Spin-Outs Getting It Done In Challenging Market

For the first three quarters of the year, Buyouts has identified at least 15 debut buyout funds being raised by U.S.-based sponsors, five of which are spin-outs from established firms. Together they’ve raised more than $4.7 billion for their first funds.

New shops “have to go build a franchise,” said Erik Hirsch, chief investment officer at Hamilton Lane, the blue-chip manager of $23.5 billion in discretionary assets with oversight of an additional $140.3 billion in advisory assets. “That includes all the challenges that come [with that]—[assembling] the team, raising capital, building a brand and creating the infrastructure. All of this in a world where expectations from LPs are higher than ever and competition for capital is fierce.” Hirsch added: “Is it doable? Yes. Is it easy? No.”

Indeed, six years ago it seemed like pensions, endowments and other investors were practically shoveling commitments to the asset class, both to established and next-generation franchises. Since the financial downturn, many LPs have pulled back on commitments to the asset class, or pruned their programs to focus more on a few cherished firms. The performance of private equity relative to the public markets has come under scrutiny. And LPs have more leverage at the negotiating table, demanding lower fees, higher GP commitments, and other sweetened terms before they open their purses.

Oh, and one other thing. There are close to 2,000 private equity funds seeking commitments out there. Hamilton Lane, for example, is on course to have entertained as many as 700 pitches from private equity firms by the end of the year.

So it was with some surprise that in selecting a batch of younger firms to profile for our annual look at next-generation managers we found an inordinate number of spin-outs. Who would want to leave the safety of the parental nest and go solo at a time like this?

Well, apparently partners who want to help overturn the established order of partnership terms and conditions. Many are offering highly LP-friendly terms, such as extra big GP commitments, in an effort to secure the capital and good will of institutional investors. Siris Capital Group—a spinout from Ripplewood Holdings featured in last year’s look at next-generation managers—employs a distribution waterfall still unusual in the United States but common in Europe for its debut fund, in which the general partners don’t get to share carry until returning at least all invested capital.

Partners at start-ups are also pitching a number of advantages they feel they offer over established firms. Many attack relatively unserved markets, where they expect to find less competition for deals and lower prices for properties. They can also point to research showing that investors can do at least as well investing with next-generation managers as they can with established firms. A recent analysis by Buyouts showed that the bottom, median, and top-quartile IRRs for 120 debut domestic buyout funds of vintage year 2007 or older were all higher than for our entire database of domestic buyout funds.