Despite the billions set aside for private equity emerging manager programs, finding backers is still extremely tough for new groups. And it’s only getting tougher in an environment where the credit crunch and the dead IPO market are wreaking havoc on buyout returns. So who gets these dollars and how?
Altogether, Buyouts has identified at least eight institutional investors with emerging manager programs, as well as a dozen or so advisors that make a specialty of advising them on their selection—see table. Altogether at least $4.5 billion has been allocated for the purpose.
One thing for emerging managers to recognize early on is that institutions with these programs don’t necessarily define them the same way or have the same goals. For some, such as the New York State Common Retirement Fund, the program fulfills a social agenda, such as backing women-owned or minority-owned firms. For others the program is designed to benefit the local economy, like the California Public Employees’ Retirement System’s Golden State Investment Fund. Other investors have a purely financial motive, such as forming early relationships with potential top-tier firms. For all investors, emerging manager programs help replenish their pool of talent as older firms lose their Midas touch, or dissolve.
Beyond those differences, some investors actually define the term “emerging managers” in a way that precludes many groups from getting money. Peter Haabestad, a former investment banker at Susquehanna Financial and now managing partner of Guardian Capital Partners, found that many investors, though ostensibly with an appetite for emerging managers, limit their commitments to certain types of firms. “To many of these institutional investors, emerging managers are a team spinning out of a large firm, such as Cerberus,” said Haabestad. Someone he spoke with recently even defined “emerging manager” as an existing firm that has adopted a new strategy.
Investors have also grown more selective when choosing emerging managers, given a credit crunch that has made many investment strategies obsolete. New firms face an environment of less leverage and little or negative income growth. They need to almost always show up at an investor’s door with an operations team, not just a strategy of “buy and hold until the market is willing to pay you a higher multiple than you paid six months prior,” said Dan Vene, a vice president with C.P. Eaton Partners, a Connecticut-based placement agency. Added Jeffrey Stern, managing partner of Forum Capital Partners, a placement agency in New York: “The bar [for emerging managers] is as high as it’s ever been.”
How To Clear It
For their part, many investors say they’re surprised by the chutzpah of groups that show up trying to raise a first-time fund.
The main culprits appear to be investment bankers, consultants and hedge fund managers. “Investment bankers have been selling deals to funds and see how lucrative it can be,” said Russell Pennoyer of Benedetto, Gartland & Co., a New York placement agent. Yet, often they do not add greater value than people who are in private equity already, leaving a potential backer to ask, “What do they bring to the table?” Clint Harris, founder and managing partner of Grove Street Advisors, which builds and manages private equity programs for institutions, including CalPERS, said that his firm commits to only one emerging manager for every 40 it sees. “A lot of first-time funds are total nonstarters,” he said.
The first step for many emerging managers is to get feedback from placement agents, communications consultants and even potential anchor investors, all of whom can provide an unvarnished view as to whether the concept has a chance. The story must make sense and offer something appealing, “and that’s often hard for people to figure out on their own,” said Pennoyer, noting that it can sometimes take years before a firm is ready to go to market.
That hurdle crossed, most new fund managers find that investors, even those with emerging manager programs, will only back experienced investment teams. Some of the questions would-be backers ask when deciding whom to include in their programs are: Have these people worked together before? Has the team invested together before? Is there a lot of turnover in the team? One example of a group whose experience working together clearly helped their fundraising is KarpReilly LLC, which, as of October, had raised $200 million of the $250 million it is targeting for its debut fund. Allan Karp and Christopher Reilly had worked together for many years at mid-market buyout firm Saunders Karp & Megrue.
One way to build a track record, of course, is to do one-off deals with one-off financing. Doing so, a firm can eventually accumulate enough of a track record to attract institutional money. Todd Robichaux and Doug Wheat formed Dallas-based Southlake Equity Group in 2007 to buy companies with enterprise values of $20 million to $150 million in the south central United States. Although the two had worked together for many years in two previous private equity firms, when a new partner came on board, several potential investors said they would like to see the three principals do a transaction together. The firm ended up delaying its fundraising to do a deal in concert.
Along with a track record, groups that have already attracted some money from backers tend to have a much easier time getting more from an emerging managers program. An obvious starting point is the GP’s own commitment, which placement agents suggest should be a minimum of 5 percent of the fund. Tailwind Capital Partners, which closed its first fund earlier this year, put in about 5 percent of its own capital. “This resonnated very well with LPs. That is the sort of alignment of interest that LPs love to see in any manager, especially a newer one,” said Michael Sotirhos, a partner with Atlantic Pacific Capital, a Connecticut-based placement agency. Wealthy investors can also be a good place to find money. Guardian Capital’s Haabestad said that wealthy investors tend to make their decisions based on the rapport they feel with the manager because they are committing their own money. “They can go with their gut,” said Haabestad. “When it’s a third party making the decision, they get paid to check the boxes.”
Guardian Capital is also having an easier time on the fundraising trail thanks to anchor investor Mass Mutual, a firm that likes backing emerging managers. Haabestad had a prior personal friendship with a senior executive at MassMutual, which developed into a professional relationship over the past five years. Having an anchor investor is “a prerequisite,” said Haabestad. “The deck is stacked considerably against you if you don’t.” He advises that before creating a PPM and quitting your job, ask potential anchors key pre-commitment questions like how appealing your prospective fund and its strategy are, and “Is that something you could get behind? If so, how firm is your commitment?”
A differentiated investment strategy, whether by sector or investment style, and deep industry knowledge and experience, are also essential to raising emerging-manager funds, sources said, because LPs already have so many investments in their portfolio. The emerging managers that are getting the commitments are the “groups that have a well-defined investment strategy consistently applied in a disciplined way with a cohesive team, producing strong realized results,” said Forum Capital Partners’s Stern.
That said, extremely narrow focuses can be a turnoff. Richmond, Va.-based Ascential Equity, founded by former Virginia Treasurer Bill Wiley and former Virginia Treasury investment pro Greg Schnitzler, headed out to raise a debut fund in early 2007. But the firm had difficulty attracting money for Ascential Equity I, since investors had a hard time embracing a strategy of investing in the community banking sector, according to Schnitzler.
If a strategy is “too narrow you take a huge risk because the sector can just turn off,” said Grove Street’s Harris. The worst two funds Grove Street invested in during the past 10 years were both industry sector funds, including a buyout fund that had the misfortune to invest in telecom services circa 1999.