Friday Letter New reality bites for Duke Street

The UK-based buyout firm’s decision to give up on raising a fund and instead work on a deal-by-deal basis highlights the difficulties facing firms that can’t offer scale or specialisation.  

In recent months, we’ve heard whispers about various firms supposedly struggling on the fundraising trail. One of these, UK-based mid-market buyout firm Duke Street Capital, has obviously decided to give up the fight – at least temporarily. It said this week it had pulled fundraising for its latest €850 million-target closed-ended vehicle, and will operate on a deal-by-deal basis instead for the foreseeable future.

It’s unlikely to be the last.

Some of the fundraising problems facing these firms are beyond their control. The difficult exit environment is putting a squeeze on the distributions that allow investors to make new commitments. Europe is clearly a difficult sell to investors at the moment (Duke Street’s two main markets are the UK and France, both of which are fiercely competitive and macroeconomically unpromising). Many established LPs are actively trying to cut down their number of GP relationships, so they are all too eager to find reasons not to invest. And with so many funds either in the market or about to come to market, competition is fierce.

You could even argue that switching to a deal-by-deal structure makes a lot of sense. Duke Street managing partner Peter Taylor told PEI: “We’d been facing the issues surrounding fundraising for a while and had been working on an alternative. The move to deal-by-deal fundraising gives us flexibility.” Some firms, like Quilvest Private Equity, have used the deal-by-deal model successfully for decades.

In the current environment, the fundraising process is even more time and resource-intensive than usual. By postponing it to a later date – Taylor insisted his firm would be back with a fundraising in 2013 as it moves to adopt a “hybrid” funding model – the firm can put some extra bodies to work improving its portfolio.

Equally, there are plenty of LPs who are wary about committing to a ten-year fund in the current climate, but still want to invest in deals. Taylor said his firm had even managed to locate some promising new pockets of capital from investors who didn’t want to invest in funds but wanted direct exposure to buyouts. So it should be easier to raise capital for a specific transaction, where investors have much greater visibility.

Then there are the internal economics to consider. Although there's no management fee, deal-by-deal funding means deal-by-deal carry. So if they can pull off a good deal, managers will enjoy the financial upside more swiftly than they would whilst waiting to meet a fund’s hurdle rate. This is proving a very strong incentive for smaller firms to eschew traditional fund structures, according to lawyers working in the industry.

But however hard you try to put a positive spin on this situation, it clearly bodes ill for some of the firms currently on the fundraising trail. After all, although LPs can clearly afford to be picky at the moment, they’re not sitting on their hands altogether. Funds are being raised, even in Europe.

Only this week, Clyde Bowers Capital, a Scottish industrial specialist whose principals have a strong operating background, closed its third fund on £420 million. The success of this fundraising illustrates the “new world” of private equity, according to chief executive and chairman Jim McColl. “Past private equity models had high reliance on financial engineering, but outside investors are now looking for added value from an operational team,” he insisted. “It is doubtful that the old model of funders supplying money without operating expertise will ever come back.”

This is only partly true. After all, the likes of EQT and BC Partners managed perfectly well last year despite being generalists. This was because of their strong track record, of course, but also because of their scale: diversification mitigates risk, just as sector specialisation does. But if you can’t offer investors either of these things; if you are, in the parlance, JAMBO (just another midmarket buyout group), you’re going to have a hard time attracting capital for a standard fund from smart investors any time soon.

And speaking of smart investors… If only we could be all be as savvy as artist David Choe, who way back in 2005 took stock instead of cash for daubing his graffiti on the walls of Facebook's HQ. If the company's float goes ahead as planned, his stake will be worth more than $200 million. Perhaps he can be persuaded to invest in the European mid-market?