Starting an equity fund

[Paul Ko]

Hi All,

Long time follower, first time posting.  We are getting ready to launch an equity fund for an opportunity we have found.  I wanted to get some feedback to see if our offered returns are "market rate" and to see if we need to change anything to attract investors.

1. Pref payments to investors paid out monthly at 4%

2. 100% profit split to investor to next 4% IRR (total 8% IRR to investor)

3. Waterfall up to next 3% IRR (Investor 75% - Sponsor 25%)

4. Waterfall anything over and beyond (Investor 50% - Sponsor 50%)

Depending on the deal, the investor is looking at 8% IRR at a minimum, and after profit splits they would be looking at between 11% - 18% IRR total.

Any feedback would be greatly appreciated!

[Brian Burke]

Welcome to BP (as a poster), @Paul Ko!

A 100% profit split to a specific hurdle is the same thing as a preferred return.  So really, items 1 & 2 are the same thing.  I think I understand your intent, which is to have a guaranteed payment for the first 4%, but I'd caution you against that.  This somewhat turns your equity into looking like debt if you have a guaranteed payment.  If income falls off dramatically such as happened in the great recession, where is that money going to come from?

Next you have a 75/25 to a 11% IRR. Probably wouldn't get a lot of objection there, seems in-range of a lot of offerings. Keep in mind that you are using IRR hurdles, which means that before the sponsor receives any profit splits all investor capital must be returned. This essentially means that the investors receive 100% of all distributions until they have their money back plus the 8% pref. Sponsors that don't understand this might start writing themselves checks earlier than they should--don't get caught in that trap. If you want to receive portions of the cash flow before all investor capital is returned you need to change your hurdles to an annualized return instead of an IRR and then your operating agreement would need to specify in what order capital is to be returned.

A 50/50 over an 11 would likely be perceived as being rich to the sponsor.  Usually you don't see 50/50 tiers until a higher hurdle such as 15% or thereabouts.  Sometimes not at all.

None of what I just said really matters, however.  Setting terms is really up to your audience.  If you have a lot of investors fighting to give you money, you have more leeway to set terms more in your favor.  On the other hand, if you have no audience and you are trying to attract investors, any terms that anyone tells you is "market" might not be good enough.

And finally, keep in mind that you don't "attract" investors with terms.  Not even with deals.  Nor projections.  You attract them with your track record and your trustworthiness.  You could offer your investors 100% of the deal but if they don't trust you or don't think you can successfully execute the business plan they won't invest.  Be sure to put that at the forefront--the terms are secondary.