Houlihan Lokey private funds group managing director Andy Lund, pictured, and vice president Ed Stubbings examine the potential pitfalls of the first-time private equity fundraise, and how firms can overcome them.
Private market first-time funds have significantly increased in prominence in the past decade. In 2017, $26 billion of capital was raised for 226 first-time funds globally, representing 25% of the total number of funds raised that year.1 The reason for this rise in prominence is twofold. First, more investment professionals are willing to leave established companies to form new firms, and second, more limited partners are eager to support new platforms.
These market dynamics have not always been the case. As recently as 2009–2010, many emerging managers struggled to raise capital. Limited Partners’ (LPs) views on such firms were that they were risky, and did not offer the potential to deliver outsized investment returns compared to established managers. Perceptions of both of these factors have changed over time. Significantly, LPs are now undertaking more detailed analysis of managers’ deal-by-deal performance which has enabled them to make better judgements as to which managers have performed, and which individuals at those firms have driven that performance.
With regard to risk, while market risk is present for all private managers, execution risk can be limited. As such, firms which are perceived as spin-outs of established teams from mature organizations tend not to be perceived as holding the same risk as first-time teams. Similarly, the ability of individuals to leave organizations with track records attributable to them is one way to convey successful prior investment experience to LPs considering the new fund. Lastly, LPs who are willing to be early supporters of the firm and who, through that support, allow the manager to reach a first closing will help reduce fundraising risk.
As it relates to the return potential of emerging managers, a study of more than 13,000 portfolio companies found that performance persistence has declined as the private equity industry has matured and become more competitive.2 This means that the value to LPs of supporting a manager across multiple funds, despite waning performance, is falling. Many LPs will now replace existing managers with new firms, with market data supporting the switch: in the 15 vintage years between 2000 and 2014, first-time funds have outperformed established peers on 13 occasions.
The supply of new firms for LPs to invest in has also increased. Many investment (and operating) professionals, particularly those at the principal and junior partner level, are now able to take advantage of strong personal track records at larger organizations and avoid the shift that many large and growing firms undertake from making investments to asset management, with founder wealth driven by management fee acquisition rather than increases in carried interest throughout performance. This entrepreneurial drive, previously very challenging to capitalize on, is now increasingly supported by LPs.
As perceptions of the relative risk and return of new and established managers have changed, and barriers to entry have decreased, LPs have increasingly backed emerging firms. Preqin survey data highlights 59% of LPs now invest or consider investing in first-time funds and spin-offs. As is often the case, however, first-time funds are not created equally, and many new firms do not successfully convince LPs to support their funds.
What does it take to succeed as an emerging manager?
While there is no definitive list of factors that can predict the success of a new firm, the following elements have all contributed to successful first-time fundraises in the past:
• Teams with experience in working together with main senior hires in place (more than just the founders)
• Attributable prior track record, or single deals post-departure to prove the concept
• A clearly defined, credible strategy that keeps the story simple
• Evidence of the team’s ability to exit investments (i.e., fully execute strategy)
• Fund size is appropriate for the strategy, and supported by prior deal pace and future deal flow
• Attractive pipeline of investments
• Term sheet is in line with market expectations for the proposed strategy and team size
• Support from “early adopter” investors
• Demonstrated ability to offer co-investment
• Patience—most fundraises take more than 12 months and most capital is raised in the last six months of the fundraise versus the first six months
Even if a firm has many of these elements, fundraising remains a challenging and fundamentally inefficient process. The greatest challenge in converting an LP’s interest into a commitment is no longer the lack of capital, but the lack of time to evaluate each opportunity. The ability to articulate a GP’s story clearly, and in a way which differentiates the firm to others in the market, takes practice and patience—the hardest part of the process is reaching a first close. Once a first close has taken place, LPs who have chosen to “wait and see” how the story develops may re-evaluate the fund.
If you’re thinking of making the leap, what are the first steps?
64% of GPs surveyed by the BVCA3 recommended using a placement agent for a first-time fund, and for good reason. Preqin data shows that 43% of first-time managers using a placement agent exceeded their fundraising targets, compared to 23% of first-time managers who did not. Furthermore, placement agents can give confidential early guidance on the optimal fundraising approach for the specific circumstances.
In addition, and ideally in conjunction with a credible fund formation counsel, take time to structure exit agreements to limit the prohibitions on solicitation of employees, solicitation of investors of the firm, and competition.
What are the typical pitfalls, and how should you avoid them?
Many of the problems that present themselves in first-time fundraises are self-inflicted and avoidable. The following pitfalls represent the most common mistakes that new firms make:
• Launching too soon to too many LPs
You only get one chance to make a first impression. Some managers approach a large number of LPs before the fundraising story is at its best. Once an LP declines a fund or loses focus, it’s hard to revive interest.
• Overcomplicating the story, or coming to market as a tweener
Many new managers either seek to do too much under one investment strategy, or create a strategy so unique that it doesn’t fit within LPs’ mandates. An agent will help you refine your messaging; the rule of thumb is to make your story unique, but still conforming.
• Going alone
LPs will want to see a core investment team in place who have worked together previously, before backing a new manager; in addition, having only one partner or senior professional raises key man risk concerns.
• Changing the strategy or fund size during the fundraise
One potential result of approaching LPs too early without the right fact pattern is that managers will then seek to make changes to chase LPs’ strategies. The damage, often, has already been done.
• The first deal isn’t what LPs would expect
Make sure your first investment is entirely “on strategy.” The first deal will define how LPs perceive your fund.
• Not hiring an agent…
And then hiring an agent. Placement agents will add the greatest value when helping develop your firm’s messaging, and positioning your story with LPs. While agents can still change the trajectory of a fundraise, the biggest impact can be made prior to and immediately following launch.
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