Develop an Economic Model
Besides demonstrating the financial potential of its pipeline, a fund manager must demonstrate that it is a sustainable business capable of paying for its own operating costs. Fund economics, the capstone of the fund design process, integrates the important elements of the fund’s structure and operating model, highlighting inter-dependencies and ultimately helping the fund manager make potential tradeoffs and decide whether or not a given fund strategy is viable. Fund design and operational modeling must culminate in a financial model that accounts for these costs, as LPs will look closely at a fund’s economic model before investing, to ensure that it is credible.
A strong economic model is the main tool fund managers have to demonstrate how their investment strategy is viable and when and how their investors’ capital will be deployed. A fund manager that cannot articulate a strategy for managing key fund features like management fees, carried interest, and capital deployment draws strong and immediate caution from investors. Furthermore, strong fund economics can help a fund better understand any potential internal inefficiencies in their capital allocation strategy and develop a more realistic approach to manage the flows of capital.
Three important considerations to remember when developing coherent fund economics are:
- Create a model that integrates all factors of fund management and investment strategy into the fund economics.
- Understand the interdependencies between the various factors.
- Given a limited budget, determine the best way to make the economics work.
Creating a comprehensive model
Just as fund managers create financial models to evaluate their investees, they must create similar models to understand their own economics. Fund managers should be able to answer questions about the following core elements of their fund’s economic model: fund size, investing returns, cash flow, operating budget, and deal instruments.
- Fund Size:
- What is the expected capital commitments for the fund?
- What is the type and size of investments to be made?
- Investing Returns:
- What are the projected gross returns for the fund?
- What are the projected net returns to investors?
- Fund Cash Flow:
- What are the projected reflows of capital to the fund from investees?
- How are these reflows to be used?
- Operating Budget:
- How much does it cost to run the fund?
- Is the management fee sufficient to cover these costs?
- Deal Instrument:
- What type of deal instruments is the fund using?
- What are the projected loss rates for investments?
Fund managers should look deeper into the sub-components of each element to arrive at accurate estimates. For example, payroll is an important determinant of the operating budget and overall economics. One must analyze the hours it will take on a practical, day-to-day level to screen and perform due diligence on the volume of deals expected. With an accurate estimate of hours required, fund management can determine the ideal team size, salaries (depending on market rate), and, ultimately a full payroll cost estimate. Fund management must also consider whether impact screening adds additional hours to the due diligence process and, if so, how many.
Understanding the interdependence between elements
The economic model of the fund must be dynamic so that fund management can see the financial tradeoffs of potential business decisions. Changing one budgetary factor will impact others, and fund managers should be able to explain to investors the tradeoffs that were made and why.
The type of deal instrument a fund uses to invest in portfolio companies has implications for fund economics. This guide focuses mainly on private equity funds. Equity investments typically take longer to start generating returns than investments with other instruments and, depending on how a deal is structured, can tie up investment capital for quite some time, impacting fund cash flows. Debt investments, by contrast, have much earlier, more predictable cash flows back to the fund, which may be used as operating funds (depending, of course, on a fund’s LP agreement). Instrument type and cash reflow usage therefore affect the calculation of the fund’s operations budget and internal rate of return (IRR).
Economic modeling shows fund managers that fund design is an iterative process, informed by and informing the fund’s investment and impact thesis, foundation, and structure. An economic model is not completed on the first try. Rather, a model is a tool that helps a fund manager to identify where changes are needed in order to make all elements of their fund strategy come together in a coherent whole.
Making the economics work on a limited budget
Funds have an operating budget from which they conduct their business activities, principally investing, but also post-investment support, back-office, and other types of administrative details. As with any business operation, the budget is limited. Fund managers must review their designs to ensure they have included the most accurate underlying assumptions in their model and can modify the design accordingly. The fund may consider different adjustments to make the economics work (Figure 4).
Generating Returns for Investees
Any fund is only as successful as its portfolio companies. For investees to generate sufficient financial returns, the fund must help its portfolio companies improve their internal rates of return (IRRs). A fund can help its portfolio company increase profits in four ways (Error! Reference source not found.).
- Earnings growth comes when a company increases sales or is acquired by another business. A company may increase sales by, among other means, improving the quality of products or services it offers, making strategic changes to their price point, effectively marketing to new segments, or better understanding its target clientele. Quality management is essential to facilitate this kind of growth and should be supported by the fund management team. Sales can also increase as a result of acquisition. Executing an acquisition requires the fund manager to find a successful company with the willingness to sell, with a large upfront investment to buy out the owners and subsequent work to merge operations.
- With margin expansion, a company maintains the same revenue but operates at a higher margin either through improved production efficiencies or by adjusting the mix of products produced. Production efficiencies may improve by reducing production costs, increasing economies of scale, or improving efficiencies along the supply chain. These improvements require quality management at the company level to identify and act upon these efficiencies, alongside a flexible, quickly adaptable labor market. Improved efficiencies can be identified by recognizing a shift in market needs, a new training opportunity for labor, or a potential opportunity for better resource efficiency.
- To improve transparency and governance, a company may train and hire trustworthy staff that align with the impact and business objectives or set monitoring and incentive mechanisms for their team - to name a few strategies. This can help them obtain higher prices for their product or services, as buyers and other stakeholders feel more informed and protected.
- Multiple expansion through greater market share or profit growth occurs when the company’s operations do not change but attract a higher price because either (1) the company has reached a size at which it is a viable IPO (Initial Public Offering) candidate or attractive as an M&A (Merger and Acquisition) target or (2) high expectations of future profit growth are built into pricing.
Figure 5 illustrates how these strategies work in practice.
For impact fund managers, the use of impact data can help expand earnings or margin and inform the ways they engage with investees. The Business Value of Impact Measurement
report from the GIIN highlights ways in which impact investors and investees use impact measurement practices to inform investment and management decisions to drive business value:
Measuring social and environmental performance can help investors drive growth in the revenue of companies and projects in which they invest—primarily by enhancing their understanding of customers, which enables serving them better. Most businesses (regardless of impact intent) track some information about their customers and seek their feedback on product and service offerings. Impact investors, however, often seek to understand customers’ needs and usage of products and services through the lens of the impact on customers’ lives and on broader community well-being. Such data can lead to more effective marketing, identification of new customer segments, product development, and optimal product pricing—all of which ultimately result in revenue growth.
Examples of data used to drive revenue growth include customer income levels and degree of access to services such as energy, finance, and healthcare. These data can be gathered prior to investment—through either existing census-type data or original surveys—to serve as a measure of potential for impact. They can also be used during investment management to inform business strategy by segmenting and better understanding customers. Impact investors and their investees can then track the reach and evolution of product/service usage to prompt adjustments to investees’ strategy and operations.
On the GIIN’s survey of the state of impact measurement and management practice, 37% of respondents use impact data to improve investees’ operational efficiency, and 31% help investees design or refine products and services.
Gross versus Net Returns
When a PE fund does eventually begin to earn returns from its portfolio companies, it is important to measure both gross and net return. Gross return is what the fund earns on an investee, while net return is what an investor earns on the fund. The difference between these two types of return is the gross–net gap, which can result from organizational costs, management fees, expenses (legal, audit, board meetings, etc.), carried interest, or poor cash management. Investors will want to understand this gap, which can be significant and, sometimes, controlled and improved (for more, see the section on modeling fund economics).
Until a fund begins to earn a profit from its investments, the IRR remains negative for the fund and for all of its LPs. Most LPs see no revenue until the fund starts exiting investments, usually several years (typically six or seven) into the life of a fund.
Funds must track their IRR over the life of their investments and across their portfolios. For a strong-performing fund, a typical J curve (Figure 6) will be shallow during initial capital deployment and lumpy and steep once the fund begins to exit its portfolio companies. A fund manager should aim to reduce the depth of the J curve with each subsequent fund by improving portfolio company IRR more efficiently and thus generate returns faster. First-time fund managers will come under acute pressure from investors to prove their capacity and produce returns. The J curve illustrates the lack of liquidity implied by the typical PE fund structure. It is hard for such funds to attract institutional investors that require a certain degree of liquidity, such as pension funds. In order to ensure liquidity and offer options for early cash redemption, funds can structure themselves as debt or quasi-equity funds.
Figure 6: The J curve
Fees and returns (Figure 7) are structured to align the interests of the fund manager and the LPs. Private equity fees, an important point of negotiation between fund managers and prospective LPs, comprise two types: management fees and performance fees. PE funds typically charge management fees around 2%. Expenses amounting to more than 2% to 4% of the fund signal to LPs that capital is inefficiently allocated. The agreement between fund and LPs regarding expenses must be incorporated into the private placement memorandum (PPM).
The fund manager is compensated through both the management fee and the performance fee (or carried interest); however, fund managers should focus on maximizing carried interest, not the management fee. Fund managers typically receive a management fee calculated based on actual capital deployed into deals. Some managers may never get paid the full management fee if they never invest the entirety of the fund capital. In many ways, a fund manager borrows money to be returned to LPs with interest before any of the returns come back to them.
In general, fund managers receive an upfront 1% from LPs for fund launch costs and then receive the remainder of management fees later. Remaining fund expenses (legal expenses for the fund and investments, audits of the fund, fund administration, and fund communications) should account for less than 0.5% of the fund. The performance fee or carried interest is typically 20% of the fund’s profits from investments.
Fee Life Cycle & Calculation
Figure 8: Fee life cycle
During the investment period of a typical PE fund, the fund manager earns a percentage of the committed capital (typically 2%) through the management fee. That is, once investments are made into portfolio companies, the fund manager typically earns 2% of the cost of the portfolio investments. The cost of the portfolio goes down every time an exit is completed (Figure). The initial drop in the J curve is what is actually invested without fees. The implication, then, is that a fund will run out of money for expenses if relying solely on management fees. This can only be mitigated by raising another fund or earning a carry. If no carry seems likely in the near-term, the fee structure can become a disincentive for a manager to exit.
Carried Interest and the ‘Payment Waterfall’
Before the fund manager receives any investment revenue, the LPs must receive all their invested capital back plus an additional profit, termed the hurdle rate, which is usually a percentage of the disbursed investment amount. After LPs receive their investment and the hurdle rate, the remainder are capital gains, typically split 80/20 with the fund manager. While this 20% is a typical carry, this number is important to agree upon as part of investment terms with LPs.
Figure 7: Payment waterfall
 Hannah Schiff, Rachel Bass, and Ari Cohen, The Business Value of Impact Measurement (New York: The GIIN, August 2016), 7, https://thegiin.org/research/publication/business-value-im.
 Mudaliar et al., State of Impact Measurement and Management, 47.