What Is a Pledge Fund?

A pledge fund is a type ofinvestment vehicle in which the participants agree, or "pledge," to contribute capital to a series of investments. Unlike ablind pool, contributors to a pledge fund reserve the right to review each investment prior to contributing. If they do not approve of the specific investment being considered, they can refrain from investing in that particular project.

Pledge funds are a common approach toventure capital investing among investors who wish to retain control over individual investment decisions.

Understanding Pledge Funds

The concept of pledge funds gained popularity following thedotcom bubble of the late 1990s and early 2000s. During that crisis, blind pool funds which had made aggressive investments in technology companies faced enormous losses. In response, investors turned to alternative approaches that might permit greater oversight of the investment process.

For these investors, the main virtue of the pledge fund format is that it does not force individual investors to back ventures they do not wish to invest in, but which the majority of investors support. Rather than being coerced into taking part in these investments, pledge-fund investors can opt in or out of investments on a case-by-case basis. For many investors affected by the dotcom bust, this was a welcome innovation.

Although it has its roots in the technologystartup sector, pledge funds are used across a variety of industries and are not restricted to early-stage investments. Indeed, because of the added flexibility which it offers to investors, pledge fund managers may find it easier to raise capital using this model as compared to blind pool funds.

Aside from allowing investors discretion over whether to back specific opportunities, pledge funds are generally structured in a manner similar to conventionalprivate equity funds. The cash contributed by investors is held in aspecial purpose vehicle, which is used asequity capital when financing acquisitions. The money raised is also used to fund administrative expenses andmanagement fees.

While the pledge fund structure offers greater control to investors, it also has potential drawbacks. Specifically, pledge funds may be less able to take advantage of time-sensitive investment opportunities, because of the lack of certainty around investor capital. Similarly, pledge-fund managers may have difficulty recruiting third-party investors to assist in large deals, since the individuals involved in the pledge fund might differ from one deal to the next. 

Lastly, sellers with multiple suitors may prefer dealing with a more traditional fund structure in whichpermanent capital is already in place—especially if they wish to close as quickly as possible.

Real World Example of a Pledge Fund

Suppose you are the manager of a pledge fund specializing incommercial real estate acquisitions. You develop a strategy document outlining your investment approach, with several examples of potential acquisition candidates. Based on your market research and financial modeling, you receive preliminary interest from 10 investors.

Because you are using a pledge fund model, your 10 investors do not contribute capital into your fund initially. Instead, they agree to review each investment individually and then decide whether to invest capital in each proposed deal. With that general commitment in hand, you set out to find and develop potential deals.

Because of the flexibility you offer to your investors, you were able to find 10 backers relatively quickly. Some of them were specifically seeking the control that your pledge fund provides, and they would have been uncomfortable if you had used a blind pool model.

On the other hand, your pledge fund structure is not without complications. Specifically, it prevents you from knowing with certainty how many of your investors will choose to invest in a particular project. For that reason, you cannot be sure whether a given project might be too large for you to tackle. Similarly, when negotiating with sellers, you need to project confidence that you can close the deal despite not knowing for sure whether your investors will provide the needed funds.