The Bones of an Investment Fund

Woo! Welcome back to Investment Fund Secrets. I'm Bridger Pennington, and today I want to talk to you about the bones of a private equity fund. Alright guys, welcome back to the show. This has been an exciting last little bit. We upgraded the studio a little bit, as you can tell. We got a brand new mic, so hopefully you guys can hear us a little bit better. And then also, we just finished our quarter distribution to our investors. It went fantastic. We've been doing really, really well lately. I'm not going to make any earnings claims or anything on this podcast and this show, but One of my investors, he's actually a former Fortune 500 company CEO, fantastic guy. I sent him out the distribution, he was really excited, we did really well, and he said this, his words, not mine, he said, I like 50% returns on money. Keep the fire burning. Hope you guys are having fun this summer. Thanks. Pretty cool. Our investors are stoked, and like I said in that last episode, when you get investors good returns, it cascades into more investors and more money, and it's a lot easier to find capital because you start proving out your track record. Even if it's small. So today though, I want to talk about the bones of a private equity fund, the actual infrastructure, the deep dive into how the entities are set up and how you structure your fund. In the last episode, I talked about incentivizing investors when you start your fund. You want to do certain things to incentivize those investors to make it very easy and a no-brainer for them to give you money. First, I want to tell you a quick story. Last year, I was meeting with two guys. They called me in. These both these guys are twice my age, and one of them is a real estate investor. He's done hundreds and hundreds of real estate deals. Seriously, he's fantastic. The other guy had ran about a twenty million dollar fund. He'd done lots of other deals and companies, and they both invite me in. We sit down. They had proposed an idea to start a fund that we were going to go buy opportunity zone properties. If you don't know what opportunity zones are, you real estate guys out there. So opportunity zones are the IRS a little bit ago said. For anybody that takes an investment, you can take your capital gains from the stock market, whatever, and moves it into opportunity zones. If you hold that property and double its value by, you know, building it up, renovating it, whatever, for 10 years, you will pay 0% tax on all of your previous investments and the 10 years. I mean, it's seriously incredible. So people are flooding money into the opportunity zones right now, and we were ready to jump on this. This was our idea, and they— we'd start talking about it and milling this around. There's a lot more to opportunity zones. That's the quick overview. But that's essentially what it was. And while we're sitting there, I was feeling a little bit incompetent, right? I'm with these really expert guys. They invited me in because I had ran a fund before a little bit, and, and I had some connections to help them raise money. As we were talking, I knew that they felt like I wasn't qualified to be there. And I even said it. I said, guys, before we begin, if, if you feel like I'm not going to be valuable to this partnership, this 3-way partnership we're starting, I'm totally fine to walk out the door. I don't want to be a charity case. I don't want to be a piggyback from you guys. In this deal. So I said, I want to add value, and they said, that's totally fine, Bridger, we understand. I said, great. So we sat down, we started talking, and as the meeting moved on, I needed to contribute somehow. You ever sat in a room and you just feel like everyone thinks you're an idiot? I started to rattle off a few things in a row that really jump-started me in that room alone, and these little secrets will change you. And when you talk to partners or other investors or other people that run funds and you can spit a few of the words and definitions I'm about to give you, It will bring your status way up. I was sitting there and I asked him one question. I said, guys, so how are we gonna structure this fund? What are we gonna do to incentivize investors? The real estate guy kind of looked at me like, what are you talking about? And the fund guy kind of knew what I was talking about. He said, go on, what do you mean? I said, well, what are we gonna do about a management fee, a pref, a carried interest? Are we gonna do a carryover, a catch-up fee? I mean, what are we gonna do with all this stuff? And the real estate guy, like, his eyes kind of went up and was like, what are you talking about? And the fund guy went on to test me. He said, well, what would you do for a management fee? And I said, well, honestly, it's our first fund together. I say we waive a management fee. I say we completely waive that and we say we give our investors an 8% pref. And what a pref is, is the first 8% on that case, right? The first 8% of all returns would go directly to the investor. Us as fund managers don't make any money unless the investor at least makes 8%. That's what a pref is. It's a preference to the investor. So it incentivizes investors. We don't make money unless they make money. And so I said, I think we should waive that management fee and do an 8% pref directly to the investor, and then after that, we can do a thing called a catch-up. And a catch-up is usually something to catch up some of that interest on the 9th and 10th percent or 11th percent. You can do whatever you want. I was suggesting, so the full 9th percent will come to us as the fund, and maybe the whole 10th percent will come to us as the fund. So just to review, first 8% goes to the investor as the pref. You can write that down, pref. And then the catch-up would be the 9th percent comes to us as the fund, and the 10th percent comes to us as the fund. And they said, what do you think about carried interest? Now, carried interest is the interest earned anything above and after the catch-up. So, you have first the pref, and then secondly, you have the catch-up, and then you have carried interest. And if you spit off carried interest, it's like a buzzword. People love it and think about it all the time. Carried interest is what we will split after. So typically most funds do an 80/20 split. So for us, I suggested, hey, anything above 10%, 80% of, let's say, the 11th percentile, 80% of that will go to the investor and 20% comes to us as the fund manager. And then for the 12th percent, we'll still do 80/20 split, and then the 13th percent, 80/20, and we can move on from there. And then even above that, once we hit maybe the 20th 20th percentile, if we've gotten like a 25% return that year, we should say anything above 20%, we get a 50/50 split with the investor. So it even incentivizes us even more to go out and get better returns for them. So, and as I talked to him about this, he started— his wheels started to turn. We got the whiteboard, we started writing things down, and he like— it clicked in his mind, wow, Bridger's smart. And he said, yeah, I want to be partners with you, man. You're smart, you're fast, you know what's going on. And I— it was seriously— I'd rattled off things for 30 seconds. That was it. That's That's all I said to him and he was like, wow, this kid's smart. I need him on my team. And I'm gonna walk you through each one of these definitions in just a minute and a few more things about fund structure, but that really perpetuated me into this fund and for us to go out and start structuring this deal together. So, I wanna pull out the whiteboard real quick. For you people on podcast, don't worry, I'm gonna talk you through it. It's more to help me just visualize everything. If you're on the YouTube channel, awesome, you're gonna see everything, but I'll talk you through so you're not gonna miss anything out on the podcast. Alright, so this is our handy-dandy whiteboard and we're going to talk through the bones of a private equity fund and everything that's involved with it. So buckle up, let's go. So on this, if you're on the podcast, it's fine. We have in the middle, I drew a big box that says general partner, okay? We call it your GP. Now, that is your— pretty much the top owner and entity of a private equity fund. It's your GP, your general partner, okay? And you want to be, as a fund manager, an owner of the general partner. So for me, my company, I have a general partner called Blackbridge Capital. That's the name of the general partner, and that general partner can launch funds, as many funds as it wants, right? So that general partner primarily will own all the funds. So you can have Fund 1, Fund 2, Fund 3, all underneath that general partner, okay? Now the funds, when I mentioned fund, those actually are limited partnerships. So next to this we have a long skinny box, and I'm calling that the limited partnership, okay? So the The general partner owns a limited partnership. Now that's what you call the fund. The general partner oversees everything that's going on in that fund or limited partnership. It is the general partner. It manages everything that's going on inside of that thing. Because it's a limited partnership, you also need other people in there, and those are your limited partners. Okay, those are your investors or LPs, and your limited partners or investors will invest into the limited partnership. So you got LPs coming into the limited partnership. Which is owned and governed by the general partner, which you own as the fund manager. Now, it's very, very crucial when setting up your fund, you need 2 documents, and these documents are what we call the— a lot of people call them the Bible. These are the LPA, that's the Limited Partnership Agreement, and the POM or PMM, but Private Offering Memorandum. We call this the Bible because it has all the bylaws and everything that goes into the fund of what you can and cannot do. So if you're starting up a real estate investment fund, right, you have— you set up your, your general partner, you own that. You're going to set up a fund, and then you're going to set up these 2 documents: an LPA and POM— limited partnership agreement and then private offering memorandum. And in there, you're going to say, hey, this fund is all about real estate. We are going to only buy real estate, and we're going to buy multifamily real estate under the direction of the general partner. What that means when you say that is if somebody comes along and says, hey man, Hey, we have this awesome venture capital deal. You can invest in this company. It's amazing. For this fund, you have to say, no, sorry, we can't do it. It's not in our Bible. If it was in the Bible, then you could do it, but in the Bible, you said it's going to be a real estate fund. So your investors signed it. It's got to be a real estate fund. Even if it's the best venture capital fund in the world, you can't do it. You could start another fund though, Fund 2 or Fund 4 or whatever you want to call it, and in that LPA, you could say, this fund, we can invest in other companies, and sure ahead, you can use that fund To buy that company. So these are your bylaws. In there, you're going to talk about the pref, the management fee, and all that, all that jazz. You're going to say, hey, we're going to charge a 2% management fee, we're going to have an 8% pref, so first 8% goes to the investor, the 9th and 10th percent are going to be catch-up, and then above that, we're going to split 80/20. You're going to have that written out all in the bylaws of the fund. What's cool about this is you get to write the Bible, you get to write the rules, you get to decide on everything. And a lot of times you'll put little little subphrases. So for instance, in your fund you can say, hey, investors must come in with at least a $100,000 minimum investment. That's the minimum we'll take. That's in the LPA, it's in the Bible now. But then you'll usually have a little subnote that says, unless the general partner deems otherwise. So that the general partner can deem exceptions. And you should probably invest into all of your funds. So let's say you only got 10 grand to put in. You'll say, okay, I'm giving myself, Bridger, an exemption, but I'm gonna put 10 grand in. And you can do that if it's in the LPA. If it's not written in the LPA, you can't do it. So So make sure to write that and write little clauses that lets you out of situations, that gives— gets you off the hook. Now in this, the LPA also says investors can't make investment decisions as long as they're an LP. These investors, as great as they are, and they might be the best real estate mind on the planet, cannot make any investment decisions. They can yell and cry and call you on the phone or whatever, and they have no control over the fund because they signed the contract. And you, as the general partner in the middle right here, the GP, have management over the limited partnership. So that's all in your LPA and your POM. So that's super crucial to nail, and that's why law firms and other legal teams charge a ton of freaking money for these LPA and PPM. They'll charge sometimes $30,000 to $100,000 to write this out for you. And that's when I first started my fund, I was like, oh crap, man, I don't want to spend $100,000 to set up a fund that I don't even know it's going to work. I'm young, I'm 21 years old, I'm starting a fund, right? My dad said, you don't need to do that. He said, we're gonna grab a couple old LPAs and POMs and you're gonna read through them 27 times. And so I sat down and started reading and I spent a month straight. I've told some people this story before and I spent a month straight reading through POMs and LPAs because I didn't have $100 grand to put into that. So I read all freaking night for 30 days and finally understood what all of the documents were saying and then I would go to my attorney and say, hey, let's change this and this and this. He said, oh, that's a great idea. Let's change this and this and this and he said, that's a great idea. And then he'd give me a few tweaks and ended up being less than $5 grand to set up my LPA and POM. For my fund, very simple tricks. If you put in the time, you can do this for not a lot of money. A few things just to review: number one, you know what a management fee is. It's typically right off the top. It's if you have a hundred thousand dollar fund, you'll take usually a two percent management fee. So two grand just right off the top for managing the fund. I recommend though, if it's your first fund, completely waive the management fee. Investors hate extra fees, and you're just gonna say, "I'm not even gonna charge it." Next, you have your pref. Or your preference to the investor, and typically it's a 7% or 8% pref. So what that means is the first 8% goes to the investor. After that, you have your catch-up, which is usually the next 2 percentiles, 1 or 2 percentiles, go completely, completely to the fund just to catch up the fund a little bit, to make the fund a little bit more money. And then above that, you'll usually do something with carried interest. So a typical fund will do 80% to the investor, 20% to the fund as carried interest. Also, to review, you have your general partner in the middle. That's the governing board. You're gonna own the general partner, and then the general partner launches limited partnerships, and then LPs, or limited partners or investors, can invest into the limited partnership. And that limited partnership or fund is governed by 2 documents, the Bible, the LPA or POM. So that's a quick run-through of the bones of a private equity fund. On future episodes, we're gonna dive deeper in this, but I wanted to give you a quick Quick segment and to help you in meetings and places that you can sound smart and get your foot in the door and know what people are talking about. If you look on the news, people are talking about carried interest all the time. That's one of the biggest things they talk about with Trump, especially in office, is carried interest because it is taxed really low. There is not high taxes on carried interest, and that's for a reason— to incentivize fund managers like me and you to go out and make a freak ton of money because funds help drive the economy in America. Love you guys, and I'll see you on the next episode. Yo! So if you're just starting out, you probably have a lot of questions. That's awesome. I want to hear them. So please go to investmentfundsecrets.com, submit your questions, and if I like your question enough, I actually want to bring you on the show with me to ask those questions live to me, and I'm going to bring on another investment fund manager to answer them for you. So if you're interested in that, please submit a good question on the website. Again, that's investmentfundsecrets.com. See you there. See you there.