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One of the most common struggles I encounter with fund managers is being able to optimally set a fund target.
While this admittedly isn’t an exact science, there are some fundamental considerations that help guide this exercise:
Irrespective of the amount of capital necessary for a given investment model, managers must have a very good sense of the LP environment to be able to accurately assess viability of contemplated fund target.
From our experience we’ve found that teams with prior institutional track have commercial viability of approximately $25-$35MM/partner (seed), $50MM-$100MM/partner (Series A), and $100MM+ (growth). With limited or no prior experience, the numbers drop to about $10MM-$20MM/partner at seed, with little to no appetite for Series A and later. This is why well over 85% of new firms formed over the last five years have been seed firms.
One quick heuristic test I encourage managers to do is to test viability by going to all of their strong 1st degree connections to determine how much can be circled with a high level of confidence (always discount using probabilities as the chasm between verbal interest and sub docs is HUGE). You generally want this to be at least 25% of fund target. Lower than typically comes with elevated risk of a fundraise that won’t meet target and will come with a whole host of issues like the manager chasing the wrong profile of LP’s and having to decrease fund target mid-fundraise (!).
Min/max for investment thesis
This exercise is to determine the Minimum Viable Fund (MVF) size necessary to execute on thesis while concurrently positing the outer band of fund size after which point the investment business model holds. The latter is often expressed as a hard cap on maximum fund size.
The easiest way to determine MVF is to think carefully through portfolio construction. I.e. if the goal is to lead seed rounds with initial checks of $500K-$750K, with 20–25 companies, and a reserve ratio of 1:1, your MVF calculation would yield a fund size of approximately $20MM ($500K*20 companies)*2 (reserves). Any amount less than that would impact thesis and economic framework.
Conversely, raising a $75MM fund would be well outside the outer band of this thesis, and would give rise to a completely different business model, with different competitive parameters, etc.
I’d encourage setting a fund target that is no more than 1.2X of MVF with a hard cap that is no more than 1.5X of your target.
I sometimes see fundraising ranges that extremely broad such as $50MM-$125MM — This can send a signal to prospective LP’s that you don’t have a good handle on your business model, and will confuse LP’s on what your product is.
One last point to contemplate when considering min/max is considering medium-long term objectives. I’ve observed too many managers assume that scaling fund size is just a natural linear progression resulting from traction on portfolio metrics. While portfolio traction is unquestionably critical, it is imperative for the manager to be able to demonstrate that a jump in fund size offers similar business model characteristics.
To note, going from $10MM in a Fund I to $40MM in fund 2 translates to a very different model (leading rounds, strategic reserve planning and allocation, institutional operating infrastructure, etc.). Sophisticated LP’s get concerned with large jumps in fund sizes because of the implied business model changes that are often associated.
A general rule of thumb is anything over a 2X jump in fund size changes business model parameters (for very small funds <$10MM, the number is probably closer to 2.5–3.0x). While aspirations for the next fund’s size cannot be a primary consideration when sizing your current fund, it cannot be discounted completely.
How much is needed for the manager to subsist personally?
While it is true that many first time fund managers have experienced prior success in business prior to raising a first fund, every manager still needs to assess how much income is necessary to align with lifestyle needs.
The answer here is highly personal, but honestly determining this is paramount as wealth acquisition is a long term proposition for new fund managers, and opportunity costs cannot be ignored.
To make this tangible, let’s view a common example of a $20MM Fund I with a 2.5% management fee during the investment period (single GP).
The economics may look something like this in the first few years:
Management fee $500,000
Office/various admin expense — $50,000
Associate — $125K
Pre-Tax Income for GP — $325K (post tax income ~$200K assuming Bay Area).
Assuming a 1% GP commitment into the fund, with 25% drawn in year 1, this reduces total cash flow to about $150K in a year — hardly comfortable for those living in major metropolitan areas. With a 2nd fund likely 2–3 years away (which will likely bring in other expenses necessary for scale), managers have to set fund targets that enable them to operate without great personal financial burden. LP’s do not want to managers that are overly burdened financially as it could naturally give rise to performance issues and misaligned incentives.
Setting the right fund target needn’t be an exact science, but also shouldn’t be complete guesswork.