Conventional wisdom – at least in the world of non-exchange-traded financial markets – says that if you want to build a financial services firm, you start by launching a first fund. When I was starting out after Wharton, a credible first fund required a $50 million capital raise. When I left Barclays/BZW to start Ariel Ventures, the minimum ticket had risen to $100 million. These days, the number I hear most often is $200 million. The size of the minimum first raise is, at least in theory, linked to economies of scale, which makes sense.
At the same time, I watched the evolution of first fund size in nascent Latin American early stage investment (ESI) go from $12-20mm in 1994 to $5-40mm in 2009. Although we’re starting to see larger first funds (Ignia, Leapfrog), the hurdle still seems to lurk around $40mm. Why the difference? Two factors often drive the definition of minimum ticket in emerging markets ESI is driven by (a) average deal size (small) and (b) the mistaken belief that “new manager” risk can be mitigated by limiting the resources available to a new manager. The latter leads to fee structures that are totally divorced from operating expense requirements and a lack of follow-on capital for growth. Do you really want the guy making your early stage investments cutting corners to make ends meet?
So, what does conventional wisdom say about how you turn your first fund into a firm? The answer is that you start a second or third fund as soon as you can. In mainstream VC/PE, how much time that takes is likely to be a function of how soon your first fund portfolio produces a solid exit, flashy valuation or generates enough buzz to substitute for performance data – but probably 2 to 5 years all told. Emerging markets fund themes that rely on money from development finance institutions (DFIs) – agriculture, microfinance, SME and so on – are slammed again by assumptions about new manager risk. Key man clauses that restrict business development activities, budgets that preclude industry association dues and “no new fund” restrictions that run for long periods of time are significant obstacles placed in the path of ambitious fund managers who dream of offering multiple products and instruments. Even if cream rises, and the best fund managers will eventually launch more than one fund, impact investment can’t afford to wait a decade for conventional wisdom to produce cream.
At minimum, it is worth considering that we might be able to find better ways of addressing new manager risk. Since the term “impact investment” dates to 2007, we are all, in a sense, new managers, making this a risk we want and need to manage effectively. Do we want to lock our best investment talent into small stand-alone funds? Wouldn’t business models that leverage existing talent/experience while grooming next generation talent make more effective use of capital?
As long as we’re putting the #impinv business model back on the table, let’s also put more thought into how we can use fees structures, compensation policies, career paths and risk-sharing mechanisms to align interests more effectively across key stakeholders. When it comes to ESI, your financial capital won’t grow much if you don’t have the right human capital in place, informed and motivated.
In the 17 years since the first commercial microfinance fund, ProFund, was launched, conventional wisdom has brought us half a dozen microfinance asset managers who AUM would just begin to qualify them as an emerging manager (AUM > US$1 billion) for a major investment banking house. #Impinv doesn’t have that kind of time, so let’s skip the “conventional wisdom” and start talking about what kinds of business models and structures can offer the most responsible and cost-effective impact investment products and performance right out of the gate.
By Lauren Burnhill (@LaurenOPV)