At a recent LP-only conference, one panellist asked delegates who among them was looking at a first-time fund and considering making an investment this year, recalls Adveq’s Tim Creed, managing director and head of the firm’s European programme. Almost everyone raised their hands.
In today’s private equity world, LPs are looking for ways to invest their money. As GPs continue to take advantage of high entry multiples and cheap debt to harvest their portfolios, record levels of capital are flowing back to investors. Over the first nine months of 2015 fund managers distributed $392 billion to their investors from realisations and dividend recaps, according to data from Triago, putting the year well on the way to topping 2014’s net distributions of $477 billion.
This is translating into a buoyant fundraising environment. According to data from PEI Research & Analytics, closed-ended private equity funds collected almost $372 billion in 2015, not far off the $395 billion raised a year earlier.
For mid-level executives at private equity firms considering flying the nest to raise their own funds, the time is now, says Susan Long McAndrews, a partner at Pantheon.
“We’re in probably the best market for spin-out opportunities that I’ve ever seen,” she says. “We realised earlier [in 2015] that we were seeing more interesting spin-out funds than we could actually back in terms of having slots in the portfolio.”
Janet Brooks, a partner at placement agent Monument Group, agrees that in today’s market both the push and pull factors have lined up to make a compelling case for those tempted to strike out on their own.
One push factor is that LPs have seen less consistency among top-quartile managers; some larger funds have also been taking an aggressive stance during fundraising.
“Then you’ve got the pull factors; a lot of first time funds are setting up smaller sized funds, and there is always a lot of investor appetite for lower mid-market or mid-market funds; [LPs] like the fact that some of these entities are therefore more focused, whether it’s on geography or on sector; and there’s probably greater alignment too,” she says.
This alignment comes from the realisation on both the LPs’ and the GPs’ part that this first fund as a new outfit is make or break. First-time teams need to lay down a meaningful amount of their own capital to prove to the market that they’re all in.
Eric Zoller, partner and co-founder at US-based placement agent Sixpoint Partners, pinpoints three drivers for spin-outs: the rise of recapitalisations; ageing founders in firms “where the next generation of partners don’t feel like they have a seat at the table”; and firms pushing into a multi-strategy approach, which can leave one vertical feeling orphaned.
“The spin-outs of today are very different from the traditional emerging manager profile of [the] recent past in that they have established, overlapping investment teams with attributable track records and they’re deploying capital into proven strategies: the LPs can check boxes with them,” Zoller says.
Long McAndrews agrees that thanks to a strong five-year post-crisis period for the asset class, most people’s track records – although not always straightforward to verify – look good, allowing newly-established firms to come out with bold fund targets. Whereas in the past such groups would use small initial offerings to gain traction, she is seeing groups successfully close debut funds of between $500 million and $1 billion in remarkably short periods.
A recent example is Boston-headquartered Silversmith Capital Partners, launched by former Bain Capital Ventures duo Todd MacLean and Jeffrey Crisan and former Spectrum Equity managing director Jim Quagliaroli, which closed its debut fund on $460 million last September after a little over three months on the road.
Other notable spin-outs seeking heady sums include Gamut Capital Management, launched by former Apollo Global Management senior partners Stan Parker and Jordan Zaken which is seeking to replicate Apollo’s strategy in the lower mid-market and is targeting $750 million for its debut offering. Meanwhile, Altas Partners, founded by Onex veteran Andrew Sheiner, which as of last October was more than halfway toward its $600 million target for Fund I.
The interest among investors in spin-outs and first-time funds is certainly there, as Creed’s anecdote shows. According to Coller Capital’s 2014 Private Equity Barometer, 70 percent of North American investors, 58 percent of European LPs and 53 percent of Asia-Pacific LPs were intending to invest directly in first-time funds in the next two years.
However, Creed, whose firm has a history of investing in emerging managers, says he finds the idea that a whole room of investors could successfully find and back a first time fund “quite scary”.
“Backing a first-time fund is very, very hard,” he says.
The clear benefits – including the lack of a legacy portfolio and strong alignment of interest – carry a huge amount of risk. Often teams have not worked together before, and do not have either a reputation or an established sourcing network as a group.
“Although first-time funds in aggregate do outperform, the range of outcomes is far more binary,” Creed says. “What worries me about many people looking for first-time funds is they only hear the success stories.”
Although investors are talking the talk, the data show that many are heeding the risks to which Creed points. Fundraising figures for first-time funds globally have steadily declined in recent years, down from 189 funds raising a combined $36.8 billion in 2012 to 92 funds raising just $16 billion last year according to data from PEI Research & Analytics.
“There are definitely a few investors who historically would say no that are now prepared to look at something, but it’s still a very small part of the overall LP universe who will look at first time funds,” says Brooks.
There’s undoubtedly plenty of capital around to invest, but LPs are still very discriminating, Long McAndrews adds.
“These opportunities do occupy a treasured slot within one’s portfolio,” she says. “[For many LPs] there’s a one-in, one-out type of mind-set in order to avoid over-diversification.”
With first-time funds, the bar is even higher; without an established team with a demonstrable track record and a market reputation, new firms are asking investors to take a leap of faith. However, those teams emerging from senior roles in the industry’s most sought-after firms can mitigate that challenge through the strength of their former house, says Warren Hibbert, partner at placement agent Asanté Capital Group.
“There are so few obvious winners in today’s market, relatively speaking, and it remains so bifurcated, that LPs race towards the consistently strong performing firms out there,” Hibbert says.
“LPs are looking for funds where the fundraising risk is low so they don’t end up dedicating time and resources where the fund doesn’t get raised. That comes down to track record, individuals [and] brand name as far as spin-outs are concerned, and the bar is incredibly high, but so is the reward.”
Regardless of favourable market conditions, fundraising is never easy. However, it seems the spin-out funds that tick all the boxes are able to raise more money today than at any point in the past, and are worth serious consideration by investors. LPs that pass on the newcomers of today may well find themselves shut out of the most sought-after funds of tomorrow.