

Published on: 01/08/2023
By: Erwan Coatnan de Kerdu

Who finances investment funds?

Unlike business angels, who are individuals who invest their own money, VCs invest money from individuals and companies. These financiers are called limited partners (or LP’s). An investor wishing to create his investment fund will have to convince a multitude of LP’s to finance his structure.

LP’s can be :

  • Institutions: banks, large groups, family offices, pension funds…
  • Individuals: entrepreneurs, industrialists, investors, any person with significant financial assets.

On average, the creation of an investment fund – and especially its financing – will take between one and two years. You can see that the process is longer than that of a startup fundraising (between 3 and 9 months). Most of the time, it will require more than 200 first meetings with as many LP’s and then multiple meetings to convince the LP’s to invest.

How is an investment fund structured?

The LP’s will invest in a management company that will be managed by the general partner(s).

The GP’s are responsible for the management company and therefore for the investment fund. Their responsibilities are referenced in a document that binds the GP’s with the LP’s: the Limited Partnership Agreement or LPA. This document contains :

  • the terms of the partnership
  • the investment strategy of the fund
  • the responsibilities of the GPs and the LPs.

What is the business model of an investment fund?

A fund earns money in two ways: one is to pay itself while the fund’s money is deployed, and the other is to reward investor performance.
This is the 2/20 rule.

1/ The 2% management fee: each year, the investment fund will be able to pay its operating costs (salaries, offices, travel, etc.) using 2% of the total amount of the fund.
If you are in a €100 million fund, €2 million is allocated each year to fund expenses. These management fees will be used for about 7 years, i.e. 14 million euros out of the 100 million.

2/ The 20% carried interest: do we pay the musicians at the end of the ball? Not quite true in the VC world but not far off. The GP’s share the profits of the fund with the LP’s once the fund is closed, between 10 and 12 years after its creation.

  • 80% of the fund’s profits are returned to the LP’s
  • 20% of the profits go to the GP’s (and the fund team depending on the internal allocation).

This aligns the interests of the stakeholders of an investment fund and it is with carried interest that investors can make substantial gains.

How and when are funds deployed?

The life of a fund is 8 to 12 years. This is composed of two phases:

1/ Initial investments during the first five years

The investment fund will deploy 40 to 60% of its available money in startups that it will have to source, analyze and finance. In general, an investment fund will make between 20 and 30 deals during this period. This corresponds to an average of 4 to 6 deals per year.

2/ Reinvestments or follow-ons

Venture Capital is a risky business – from an investment perspective. Each fund will see some of its startups fail to achieve the potential hoped for at the time of the initial investment.

The fund will keep a reserve to fund the most successful startups when they do further rounds of funding. This allows the fund to avoid being diluted between rounds and to optimize its multiples on its potential winners.

There are several schools of thought depending on the type of investment fund (size and stage of investment) but the reserve for these deals is around 40 to 60% of the fund’s total.

Return on investment and fund performance

LP’s invest in this type of fund with the ambition of having a higher return on investment than what other less risky investments can offer. A typical return expected by LP’s will be around 2.5 or 3 times the amount invested. A €100 million fund will therefore have to make between €250 and €300 million, i.e. €150/200 million in capital gains.

There are several points to be drawn from this analysis:

  • the larger the fund, the more difficult it is to have a multiple of 2.5 or 3
  • the fund will automatically be looking for startups with the potential to achieve a high valuation and/or a significant sale within 5 to 7 years.

Let’s take the example of an investment for a €100 million fund that invests in a startup for €2.5 million against 20% of the capital (valuation at €12.5 million post money). This startup then raised two more rounds of financing before being bought out for €150 million, five years after the fund’s initial investment. After the two fundraisings, the fund holds only 12.8% of the capital – considering that the two fundraisings lead to dilutions of 20% each. The fund will therefore recover 12.8% of €150 million, or €19.2 million. This gives a multiple of 7.8 on this investment. A nice result but not enough to return the fund’s money.

Obviously the fund will invest in about 20 other startups but the reality of the startup world is that out of 20 to 25 investments, only a handful of them will achieve a significant multiple, the majority of startups will never return anything to the fund and another part will return between x1 and x3.

This is the mathematical reality of an investment fund and it guides the choices of investors. That’s why not every company can get VC funding. Raising money with VCs is going to force you to take a trajectory that allows your startup to get bought out for several hundred million or billion euros, all within a timeframe of less than 10 years, more likely 5 to 7 years.


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