Pitching for a slice of American pie

On the face of it, European GPs aiming to raise funds from US institutions could not pick a better time than now. “There is substantial interest in Europe from US investors, which has been growing apace in recent years and is now greater than ever,” says John Barber, a director of UK placement agent Helix Associates. “People in the US are frustrated by conditions in their home market, which in general is highly competitive and over-funded, and they perceive Europe to be a much more attractive environment.”

Barber's conviction stems partly from the recent experiences of his firm, which earlier this year worked with its US-based joint venture partner Monument Group on the placing of the €650m debut fund raised by Nordic private equity firm Altor Equity Partners. US investors contributed 40 per cent of the fund total (some €260m), in the process contradicting the received wisdom that first-time funds will struggle to attract capital from outside their home market.

Putting to one side the quality of the individuals involved, another explanation for Altor's experience is the sheer weight of capital being thrown at European mid-market funds by US investors and, as a concomitant, a relative shortage of quality product to invest in. “Sophisticated US investors are more open to investing in first-time funds than they used to be because there is a squeeze on European mid-market GPs of repute,” says Barber. “Many of those firms are not seeking particularly large amounts and tend to re-visit their loyal supporters, which doesn't leave much room for new backers.”

Altor says its fundraising was also precisely targeted. “We spoke to a small group of highly experienced investors,” says Frederik Stromholm, a founding partner of Altor. “We visited the US on three occasions and spent 11 days there in all. We only saw potential new investors for about one and a half of those trips and of the 20 people we visited, 15 invested.” But he adds: “We might have had a different result if we'd met with 20 different state pension funds.” Such a strategy would have been less likely to succeed given pension funds' tendency to be risk-averse.

Tough at the top
For some of the larger European buyout funds, the going can be tougher. One leading US placement agent observes: “In Europe and the US there is a flight to perceived quality, which has benefited Permira, for example. But for the likes of Industri Kapital, Terra Firma and Doughty Hanson, fundraising has proved a long hard slog.” Adds Tom Dorr of Connecticut-based Morgan Stanley Alternative Investment Partners, which manages a $4.3bn private equity portfolio: “The money used to go to the big-name buyout brands that were easy to identify. A lot of investors didn't have the resources to assess too many different options, and simply went en masse to where they felt safest. But now the money is going to quality mid-market funds that have been around for a while and had the opportunity to prove themselves.”

Some say that the enthusiasm with which the mid-market is being embraced risks creating a ‘bubble’. “We're being cautious in the European mid-market,” says a leading US LP. “There were four to five funds in the market recently that we didn't invest in because they didn't meet our investment criteria and they were highly popular and oversubscribed.”

Not everyone shares the view that the mid-market is becoming over-invested. Ray Maxwell, managing director at INVESCO Asset Management: “The money seems to be going to the brand names, and when it does go to the mid-market it goes to the pan-European investors like Duke Street Capital rather than the single geography investors. It's a hard sell for smaller funds because there is a critical mass issue on the part of the US LPs.” A leading fund of funds manager points out: “You have to remember that the LPs are advised by consultants who tend to be risk-averse because they don't want to put themselves in danger of being sacked for their advice.”

Kelly DePonte of San Francisco-based placement agent Probitas Partners agrees that US investors, particularly the more risk-averse public funds, will tend to back the large buyout propositions. But he sounds a warning to those funds co-investing with their peers. “Some LPs are getting a bit fed up with investing in pan-European funds that do club deals as they result in over-exposure. You want diversity but what you get is a number of the funds you invest in bidding for the same asset – either on the same side or on different sides. And then two or three of your funds only win by paying the top price.”

Funds raised 2002: Origin of funds and fundsraised by country of management

Origin of Funds raised by
funds country of
2002 management 2002
Em % Em %
United Kingdom 6,664 24.2 14,201 51.6
France 2,803 10.2 4,799 17.4
Germany 2,444 8.9 1,644 6.0
Netherlands 2,063 7.5 1,195 4.3
Italy 1,984 7.2 1,996 7.2
Finland 678 2.5 720 2.6
Denmark 487 1.8 301 1.1
Spain 426 1.5 640 2.3
Switzerland 403 1.5 209 0.8
Norway 399 1.4 347 1.3
Sweden 267 1.0 642 2.3
Belgium 197 0.7 125 0.5
Austria 171 0.6 177 0.6
Poland 98 0.4 119 0.4
Portugal 75 0.3 72 0.3
Greece 69 0.2 66 0.2
Ireland 50 0.2 201 0.7
Czech Republic 34 0.1 49 0.2
Iceland 14 0.05 12 0.0
Slovakia 7 0.03 7 0.0
Hungary 0 0.0 12 0.0
Other European 139 0.5
Unknown European 532 1.9
European total 20,001 72.6 27,533 100.0
Asia 687 2.5
Canada 287 1.04
Israel 0.0 0.0
US 5,105 18.5
Other rest of world 1,127 4.1
Unknown rest
of world 326 1.2
Total rest of world 7,531 27.4
Total 27,533 100.0

Endowments matter
The main hope for venture funds looking to sell themselves to US investors rests with endowments and foundations. According to the recent ‘Report on Alternative Investing’ by Goldman Sachs and Russell Investment Group, they are the most enthusiastic backers of private equity in North America – currently committing 14.2 per cent of their total funds to the asset class. By comparison, corporate investors commit 7.7 per cent and public organisations 5.9 per cent. Unencumbered by the liabilities faced by public funds – which have responsibility for the vast amounts they invest on behalf of state or city employees – endowments also tend to be among the most daring investors.

Says Barber: “Endowments tend to target imperfect markets that offer higher returns but are also more ‘beta’. They can take on more risk mostly because they're not answerable to anyone apart from their own investment committee. They don't have to operate within a ten-year fund of funds life, for example, as they're evergreen, which means they're more tolerant than most of a risk profile – put in extremes – where 50 per cent of investments deliver a really great return and the other 50 per cent blow up in their face. An investor like CALPERS is happier putting a large chunk of money into a reliable mega-fund in order to tap into private equity's overall out-performance.” It is noteworthy that a number of European funds, including Altor and Cabot Square Capital, have enjoyed significant support from US endowments.

Lack of communication
The extent to which European funds need to promote themselves to potential US investors varies greatly, according to Morgan Stanley's Dorr. “Some ‘standard-bearing’ funds are so readily received by the market that they can reach their target from existing investors together with people who have come knocking on their door asking to invest – they won't use a placement agent and they may not visit the US at all,” he says. “But if you're not in that class, it's certainly helpful to have a placement agent in order to identify investors and package your proposition in a professional way.”

According to DePonte, too many funds are still showing signs of complacency. “Many GPs only communicate with LPs when its time to fundraise, whereas you really need to visit at least once a year. Partly, their attitude is a legacy of the good times in 2000, when people didn't need to put much effort in. Another reason is that a lot of firms are great at investing – but are not nearly as good at marketing themselves.”

Perhaps there are lessons to be learned from Permira's €5.1bn fundraising for its Europe III fund. While sceptics have suggested that a ‘herd mentality’ on the part of LPs was responsible for the fund's success, it may also have had something to do with a marketing campaign involving 300 investor meetings that commenced 18 months before launch.

The problem for larger funds is that by nature they cannot restrict their marketing effort to a small and hence more manageable investor base. Says Barber: “If you are seeking several billion euros, you have to devote an enormous amount of time to it – particularly if you don't have a long list of healthy legacy relationships. Logistically it's very hard because you have huge distances to cover and it's difficult reaching certain places. In addition, you may have to go for follow-ups and possibly ‘off-cycle’ [outside the normal fundraising cycle] in order to attract into a future fund those investors that got close to committing to your last one but backed away, as well as to introduce yourself early to new names. In these times, for the most part, the marketing of a new fund is not the time to initiate a relationship with an investor, given how cautious they are as well as their range of choices.”

But it is not all one-way traffic. Although it is clearly essential for European GPs to spend as much time as practically possible in the States, there is plenty of anecdotal evidence that a flow of industry professionals is heading in the opposite direction. “There are obviously leading US investors such as HarbourVest and Goldman Sachs who have a strong presence in Europe, but equally there are a lot more people doing ‘survey’ trips,” says DePonte. “There are a lot of institutions relatively new to the asset class and they are aware of the need to form new relationships in Europe.”

Convergence of terms
There are also now fewer structural impediments for US investors. In particular, with fund terms and conditions, there is now little difference between the expectations of US and European LPs, and what differences there are tend to make European funds look attractive by comparison. Josyane Gold, a private equity partner at London-based law firm SJ Berwin highlights one example: “‘Fund as a whole’ carry is typical in Europe, whereas in the US ‘deal by deal’ carry is more prevalent, but a number of funds there are moving to a ‘fund as a whole’ approach. It's interesting that Hicks, Muse recently drew attention to this aspect of its latest European fundraising effort, but the fact is it's always been like that here.” US investors were also slower than their European counterparts to demand hurdle rates as standard.

But Altor's Stromholm warns that US investors are no longer so easy going: “Certain US investors are even more focused on alignment of interests than their European counterparts. They're not so worried about fees but there are a number who saw venture capital firms cash in on their early successes in technology before the bursting of the bubble, and are keen to address what they now see as a problem.” Barber adds that US investors will be more likely than Europeans to demand clawback and no-fault divorce provisions.

Particularly when it comes to no-fault divorces, some in Europe feel US investors are beginning to apply too much pressure. “The no-fault divorce has been very wrongly used by some LPs in the last few years, especially those who are simply seeking to revise their overall investment policy [rather than punish under-performance],” says Dominique Peninon, managing partner at Paris-based fund of funds manager Access Capital Partners. He says GPs would be within their rights to resist such a clause, but this would be a luxury some simply cannot afford in a tough overall climate.

But what will determine the success of European fundraisings in the US over coming years will have much more to do with GPs' ability to sustain out-performance than the minutiae of fund terms. Piers Dennison is the recently appointed investor relations director at UK-based buyout firm Candover, which is set to hit the fundraising trail again in the next 12 to 18 months. He warns that European private equity's grip on American purse strings could be easily loosened: “The level of appetite at the moment is a combination both of what Europe can offer, and disillusionment with returns in the US. However, while Europe may be a more familiar place for Americans to do business than the Far East, there will be terrific investment opportunities in Far Eastern economies as they continue to develop. The European ‘familiarity factor’ will only help to attract investments as long as we keep delivering returns.”

But for the time being there is little sign of waning appetite. According to the Goldman Sachs/Russell Investment Group survey, North American institutional investors forecast an increase in their allocation to private equity from the current 7.5 per cent of total assets to 8.2 per cent of the total by 2005 (see graph). This will not necessarily mean a large numerical increase in capital invested because total assets have declined over the same period (despite the same percentage being invested in private equity in 2003 as 2001, the total commitment by North American institutions fell from $220bn to $179bn).

Taking into account that the US has 70 per cent of the world's pension funds, there is little danger of European GPs under-estimating the importance of developing good relationships with LPs on the other side of the Atlantic. And that task is made considerably easier at a time when Europe is viewed so favourably.

Coping with ERISA
Europeans thinking of launching part of their fundraising campaign in the US for the first time need to be aware of ERISA – particularly funds of funds.

US employee pension plans are regulated by ERISA, the Department of Labor's Employee Retirement Income Security Act of 1974, which European GPs seeking funding from US investors need to take into account.

Managers of directly investing funds can actually avoid compliance by qualifying as a ‘Venture Capital Operating Company’ (VCOC). To do so, at least half their assets must be invested in portfolio companies where the fund has management rights. But funds of funds, which invest in other funds rather than directly in companies, do not qualify for this exception.

Constricting and onerous
The only other means of avoidance is for so-called ‘benefit plan’ investors to comprise less than 25 per cent of interests in the fund. But it is difficult to stay under this limit because a range of governmental and foreign pension plans count as ‘benefit plan’ investors as well as being subject to ERISA.

“If you're mainly seeking commitments from high net worth individuals, foundations or endowments, it's easier to keep below 25 per cent as they do not represent benefit plan investors,” says Joseph Hugg, a partner and chair of the ERISA and Employee Benefit Practice Group at Boston-based law firm Testa Hurwitz & Thibeault. “But a lot of funds get most of their commitments from public pension plans.”

If a fund of funds is unable to comply with the 25 per cent rule, it must assume the burden of looking after ERISA investors' interests. This means becoming a Regulated Investment Adviser subject to the Investment Advisers Act of 1940. The list of duties and responsibilities this implies is too long to be reproduced here, but words used by those familiar with compliance include ‘constricting’ and ‘onerous’.

Some flavour of this is provided by Jedd Wider, a partner at New York law firm Orrick, who says: “The fund sponsor must act solely in the interests of the benefit plan investors for their exclusive benefit.” Failure to comply with the duties could result in severe financial penalties being imposed by the US Government's Department of Labor.

But before dismissing full compliance and relying on the 25 per cent rule, it is worth considering the words of one leading fund of funds manager who says: “There are various legal ‘fixes’ to avoid compliance, but I would say that most funds take a serious view of their responsibilities and don't want to try and circumvent the rules. While they are onerous, there is a real benefit in showing that you are prepared to exercise fiduciary duty and act in investors' best interests.”

There are two other key tax/regulatory issues to be taken into account by European funds seeking access to US capital:

Unrelated business taxable income (UBTI): certain US investors generally exempt from tax in the US are taxable in respect of UBTI. UBTI is not applicable to dividends, interest and capital gains from a fund's investment activities but is applicable to all or part of the income earned from investments in whole or part financed by leverage. This makes it of particular concern to, for example, leveraged buyout, real estate and hedge funds. The sponsor will generally be required under the fund's limited partnership agreement to avoid or minimise UBTI, or may be required to give investors the right to opt out of UBTI-generating investments.

The Investment Company Act of 1940: This Act comes under the auspices of the Securities and Exchange Commission (SEC) and imposes onerous disclosure demands on qualifying companies, including mutual funds, that engage primarily in investing, reinvesting, and trading in securities, and whose own securities are offered to the investing public. Private equity funds can gain exclusions via section 3c1 (the ‘100 persons rule’) or section 3c7 (the ‘qualifying purchaser’ rule). The difference between the two exclusions is significant: Section 3c1 will allow you no more than 100 US investors in your fund, while section 3c7 will permit up to 499. Details of the Act can be found at: http://www.law.uc.edu/CCL/InvCoAct/