Private equity: an ever-renewing landscape

Private equity (PE) has seen a meteoric rise in the last 20 years, and the evolution of the global PE ecosystem over the last decade has been nothing short of dramatic. Not only has institutional interest in the asset class surged globally, but as with many industries, there has been a continual cycle of rebirth as new firms and strategies are formed and others fall by the wayside.

At one end of the spectrum, so-called “zombie funds” are being run off by managers who have struggled to raise new capital, with their general partners (GPs) trying desperately to eke out an existence by holding on to old investments in hopes of a late-inning home run. On the other end, new firms are constantly being created, leading to new investment strategies and fund launches.

Perhaps most notably, the pace of new fund formation has been staggering in the wake of the global financial crisis. Over the last 10 years, more than 1,200 first-time funds were raised globally with an average size of $260 million, representing 44% of all funds raised by number and 17% of the total capital closed upon. In hindsight, this makes sense given that many PE managers encountered significant challenges during the global financial crisis, causing several of them to splinter and/or veer down the zombie fund path. According to a study by Bain & Company, 26% of the approximately 4,000 buyout firms that had raised a new fund globally between 2002 and 2008 “went dark after the crisis hit, not raising another fund since 2009 and appearing unlikely to do so ever again.” In such situations, the best people tend to depart rather than hang around to milk legacy fee streams. At the same time, a generation of younger, talented PE professionals who rose through the ranks during the 2000s have now reached the age and stage of their careers where they are ready to step out on their own. Talent and credibility is the tinder for new fund creation.

Source: Preqin, 2007-2016. Global data for buyout, growth and turnaround funds. For illustrative purposes only.

Source: Preqin, 2007-2016. Global data for buyout, growth and turnaround funds. For illustrative purposes only.

While every situation is unique, there tends to be a common pattern to how the PE industry rejuvenates. These days, new funds tend to take one of three forms:

  • Spin-outs – Teams within established PE firms leave to raise an independent fund. Often, this occurs when their previous firms move up market with successively larger funds, creating unwanted pressure to deploy larger amounts of capital in more efficient segments of the market. This commonly leads to a desire to get back to one’s roots pursuing smaller deals. Other times, spin-outs follow a difference in opinion over firm strategy or fund economics. Regardless of the scenario, there is always a concurrent desire by the members of the departing team to strike out on their own and control their own destiny.
  • Graduating fundless sponsors – Many other firms start as independent or “fundless” sponsors, investing on a deal-by-deal basis with the backing of family offices and/or more risk-tolerant institutional investors. This structure gives the team time to mature and jell as a group, and to build a track record off which to ultimately raise a more traditional blind pool. By evolving to a commingled fund structure, these firms can gain greater stability and credibility, and also bypass the need to laboriously raise capital for each deal.
  • New in-house strategies – A third form of new fund formation occurs when well-established PE firms launch companion fund strategies. Typically, this follows a period of robust firm growth that forces GPs to move up market and abandon the segment previously occupied by their flagship strategy. Rather than leave their roots completely behind, GPs elect to launch a smaller fund to capitalize on their continuing deal flow with smaller transactions and provide opportunities for up-and-coming professionals. In still other cases, managers have also branched out to raise dedicated sector funds, geographically oriented funds, minority growth strategies or even companion credit strategies.

Regardless of the path, there seems to be no shortage of new GPs and fund strategies on the PE scene these days. And, in parallel, there is a growing cadre of limited partners (LPs) eager to parse through this fresh new landscape in hopes of finding the next great PE fund early before it becomes highly sought-after and difficult to access.

Why first-time funds can be so compelling

Historically, first-time funds gained a well-deserved reputation for being much riskier and for delivering volatile and/or subpar performance. Twenty years ago, a common profile of a first-time PE manager was an investment banker or consultant teaming with a former colleague or business school classmate to try their hand at principal investing. The obvious problem was that most of these newly minted GPs had neither the relevant investment experience nor a history of working together. Not only were they first-time fund managers, but they were often first-time PE investors.

However, the profile and institutional quality of first-time fund managers has evolved considerably over the last decade, and the performance implications of this evolution appear to be significant. According to Preqin, over the 10-year period through 2012, first-time funds have consistently outperformed peers in nine of ten vintage years -- a far cry from below-market performance that tainted the entire category of “emerging managers” 15 or 20 years ago.

While there are many variables at play, we would argue that the more recent class of first-time fund managers has more PE experience – on average – compared with the typical new manager two decades ago, as well as a verifiable history of working and investing together prior to launching. Moreover, many of these teams end up running smaller, more specialized pools of capital than they had previously, leading – in theory – to a higher concentration of their best ideas/deals. Regardless of the reason, the recent performance data is eye-opening, and this evolving ecosystem of new firms and funds has emerged to be fertile ground for LPs seeking to identify the next generation of top-quartile managers.

Navigating the first-time fund arena

Traditionally, first-time funds have taken a fairly long time to raise capital. For the most part, this continues to be the case. It’s not unusual to see new GPs in the market for up to two years raising their debut fund given that many of these managers lack fully attributable investment track records and/or specific experience in managing their own firms. Additionally, there are fewer LPs willing to consider investing in first-time funds. According to Preqin, more than 40% of institutional LPs will not back such managers, and another 20% will only consider them sparingly. The vast majority of PE investors continues to favor commitments to more “proven” entities.

But not all first-time funds linger in the market for lengthy periods. In fact, in the current fundraising environment, the most interesting spin-outs – those with strong, clean attributable track records and well-defined strategies – can actually raise capital very quickly. Indeed, access to the hottest such funds can be extremely competitive, and in some cases “invitation only.”

So for those investors inclined to consider this segment of the market, it is important to be proactive and engage in dialogue early with the most promising new groups in order to have a shot at an allocation. One example of this is Align Capital Partners, which recently spun out from well-established middle market firm The Riverside Company. Align closed on a highly oversubscribed $325 million fund in 2016 in a matter of months after departing Riverside.

Access aside, while the returns from first-time managers can be attractive, investors have to be exceptionally careful as navigating this landscape is not without risk.

Thorough due diligence is critical, especially considering that new managers are themselves navigating key functional areas for the first time (setting up a back office, dealing with compliance and registration, thinking about portfolio management, building teams, etc.). Beyond developing conviction in a team’s investment capabilities, it is essential that LPs understand how GPs will tackle each of these adjacent competencies given that most of the heavy lifting in those areas was likely performed by others at their prior firms.

Invariably, LPs need to place a heavy emphasis on extensive on and off list referencing when performing diligence on first-time funds. This helps to not only validate the team’s historical investment track record, but also build a comprehensive picture of the team, their motivations, their strengths and their weaknesses, which is of paramount importance when embarking on a 10-year-plus illiquid fund relationship.

For those willing and able to navigate this complex and ever-renewing landscape, there is outperformance potential to be had.

Source: Preqin Special Report: Making the Case for First-Time Funds, November 2016. For illustrative purposes only.

Key takeaways

  1. The PE industry is continually renewing itself, with a significant number of new managers and fund strategies coming to market each year.
  2. The typical profile of first-time PE funds has changed over the last two decades.
  3. First-time funds have demonstrated consistent outperformance over more established managers in recent years.
  4. The emerging manager landscape remains a complex, and potentially risky, segment of the PE spectrum. Thorough due diligence is of paramount importance when navigating the first-time fund arena.

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