The first close for a new fund is meant to be a strong statement. A buyout shop wants to come out with an impressive figure, a tally that threatens its target, signaling to prospective limited partners they ought to get in while the getting is good. And if a firm can go “one and done,” all the better.
But pulling off fat first closes these days is rare: Witness the meager monies raised by U.S. buyout and mezzanine shops through the second quarter. Fund sizes are contracting. Firms are now engaging in tremendous amounts of pre-marketing, trying their best to gauge LP interest and plan accordingly. Those efforts are easy to understand. An elongated fundraising effort drains resources and can become a distraction, while cutting the size of a fund hurts morale and puts a dent in a shop’s image.
Against this backdrop, it’s important for firms, and especially emerging managers, to understand changing LP views on first closes. In the past, especially deep-pocketed investors would often agree to be an “anchor investor”—a respected first-mover whose big dollars helped draw in other investors—in exchange for more favorable terms and conditions and other benefits. Today, even the smallest investor is looking for something akin to anchor-investor treatment in exchange for helping a firm simply reach a respectable first closing.
So let’s start with the cons for investors coming into a first close. Right now, doing so is akin to showing up early for a party whose success is in doubt. Many buyout firms find themselves falling short of their fundraising targets, raising the question of whether they’ll be able to execute on their promised strategy, and whether they’ll be able to recruit and maintain top investment professionals. Throw in continued liquidity issues experienced by LPs, and the lingering impact of the denominator effect, and it’s pretty easy for an LP to rationalize waiting for future closings.
On the plus side, LPs with pledges at the ready may be in a position to divide and conquer. “LPs are always looking for economic incentives to come in as cornerstone investors,” said Jake Elmhirst, co-head of the private funds group at investment bank UBS. “Especially now, in such a challenging environment.”
Indeed, realizing how important it is for GPs to have a good showing at first close, LPs can negotiate a variety of concessions, such as securing lower management fees and carried interest, along with a seat on the advisory board responsible for representing LP interests in future decisions affecting the partnership. They can also generate goodwill that can pay off down the road in the form of access to later funds, or related co-investment opportunities.
This is a big part of why David Turner, managing director and head of private equity with New York-based mutual life insurance company Guardian Life Insurance Company of America, looks to pursue first closes when he can. “It’s a chance to establish the relationship guidelines,” Turner told Buyouts. With regard to emerging managers, he said: “That first proper partnership agreement is key, and getting it right can really pay dividends down the road.”
Turner added that smaller LPs can really benefit from participating in first closes, saying it’s a way for them to get into bigger, high-profile funds and to gain influence with the GP that outstrips the actual size of their pledges. Turner knows this from experience. The size of his firm’s typical pledge ranges between $15 million and $20 million. Earlier in his career, Turner worked with WestLB and the State of Michigan Retirement System, where he was able to marshal much bigger slugs of capital.
The size of the GP in question can also come into play with the fundamental economics of the partnership agreement. Elmhirst of UBS said most LPs recognize buyout shops need management fees to cover their overhead and recruit and retain quality staff so they aren’t likely to push smaller funds on this point. For bigger firms, however, Elmhirst said LPs “are quite prepared to be more aggressive” on this point in the current environment.
The fundraising outlook for the rest of 2009 is undeniably bleak so it makes sense for buyout shops caught out on the fundraising trail at such a tremulous time to be open to some serious give-and-take in order to get LPs to finalize pledges. LPs are certainly expecting it. In the recent LP survey conducted by secondary firm Coller Capital, 80 percent of those polled said they believe terms and conditions of buyout funds worldwide will become more favorable to them over the next two years, a huge shift from the 20 percent that thought the same thing back in the summer of 2005.
Assuming that expectation gets borne out, LPs gaining cornerstone status will be the ones in the driver’s seat.