PITFALLS MANAGERS SHOULD AVOID

People who are raising investment funds for the first time frequently ask about the pitfalls successful first-time fund managers avoid. Although the list below is not exhaustive, I rank the following among the more common pitfalls.

1. Raising a fund without the benefit of legal and accounting professionals. Successful first-time fund managers avoid pitfalls by obtaining advice of experienced and reputable legal counsel and accountants early in the fund formation process. They engage legal and accounting professionals to advise on structuring, tax, legal, regulatory and accounting matters, including drafting a well-developed term sheet and definitive documents that reflect the final structure and terms of the fund. Laws, rules and regulations governing private placements of securities, including those relating to marketing, are complicated, and in some cases, counterintuitive. Further, the securities laws that apply to investment funds vary by state and each foreign jurisdiction has its own registration, disclosure and other requirements and restrictions. Engaging professional advisors before starting a fund formation project can help a first-time fund manager avoid costly missteps.
2. Inexperienced or ineffective Management Team. Prospective investors and their representatives and agents evaluate management teams based on the teams’ level of expertise, ability to source, evaluate and manage investments, previous investment performance and experience investing together. First-time fund managers often face tougher scrutiny than more seasoned managers. Successful first-time fund managers are very discerning in building their teams, choosing leaders with relevant knowledge, experience and networks. Successful first-time fund managers also are diligent and deliberate about creating and presenting a track record of performance that demonstrates their superior investment acumen and risk management capabilities. They also choose team members who communicate and collaborate well with each other, as well as with founders and portfolio company management. Those managers prepare for the teams’ growth and are forward-thinking about compensation and promotions. Inexperienced or ineffective management teams often splinter, leading to key person events or early dissolution of the fund. They also elicit assistance from industry experts and other advisors with experience in fundraising, investment sourcing, portfolio management and other relevant areas to work along with the management team.
3. Inability to articulate a clear strategy or thesis; lack of focus. First-time fund managers sometimes have difficulty limiting themselves to one strategy and clearly articulating their thesis. Additionally, during difficult fundraising periods, some fund managers try to appeal to a large swath of investors by embracing a multi-pronged strategy with no real focus. Successful first-time fund managers understand that investors tend to be wary of “mission creep” and do not reward young managers who do not focus on what they do best.
4. Chasing improbable investor prospects. Successful first-time fund managers target investors that are most likely to be interested in their products, based on the proposed size of the fund, investment focus, thesis and strategy. Those managers perform substantial diligence on prospective investors, create networks of like-minded investors and only pursue likely candidates. Seeking improbable investor prospects burns valuable time that could be spent marketing to suitable investors. A new fund manager must know its fund and the most appropriate target market, and not try to be everything to every investor.
5. Underestimating the fundraising timeline. Fundraising for first-time fund managers frequently takes 18 to 24 months or more, even for small funds. Successful first-time fund managers are realistic about the fundraising timeline and establish reasonable investor expectations for the fundraising period. Fund documents should reflect the timeline the fund manager believes will be achieved in light of market conditions then existing and other factors that are relevant to the fund.
6. Having insufficient back-office support. Operating an investment fund is challenging, particularly while fundraising. The accounting, reporting and investor relations functions are critical to investors and savvy investors often ask targeted questions about a fund manager’s administrative competencies and capabilities. Successful first-time fund managers either have an internal team with the necessary skills and time to handle operational and administrative functions, or they outsource the duties to experienced and reputable service providers. A lack of sufficient back-office support can be fatal, particularly to a nascent investment fund.
7. Offering unrealistic terms. First-time fund managers are often unrealistic about the investment terms they offer to prospective fund investors. Some believe they should start aggressively and pull back if those terms are rejected, while others believe they should acquiesce to every investor demand. Successful first-time fund managers focus on the long view and start with reasonable fund terms designed to align the interests of investors and fund management. Those managers consider and balance competing interests with a view to acting in the best interest of the fund as a whole. They are judicious about granting investors special rights and they negotiate economic and governance provisions that are fair to investors and the management team. Successful first-time managers are realistic about the needs of the fund and the management team and will not offer terms that will bankrupt the fund manager, cripple its growth or create disincentives for current or future team members who are responsible for the fund’s success. In addition, successful first-time managers do not set themselves up for failure by ignoring or being unrealistic about the limits of their resources, including human capital, and agreeing to administrative, operational or reporting duties that the manager’s infrastructure cannot handle.