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New managers face risk, uncertainty as they bet on independence

  • Advice to first-timers: Don’t market too broadly for debut
  • And build the business before fundraising
  • First-time fundraising climbing

Even in a strong fundraising environment like today, launching a new firm is rife with risk and uncertainty.

Just ask Dana Schmaltz, a managing partner at Yellow Wood Partners. He easily recalls attempting to start his own firm in 2007-2008 with other executives from JW Childs. The group had lined up an anchor investor and prepared to hit the market with its debut fund.

But then the markets collapsed in the global financial crisis, and the fundraising sputtered.

For Schmaltz this failure opened a new path that led to his forming Yellow Wood, which earlier this year closed its second fund on $370 million. The firm focuses on the consumer sector, owing to his experience as an operator of consumer brands.

After the fundraising failed, Schmaltz still had to work, he told Buyouts in a recent interview. “We failed before failing was cool,” he said.

Instead of raising a fund, Schmaltz and a group of operating executives acquired five consumer brands out of Johnson & Johnson. These were brands, like Efferdent denture cleaner, that J&J was not spending any time on, he said.

After talking with a number of private equity firms, the group partnered with Charlesbank on the acquisition. Schmaltz became chief financial officer of the company formed around the assets, Blacksmith Brands. The company sold to Prestige Brands Holdings in November 2010 for a 149 percent internal rate of return.

“That was the genesis of Yellow Wood: ‘Can we do that but do it in a private equity setting?’” Schmaltz said.

Growing popularity

The popularity of emerging managers — those with Funds I through III — and especially of first-time funds has been climbing. Emerging managers have become the big PE story: More LPs are interested in backing these managers to get in early to firms that may become the next PE all-stars. They aim to capture what they see as the outperformance of younger, smaller funds over larger and more established pools.

Fundraising for first-time funds so far this year has reached about $30.2 billion across 170 funds, alternative-assets-data provider Preqin says. Last year, 260 funds raised $30.4 billion. The peak year for first-timers, Preqin says, was 2011, when 267 first-time funds raised $45.2 billion.

And early performance of recent-vintage first-time funds has climbed relative to more developed funds, fresh Pitchbook research shows. First-time funds from vintages 2012 to 2014 produced a median IRR of 17.1 percent, beating the 10.8 percent generated by follow-on funds for those vintages. Median cash-on-cash multiples for the 2012 to 2014 vintage years is 1.4x, compared with 1.19x for follow-on funds, Pitchbook said.

By contrast, first-time-fund vintages 2003 to 2005 generated a median IRR of 8.2 percent, underperforming follow-on funds in those vintages by 200 basis points, Pitchbook said.

Leap of faith

The emerging-manager landscape is riddled with great tries, managers who gave it a shot and came up short. While PE fundraising is as strong as ever, raising a debut fund is still a slog and requires work and sacrifice.

It requires a “leap of faith,” said Mike Bego, managing partner at secondaries firm Kline Hill Partners, which launched in 2015. “I walked away from a healthy income and healthy profit sharing to do this. And the home bills didn’t go away.”

Bego said it was important to begin establishing the business early on — building infrastructure, recruiting staff and talking with investors to line up an anchor investor — before the fundraising officially kicked off.

“I was very active networking, building out infrastructure, constructing models, laying the groundwork, getting legal work done, building presentations, picking out the right partner,” Bego said.

“You have to work super hard from the beginning, even if you’re restricted by what you can do on garden leave or whatever you have going on. Keep busy and do what you can do while waiting to launch the fund.”

New managers also should differentiate their funds, Schmaltz said. A vital question a new manager should ask is, “what makes me special?” he said. “A lot of people don’t want to really look in the mirror for too long and ask that question.”

Another point: Don’t go too broad with your marketing campaign because it’s expensive and can waste time, he said. “We only had five investors in the first pool,” Schmaltz said. “We spent a ton of time with them, not just annual meetings and quarterly letters but in phone calls, meeting them for lunch and dinner. We’d find out when they’re on the East Coast and fly down to New York because they’re there.”

“Treat them like they’re partners so they can see your thinking, and see how you’re implementing your strategy they bought into. If they do that, the chances of them coming back are much higher.”

Different dynamics

Buyouts reached out to LP sources to get recommendations on the most interesting first-time, spinout and other emerging managers in the market this year. The results are in the accompanying chart of more than 40 popular new funds.

One factor that stands out in the research is the pedigree of the firms: Many were launched by partners who came from different firms rather than by groups of people from the same shops spinning out together.

This also includes a cohort of firms formed by those with PE experience pairing with operators from the corporate world. This mix reflects the emphasis in the lower-middle market, and in the high-priced deal environment, on operational improvements, sources said.

“There is a realization that sometimes there’s a lot of benefit to having differing perspectives, differing strengths in the partnership,” said Tracy Harris, managing director at StepStone Group, who focuses on small buyout, growth, venture and emerging managers.

And in the new firms today, the operating professionals are just as senior as the private equity professionals, whereas in the past they would have been subordinate, sources said.

“GPs are realizing it’s not just a function of picking companies well. You need to know what to do with the company once you buy it,” said Christian Kallen, managing director at Hamilton Lane.

“The operating component is becoming much more important, especially at the smaller end of the market. It’s not just that the operating partners work for the investment professionals. Now it’s much more [a matter] of combined teams driving value, and is an aligned and integrated effort.”

 

 

BUYOUTS EXCLUSIVE CHART OF THE MOST TALKED EMERGING MANAGERS IN MARKET:

Buyouts’ 2017 list of most-talked-about emerging firms (figures as of October 2017)

 

Action Item: Check out the Buyouts emerging-manager archive: http://bit.ly/2izSw75

Photo of Dana Schmaltz sourced from Yellow Wood website.