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Editor’s Letter: How to raise a first-time fund in an uncertain environment

Find a specialization, and focus on that with everything you’ve got. Become the best at it and build a track record using your own money, or find investors willing to fund individual deals. When you’re ready to come to market, ensure you have a built-up back office and infrastructure that shows you’re more than just two people in a basement.

And be realistic about terms. LPs understand that young GPs need to keep the lights on, but in return they’d like some other economic consideration. The easiest way to match that expectation is to offer a European-style waterfall distribution system.

This was some of the advice given by panelists at the Buyouts Emerging Manager Connect 2016 conference.

Emerging managers and LPs gathered at the Harvard Club July 19 to parse the challenges of starting new PE firms. The turnout — the place was packed — reflected the excitement in this corner of the private equity universe.

It’s a crowded market, with GPs taking advantage of the strong fundraising market to spin out of larger firms and make their own way. Problem is those people aren’t always ready to start their own firms. It falls to LPs to find the quality shops.

And LPs have been backing away from first-time funds amid the uncertainty in the markets. Preqin found that fundraising for first-time vehicles hit its lowest point in 2015 since before 2005, the first year the research firm started tracking the data. This broke a run of strong fundraising years for emerging managers.

Every LP would like to find that sleeper hit, the manager no one really knows about who hits home runs. But as the saying goes, LPs don’t get fired for committing to Blackstone (or name your brand-name PE shop).

And that’s been the mentality in this era of volatility: stick with the managers you know. Those managers understand that, and many have come back earlier than expected with their next fund or have organized new strategies to capture more of that investor demand.

So not only must first-time funds find ways to prove themselves to LPs, they have to compete more and more with large GPs who have formed funds to target the smaller side of the market. These GPs can easily tap their existing investor bases to get these strategies kicked off.

It’s a tough world for first-time funds, but the demand is there. And as long as the Federal Reserve keeps interest rates low, institutions need private equity to help them meet their return expectations. And as long as they need private equity to hit their goals, they will look to new firms to broaden their portfolios and tap into the energy of first-time funds. In a study, Cambridge Associates found that first- and second-time funds are usually among the top performing vehicles in any vintage year.

Meanwhile, here’s some advice from a first-time fund manager who last month closed his debut vehicle: Andrew Nikou, founder of OpenGate Capital, which closed Fund I on $305 million, exceeding its $300 million target:

Target size for first-time funds is an important consideration — one that LPs will absolutely focus on. The ultimate size should be substantiated by the GP’s ability to back up the number with a rationale that they can prove out. Does your strategy support it relative to the market you are in? Do you have a deal pipeline to support it? Are there past and/or pending deals that support it? Can you deploy the capital without drifting away from your strategy?

Read more on the conference beginning on Page 26.

Photo: Private Equity Editor Chris Witkowsky reflects at home. Photo by Wendy Witkowsky