New Firms market 'pledge funds'

Funds are finding it increasingly difficult to raise money from Limited Partners, after the past two years of global crisis and under performance, be it VC or PE funds. LPs are unhappy about the way things are being managed so far, including the opacity and general lack of control on the investments the fund makes. This has manifested itself in 2 ways.

One is that more LPs seek a fund where a significant portion is put up by the General Partners themselves. Many good funds already have this feature, but its other types of firms like investment banks or brokers which set-up a fund for the fee-income it generates that are under pressure.

Second is the emergence of pledge funds as a model. Pledge funds are a back-to-basics way of arranging deals where investors form a group and each investor is contacted for a specific deal and has the ability to accept or refuse to invest in the deal. A pledge fund’s structure from an LP’s perspective is fairly convenient. Its also a low cost alternative for the investor as the investor may have to only pay a small retainer to the GP for covering deal scavenging costs till the money is invested, after which fees on the invested capital as compared to the fees charged on the entire committed funds in a normal PE/VC fund structure. One can see it as investment banking which is not quick and dirty.

PE and VC funds are usually formed as limited partnerships where investors become limited partners and managers of the fund become general partners. LPs are typically a mix of institutions such as insurance firms, pension funds, university endowments and high networth individuals. The pledge fund GPs handle all of the admin functions of the fund much as one would expect at a traditional firm; source, vett, and scrub deals for its members. It is the members that ultimately determine what deals they participate in. Traditional PE or VC firms, by contrast, typically offer their limited partners little to no say in what deals the fund invests in and in overall day-to-day firm operations.

The entry barriers for setting up such firms are low. One only needs to be in the know and be known among a group of investors. Till the deal doesn't come along they don't have go through registration and regulatory formalities. Also, GPs sometimes choose to work with greater flexibility; a pledge fund as opposed to a regular fund structure enables this. Infact many retired bankers and VCs are involved in such funds in US.

One major difficulty for the pledge fund structure is the seller may not take a fund seriously, especially in the PE space where large more complex deals happen. Hence this model may remain limited to smaller deal sizes. Even the risk each LP takes is higher as the LP doesn't spread his risk across as many investments as the traditional PE structure, dictating smaller deal sizes.

Also the time taken for the money to come in, after getting investor approval, may cause the deal to slip away to other 'funded' PE firms. One variant of the pledge fund structure that takes care of this is the warehousing model, in which the investor allocates a corpus, but does not release the money. Instead, the GP has to source the deal and execute it before more funds can be allocated.

VC's do not face these challenges as the deal sizes are small and the cash has to come in a phased manner. Infact the purpose of the entreprenuer is served better as traditional VC funds have gone more late stage because they now have to raise and invest larger sums of money. It is bringing back the angel investor to entrepreneurs who need seed capital the most, the small garage start-ups.

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