Setting up Shop: What Does It Take to Establish a Private Equity Firm in Today's Market?Published: May 06, 2008 in Knowledge@Wharton
Establishing a private equity fund as a founding partner is the objective of thousands of practitioners across the industry. For the fortunate few, success has involved talent, good timing and perseverance combined with industry growth that has supported the entry of new firms. With the market continuing to mature, what are the hurdles, and what will it take to successfully start a private equity shop going forward? A leading private equity fundraising advisor and two leading investors with extensive experience advising and backing new private equity firms discussed these issues with members of the Wharton Private Equity Club (WPEC).
Greg Myers is managing director of the Private Fund Advisory Group at Lazard & Co. He has 12 years of experience advising private equity firms across Europe, the United States and Asia on fundraising transactions. Currently based in London, Myers is responsible for Lazard's European and Asian fundraising origination and execution activities.
Mike Pilson is director of Private Equities at DuPont Capital Management. He has 12 years' experience in private equity fund investment and investment banking. Pilson currently oversees a $3 billion portfolio comprising over 100 private equity fund interests.
Rick Slocum (WG'85) is director of Private Investments at the Robert Wood Johnson Foundation. Slocum has 27 years of experience across private equity fund investment, direct investment and investment banking and was most recently senior director of investments at the University of Pennsylvania. He currently oversees a $2.5 billion portfolio in commitments with investments in private equity, venture capital, growth equity, distressed investing, opportunistic credit and real assets.
WPEC: In your experience, what are the different profiles of new private equity firms, and what motivates new general partner teams to set up shop?
MP: New private equity firms typically come in one of a few forms today. First, a spin-out of a sub-group of partners from an existing firm -- for example, West Hill, a recent spin-out from the established U.S. buyout firm J.W. Childs. Second, a spin-out of a group of partners from different firms that have teamed up, such as Vitruvian Partners, a European private equity firm that was established last year by ex-Apax, BC Partners and Bridgepoint investment professionals. Third, a new firm formed by individuals that have been practicing private equity-like investing in a non-fund format, such as Intervale Capital, which was started recently by Charles Cherington and Curtis Huff. In each scenario, the motivations are different but the goals the same: to have your own shop -- one where you have designed the investment process, strategy, and team economic structure to achieve the best team-based decision making, cohesiveness, transparency and, ultimately, the best returns. Most spin-outs today are the result of younger partners developing into full partners with the desire to have more of the carry and more influence within their respective firms.
GM: Another major profile of a new firm that can attract institutional investor funding is a spin-off from a bank. Merchant banking spinouts are often driven by strategic change in the mother organization; for example, issues with conflicts of interest or balance sheet risk considerations. Metalmark Capital, for example was spun out of Morgan Stanley in 2004. The firm went on to be acquired by Citigroup in 2007 as the bank made a strategic decision to rebuild its exposure to the private equity business.
The second motivating factor is similar to the private equity firm dynamics Mike describes. Either the whole investment team, or a sub-set, seeks independence from the mother organization for reasons including economics and ability to form and execute an investment strategy independently.
RS: I think that Mike and Greg have provided a good summary of many of the motivations one sees in forming new private equity firms. Another format I've seen includes an ex-CEO or CEOs getting together to form a new fund, sometimes with sponsorship from an established group. Operational expertise, particularly when combined with investment experience, can be an attractive format. Also, new areas for investment -- for example, private equity real estate investing in India -- will attract investors who may have skills in other markets that they believe can be applied in new locations.
WPEC: Private equity has emerged as an asset class of its own over the last 25 years. Historically, what has driven the demand for investing in funds advised by new firms? In your opinion, are the same demand factors driving the market for new opportunities today?
RS: If you go back to the 1980s, buyout funds could be established to exploit the inefficiencies in both the financing markets and the corporate sale process. Auctions were less frequent for awhile, while the idea of buying companies with significant leverage was pretty novel. As a result, professionals with strong financial skills and good access to Wall Street could raise funds to exploit financing inefficiencies. Strong returns could be generated by successfully cutting costs and reducing leverage of strong cash-flowing entities. Today's market is much different, and, at least in the U.S. and now Europe, is looking for strong operational and business-building skills. In addition, popular investing themes -- where skill sets might be somewhat different -- include investing in the emerging markets and in real assets.
MP: Private equity has emerged from a cottage industry into a fully fledged asset class over the past 25 years. The driving reason is the consistent alpha generation to institutional investors as a result of market inefficiencies left by other investment and ownership models that private equity addresses. Historically new firm creation was driven by the "new new thing". The new investment idea -- for example, industry-specific, buy-and-build, or operationally focused funds -- or the ability to back a new star investor, for example, J.C. Flowers in 2002 after he left Goldman Sachs, or new geographies -- for example, the emergence of Europe, Latin America, and Asia. As the market matured, the number of ideas has grown exponentially. I believe the same forces continue to drive the growth of private equity today. Investors will continue to look for the new new thing.
GM: After years of rapid growth, I believe that we are now at an inflection point in the industry. Many established shops are maturing with potential team succession issues looming. Simultaneously, institutional investor allocation to new managers has decreased as relationships with established managers have matured. The new wave of firms will be driven by the next generation of private equity firm partners -- newly energized and highly aligned, and with innovative ideas for embracing new market opportunities. Silver Lake is a good example: Formed in 1999 by partners from private equity and technology backgrounds, the firm identified the opportunity in the technology sector early. Success in this strategy attracted significant institutional investor interest, helping the firm become among the largest new players in the industry.
WPEC: The last few years have been strong for overall fundraising in the developed markets of the U.S. and Western Europe. What are the primary challenges for new firms fundraising in these developed markets? How have these challenges been overcome?
GM: In the developed markets, much of the dramatic headline-grabbing increases in fund sizes have been driven by market tenure and institutionalization of incumbent firms. Many have built 20-year-plus track records, proving the capabilities of their teams and rigor of their investment processes. This has assisted with establishing brands and reputations with both fund investors and markets for sourcing and financing investments, which is pivotal for raising and deploying capital. Team sizes have grown as roles have specialized to capitalize on the breadth of and competition for a range of investment opportunities across sectors and regions. At the same time, established firms have been able to stem team turnover by vesting members with carry. In short, many of the early investment strategy and organization risks posed to fund investors have been mitigated while returns have remained, allowing these firms to attract larger portions of available funding. Overall, given the opportunity set of proven and established managers, the bar for new firms is high.
RS: The last few years have broken records in terms of fundraising. Over the next couple of years, raising capital will be tougher, particularly for new funds. The new funds that will be successful will have many of the following attributes: strong principals who have invested successfully someplace else before; high integrity; a demonstrated ability to work together as a team; a strong alignment of interests between the principals of the GP and the LPs, which should include a strong personal financial commitment to the fund and back-ended carry (where the GP receives a profit share only once the fund as a whole begins to make a profit, rather than as soon as the first investment makes a profit); some sort of edge the team has to differentiate itself; a good combination of operating and financing skills; and probably a theme, such as distressed investing, consistent with the world as we know it today.
MP: The current fundraising environment in the U.S. and Europe is particularly difficult for new firms. LP capital is directed increasingly to re-investments in subsequent funds of GPs with whom the LPs already invest. Thus, there is simply less capital for new relationships and new firms. Compounding this will be overall lack of risk appetite among LPs in an uncertain economy and investment environment. The goal for a new manager should be to gain the attention of LPs in an otherwise crowded fundraising market. This may be accomplished by being very attentive to terms, structure and possibly offering a co-investment in a portfolio company or a secondary fund interest as a means of jump-starting the relationship.
WPEC: Everyone is talking about emerging private equity markets such as China and India. Are these any more favorable for new fund managers looking to establish private equity funds? In your opinion, in which other countries is there a particularly interesting opportunity for new groups?
MP: China and India have dominated the private equity discussion for the past three years. Significant amounts of capital have been raised in those markets by all types of fund managers. Most of these managers have at least one thing in common: they did not exist five years ago. Institutional LPs have been very accepting of new managers from this region, many of which have demonstrated strong networks and or business-building skills. These characteristics represent the bare minimum skill-set expected in mature markets. However, LPs are looking for a means to gain exposure to these developing markets that have double the underlying growth and a relatively less-competitive private equity environment.
RS: These markets are much more favorable for new fund managers looking to establish themselves. China and India will be developing for quite some time, and managers with relevant skills can certainly still form funds. We also believe that the skill set required to be successful in these markets will evolve over time, but that they are often quite different from skills required in the U.S. or Europe. As for other countries, Brazil and Russia are the two largest scalable countries, but we see opportunities in Eastern Europe as well. Growth capital funds have been forming in the Middle East, too, though we worry that this region may actually have too much capital already.
GM: Fewer established competitors and an imbalance of the supply of capital and availability of compelling investment opportunities make early entry to some of the emerging markets favorable. Typically, the profiles of new shops are either experienced investors returning home from developed markets, or well-connected local individuals from banking or industry backgrounds. Both profiles of new shops will face the challenge of limited or no track record in the target region and in some cases may also face the challenge of very limited market activity to point to, purely due to the stage of market development. Selling the market and investment thesis then becomes a major challenge when approaching institutional fund investors. We find that, as a result, these opportunities are funded by investors who are able to analyze the risks and take a long-term view -- typically endowments, fund-of-funds, hedge funds and other thought-leading institutions.
WPEC: What are the most important factors that you evaluate when underwriting "first fund" opportunities? Do these factors differ, if at all, from your analysis of established players?
MP: The single most important factor while assessing a first-time fund is a differentiated strategy. While the strategy is not the only factor to be considered, it is a nonstarter if the strategy is a "plain vanilla" LBO or a similar, "me-too" approach. As there is more firm or partnership risk with a first-time fund, the question with these strategies is: Why take on the perceived extra risk for a non-differentiated strategy? In addition to strategy, the analysis for first-time funds is often centered on deal attribution, who did what at the previous firm, strength of team and how they worked together in the past, terms and alignment of interest. Established players, on the other hand, may be evaluated more on team, track record, investment strategy and organizational dynamics.
GM: There are a number of due diligence items that we emphasize when we evaluate a client on a potential first-time-fund assignment. The first is investment team chemistry. In addition to demonstrating that they can work together -- perhaps through overlapping prior backgrounds -- do they have the conviction and passion to weather a fund raise and establish an independent enterprise? Deal flow visibility is also very important. In the new setting, we want to be sure that the manager will be able to source attractive investments that are consistent with their thesis and the expertise demonstrated by the prior track record. Then, as a placement agent, investor demand is also key -- we want to have foresight on market demand before taking on an assignment.
WPEC: At the time of going to press, the LBO markets were challenging due to the credit crunch. Comment on the current market environment for fundraising/investing in private equity funds. Has this, or is this expected to impact the fundraising market for first-time funds?
GM: The market events of August 2007 ended a robust 2003-2007 fundraising cycle. Currently, sentiment is one of caution. Thematically, investors are seeking counter-cyclical and risk-mediating investment strategies, such as distressed/turnaround and mezzanine. At the same time, investors recognize that their 2001-2003 fund investments outperformed due to the market conditions. Now may be a time to replicate those strong vintages, particularly by backing managers that have a history of investing successfully through the cycle. On balance, first-time fundraising difficulty does increase, but is by no means impossible. Expectations should be to achieve a reasonable fund size adequate to execute the stated strategy. The emphasis on having a strong institutional investor base increases because these are the partners you can rely on to remain supportive if you exhaust available capital in a short time period.
RS: In the current market, individuals with, for example, good distressed investing skills will have an easier time of fundraising than traditional buyout investors. There may be room for first-time energy sector investors in this market, and certain areas in venture capital, such as clean tech investing, should have some success. First-time funds that require leverage will have problems, as there is a distinct possibility that the current buyout industry could suffer a shakeout. In all cases, however, individuals will need to have developed real expertise someplace else first -- don't try to raise a first-time fund unless you've invested before and have a verifiable track record.
MP: Without question, the current environment has limited both the fundraising and investing activities for many private equity strategies. However, there are opportunities in every market. Specialized strategies that take advantage of the current environment should be of interest. For example, mortgages, financial services or distress and restructuring. Likewise, investors that target smaller companies where some leverage may still be available could have success raising capital. However, I agree with Rick: New GPs should think long and hard about entering this market without a well-differentiated strategy.
WPEC: What are the current economic and governance terms for new general partners raising private equity funds, and where are the hot-buttons that help them gain traction?
MP: The key word in the limited partnership agreement -- the contract between fund investors and the private equity firm -- is "partnership." With first-time fund managers, we always look for a fair but reasonable agreement. Governance is an important element when we assess a partnership agreement. We like to see, at minimum, a strong key-man and a no-fault divorce (LP consensus termination) clause. We like to see the first-time manager address the firm risk elements -- such as the potential for team misalignment or even departures -- proactively in the agreement as a sign of good faith and a demonstration of the appreciation of the LPs' perspective when underwriting a first-time fund. Additionally, strong governance clauses give LPs some comfort with first-time funds, as the conventional wisdom is that a 10-year fund life can be more volatile than the same 10 years at an established firm.
GM: Economic alignment of interests is central to structuring private equity funds, and due to the uncertainties of backing a new organization, the emphasis on this increases for new shops. New fund managers will generally be beholden to the market on many terms -- 2% management fee and 20% carried interest, for example. Team monetary commitment to the fund acts as a very important signal to investors. This is currently at least 2% of the fund, and often more to match an absolute quantum that is perceived as "meaningful." The other consideration, which is often a temptation for first-time-funds, is favorable economic or governance incentives to certain "cornerstone" investors. These arrangements should be approached with caution as they often represent considerable hurdles for other investors due to potential conflicts of interest.
RS: Alignment of interests is imperative. We would look to make sure that the management fees generated from the fund are enough to meet a reasonable operating budget for the fund, but would then require a "back-ended" carry structure. As for the size of the GP's commitment, we would take into account the liquid net worth of the principals, which may allow for a lower threshold than Greg's figures. As for governance, sponsorship by a bank or other financial institution can be a "mixed bag." For example, a motive of a fund established by an investment bank could be to facilitate banking fees -- maybe, maybe not. First-time funds often need to accept commitments from wherever they can get them. Some LPs will look at the composition of the LP base to figure out if their interests are aligned with other investors. Insurance companies may put capital into a fund really to facilitate debt transactions. Who controls the investment decision -- are certain LPs on the investment committee? -- is an important thing to consider with a first-time fund.
WPEC: What is your parting advice for budding general partners aspiring to set up their own shops eventually?
RS: Having worked on both the buy side and the sell side, I would recommend that you look in the mirror and try to figure out what is really important to you before deciding you want to do this. It can be done, but raising a first-time fund will likely be a very long and gruelling process. To be successful, work someplace else first -- another PE firm ideally, or perhaps as part of a bank or merchant bank -- develop a meaningful track record, try to develop strong relationships with LPs and/or angel investors -- anyone who you think may support you (and provide good references). Understand that many of the LP's who invest regularly already have mature investment portfolios and are not in need of many first-time funds in their portfolio.
GM: Timing vis-a-vis the development of your track record is extremely important. You should be able to show that you have led a few investments through sourcing, structuring and creating value to profitable exit realization. These investments should also demonstrate consistency with the investment strategy and differentiation of the new organization. Ideally, the details of your track record should be portable to the new firm setting. You should also have a range of supportive references on hand -- for example, portfolio company management teams, professional services providers who have worked with you and colleagues from your prior organization. Finally, bear in mind that institutional investors typically look for multi-fund relationships. A clear vision for the new shop over the short-, medium- and long-term is therefore key.
MP: My additional advice would be to network with established LPs prior to setting out on your own. The more input one can get on strategy, team composition, terms and other organizational elements, the better one can position the new firm. However, you must be open to feedback. This is also a good way to build relationships and get real feedback from the institutional investor base.