Right first time

When can an LP be sufficiently confident to back a first-time fund? Sam Robinson reveals how a due diligence minefield awaits – and also how a select few will finally reach the other side

Investing in ‘new’ funds with no track record makes for an interesting debate. Funds have to start somewhere and ‘first-time’ funds do raise money. But it’s fair to say that a fund with no track record – not least, a manager without a track record – will not get very far at all unless it has an extremely compelling proposition; one that will successfully overcome the hurdle known commonly in the industry as due diligence.

All of today’s big buyout houses started much smaller and have grown into what they are today. Now many have larger funds, different or more diverse strategies (or at least have moved up the scale from small-to-mid size buyouts to large buyouts), bigger and broader teams and expertise, and are generally more established names than they were 20 years ago. Therefore it is possible for a first-time fund to garner enough interest to launch, and then raise a further fund building its track record slowly and surely. There’s no reason why over the long term it could not establish itself as a quality private equity fund manager to match the leaders of today. However, unlike the industry pioneers, today’s new fund has significant established competition.

The result, for us as a fund of funds manager at least, is that we invest in these funds by exception. But what possible exception could get them through the comprehensive due diligence process? Due diligence, at the end of the day, is the gatekeeper to all investments, but the majority of funds won’t even reach this stage. At any moment in time there are hundreds of partnerships open for investment and seeking to raise capital, and for them to merit further investigation they have to pass a comprehensive list of criteria and specific portfolio objectives. Based on this mere fact a number of funds will be thrown out. Yet, dependent on a fund of funds’ objective, this will vary from one fund to another.

When a fund gets through to the due diligence phase, it has to pass certain strict criteria. Though there are a number of elements to this stage, it can broadly be broken down into a mix of top-down and bottom-up analysis.

The top-down/macro research focuses on the following core areas:

Strategy: Buyouts versus expansion versus venture.
Geography: Country-specific versus panregional.
Industry: Generalist versus focused.

The bottom-up/micro due diligence focuses on five areas: people, performance, product/philosophy, process and price.
People: Private equity is an investment in people before anything else, hence it is important to analyse the team and specifically the partners.
Performance: The performance of prior funds is examined in order to determine the realised returns to the limited partners. Of paramount importance is the ‘how’ and ‘why’ behind the realised returns, and a judgement as to the quality of the unrealised portfolio.
Product/philosophy: The investment strategy that the group has adopted in the past and will adopt going forward, and whether it is appropriate for the prevailing environment.
Process: Investment process of the group; it is crucial to understand the procedures and controls in place when selecting investments.
Price: This is an analysis of the commercial terms of the partnership to make sure they are “market terms” and to ensure that there is an alignment of interest between manager and investor.

So how would a first-time fund have a chance of breaking through this tight net?

One key aspect is people – so while a first-time fund itself may not have a track record, it may be managed by a person or team of people that do, in which case this element of their former track record is reviewed: what deals they worked on/led; were they successful; does this manager have the right experience to lead the strategy of this new fund? The private equity industry is a very close-knit one – with interests aligned between managers and their funds, many managers are in it for the long term. Experienced fund of fund managers will have nurtured hundreds of relationships with these people, so when it comes to first-time funds, they are often managed by experienced individuals whom fund of funds managers already know well.

There will be some occasions where the only option is to invest in a fund with no track record. This might be because it is a new sector or strategy, or you do not believe any of the existing players in the market are really harnessing that part of the market successfully.

Comfort in Brands

That said, in many cases you will find that a ‘new space’ is tapped by existing managers who over time diversify and cover it – this is where, more typically, a fund of funds will get its exposure. For example, cleantech is an emerging arena which many venture capital funds (already with a track record) have launched into. Although we would support a cleantech fund in the absence of an established manager, we would probably feel more comfortable backing an established VC that is building cleantech exposure through the addition of industry experts. In the example of an Asian first-time fund we would tend to back a familiar brand that has new Asian hires, so there is at least a consistent process, i.e., experience on the investment committee.

It is important to look for relevant experience and track record in the new fund. In the case of a spin-off from one of the established players the team and manager need to be referenced thoroughly to determine who was responsible for track record. It is also often beneficial to have known and followed a team for a while, but the risk remains that individuals led the deals but had the support of a good junior person, or other partners controlling excesses etc. There is also a risk that if the individuals come from several different firms they may not work well together.

An advantage of a manager launching a first-time fund is that they do not have a legacy portfolio to manage. Therefore, they have full focus on new investments, rather than also having to spend time on managing the existing portfolio. A fund manager without a track record may also generate interest if investors are harbouring concerns over the established groups – they may seriously consider putting money with a new manager or team with fresh drive and hunger.

SVG Advisers does back first-time funds, but they are typically in the minority. For example we invested with a spinout from a UK lower mid-market firm because following thorough due diligence: we believed in the team’s ability; saw them as dependable; knew the manager; recognised the sector was attractive with few competitors with similar experience; the team was heavily aligned with the fund and its performance; and it had no existing/legacy funds to manage.

The key is not to chase a sector at the expense of fundamentals. If there is no direct relevant experience, you have to feel confident and believe a team can evidence a matrix of skills to cover that experience. It is important to reference individuals thoroughly from a broad range of referees who have known them over time – many mistakes are made by investing in people who seem great in meetings but you (and others you trust) don’t know them.

It’s certainly difficult to raise a first fund, but not impossible. New entrants should look to start small and rely on support from investors they’ve got to know well over time and build up their reputation gradually, by managing a quality and successful fund – this will serve them well when going back into the market for the next one – gradually taking steps to form that all-important track record.