By Sam Sutton | Buyouts (July 27, 2015) — Their flight to New York was canceled. In fact, with a blizzard making its way up the East Coast, every flight to New York was canceled. The weather problems put Strattam Capital founders Robert Morse and Adrian Polak in a bit of a pickle. They were supposed to be in New York City the next day for their first meeting with prospective investors and, this being their first meeting, canceling was out of the question. Could they get a flight to somewhere nearby and drive? Philadelphia? No. Boston? No. The airline could get them as far as State College, Pennsylvania – a four-and-a-half hour car ride from Manhattan – and then they were on their own.
“We got to State College at 1 a.m. and we drove all night to New York, and it’s snowing,” remembers Morse. And then it hit him – this is a blizzard. Who knows if the LP will be able to even make it to the office?
Morse and Polak made the meeting. The LPs showed up, expressed interest, and remain in active dialog with the firm.
If you have the patience to deal with sudden snow storms and other surprises, there may be no better time to launch your first fund. New data suggests limited partner demand for managers marketing their debut vehicles is climbing toward its post-crisis peak.
General partners raising money for the first time closed on $22.4 billion through the first five months of 2015, putting new managers on pace to raise more than they have in any year since 2008, according to data provider Palico. Meanwhile, more than two-thirds of the 70 first-time funds raised year-to-date met or exceeded their target, Dow Jones reported in July.
“There’s a better fundraising environment right now, and there are a lot more managers who are able to go out there, make the leap, and go out and raise a first-time fund,” one LP told Buyouts.
Firms such as Archimed SaS, New Water Capital and Silversmith Capital are successfully raising debuts after their management teams spun out of older, more established firms. Gerald Cardinale-led RedBird Capital Partners has already raised at least $603 million through its first fund, and has yet to announce a final close.
Even in a booming fundraising environment, however, new GPs face innumerable challenges in spinning out and marketing inaugural funds. With that in mind, Buyouts compiled a seven-point checklist for managers who believe they are ready to venture out on their own. This checklist was assembled with input from several GPs, including first-time managers, as well as limited partners and service providers.
It sounds like a cliché, but before new GPs can spin out of their former firms, construct a prospectus, rent office space or ring up fresh capital, they must ask themselves one critical question (and answer it honestly): Are you really unique?
“Are you going to do something sufficiently different and better, so that it deserves a fund?” asked Morse of Strattam Capital. “The new firms that are coming out are effectively displacing the older firms, so you have a higher bar for competition.”
Out of its annual pipeline of 500 to 600 potential alternative investments, the New Jersey Division of Investment conducts full due diligence on just 25 to 50 funds per year, and only a handful of those vehicles wind up with commitments, according to a state sourcing presentation. Limited partners who spoke with Buyouts said new firms help their own cause by being demonstrably different.
Spinning out with a clearly established track record (either through pre-fund deals or with approved usage from a prior firm) goes a long way with LPs, sources said. Alternatively, clear expertise in a niche segment or an unusual approach to structuring deals or portfolio company management can also set a GP apart.
“You don’t want to have a pitch meeting that’s, ‘Hey, our track record was really good – trust us,’” said Steve Gord of Boathouse Capital, which recently closed its second fund on $230 million. “What is our reason to exist? What are we doing differently? … That’s a very difficult question to answer, and relying only on past experience will only take you so far.”
Expenses at a startup add up quickly, and that’s particularly true if you’re a new private equity fund manager. Sources recommended founders raise, borrow or save enough money to sustain their firm through their first two years of operations.
Most managers will not collect a salary until their fund holds a first close, which can take as long as a year or more, so having capital on-hand for expenses is crucial to the firm’s survival in its early stages.
“You could be a top-performing guy at a top, bulge-bracket bank, [but] it could still take you two years to raise your fund,” said former RedBird CFO Tom Mastrobuoni, who recently founded Operational Strategies LLC to help new managers find their footing. “You’re going to need a good amount of operating cash just to get to a point where you want to meet with LPs.”
During that time, founders will have to pay for functions their former firms likely kept in-house. Lawyers, accountants, IT networks, service providers and office space cost money – a lot of money. Mastrobuoni estimates launching a New Yorkbased middle-market private equity firm can cost upwards of $12 million.
“The GPs who spin out of these bulgebracket banks [had back-office functions] done for them. Here’s your desk, here’s your phone, here’s your computer, here you go. There’s a lot they need to set up that they’re just not used to,” Mastrobuoni said.
The strategic direction of the firm has been established. You have startup capital on hand. Now, how do you set up the infrastructure you’ll need to raise your first fund?
“Once you have your ‘We’re on a mission from God,’ Blues Brothers moment, you need to put the band together,” said Morse.
The approach for assembling a team and its internal infrastructure will vary across firms. At Boathouse, the firm’s four partners took a cost-conscious approach, handling many of the back-office responsibilities themselves until holding a first close in 2009, said Gord. Strattam – which launched with fewer co-founders – hired a full-time chief operating officer in Heather Malloy to construct the firm’s operational model and manage relationships with service providers.
Other firms hire consultants or temporary CFOs to help negotiate operational pitfalls, sources said. No matter the structure, LPs will want to see working management structures and processes in place before they commit to a fund, and for many GPs, the best options are often outsourced.
“Oftentimes, in a first-time fund, or a friends-and-family fund, they’re not using a top-tier auditor. Legal may not be a law firm a private equity fund would typically use,” said Marc Friedberg of Wilshire Associates, an LP advisory firm. “If they show they’re already doing those things in a firsttime fund, it goes a long way in showing they’re looking to build an institutional business.”
For many firms, the best way to set up those back-office functionalities is to outsource them to service providers. While this route can be expensive, it can also add a layer of comfort to prospective LPs, sources said.
“This is self-serving, but there’s been a lot more focus recently on the back office,” said Brendan Tyne of Augentius, a service provider that specializes in back office functionality. “You’d be surprised. We’ve had people come to us after a year of operation still doing their accounting in Excel. Now, Excel’s a great program, but real institutional investors aren’t going to take you seriously.”
Outsourcing can be expensive – even if those services eventually get billed back to the fund – so new GPs are best served by maximizing the value of their existing network and taking free advice (or services) whenever and wherever they can.
“We definitely called all of our friends who were GPs and asked for advice, and people were extremely helpful,” said Gord of Boathouse. “That was a big part of our success – being able to reach out to a half dozen or so GPs who had raised first-time funds.”
LFM Capital Executive Managing Director Stephen Cook, whose firm closed on $110 million in October, said Kim Marvin of American Industrial Partners served as an “invaluable sounding board and resource” for LFM in matters ranging from fundraising to service providers.
“Strong networks and relationships are critical to building a successful PE firm,” Cook said. “When we launched LFM Capital, we drew heavily on our team’s existing networks for talent, advice and logistical support.”
Leveraging an existing network saves costs. One first-time GP told Buyouts he made a deal with the attorneys who negotiated his spinout to delay payment until his fund closed. Other contacts lent a hand with temporary office space and IT set-ups. “We never could have done this without that,” the GP said.
Placement agents can also offer assistance. While LPs tend to be “very polite” in declining to proffer a commitment, placement agents – in deciding whether or not to take on a new fund – often provide unvarnished takes on a management team’s strengths and weaknesses, said Gord. That sort of feedback helped Boathouse hone its pitch during its initial fundraise, he said.
All of the above requires a certain degree of confidence, and new GPs should view whatever costs they accrue as an investment in their future platform. That said, the road to solvency is littered with lawsuits, so first-time managers should strongly consider taking out an insurance policy on the off chance that something goes wrong.
“I think it’s something people think about later, rather than sooner,” said Mastrobuoni, noting that people tend to get litigious when they lose faith in a new manager. “Think about how pissed you got when your brother-in-law didn’t pay you back that $20 he borrowed in Atlantic City. Add six or seven zeroes to that.”
Insurance brokers can offer variations of director-and-officer (D&O) insurance that will protect nascent firms from claims made by early investors, portfolio companies or service providers, thereby providing a layer of security to GPs who don’t want to see their first fund sunk by a lawsuit.
Those policies tend to be expensive, however. The ballpark cost runs around $60,000, said Neil Krauter, founder of insurance broker Krauter & Company. Without an active fund to bear the brunt of the cost of insurance, GPs can try to structure deals with insurance brokerages to bridge the gap – either through loans, delayed payment plans or by backdating coverage.
As expensive as insurance is, the alternative can be even more costly. “Just responding to a claim can cost seven figures,” said Mastrobuoni.
New GPs have to walk a fine line in more ways than one. Reaching out to potential LPs before spinning out is a “big no-no,” and can run you afoul of your former firm, sources said. At the same time, launching a debut fund without doing homework on LP commitment strategies and their appetite for first-time funds can cost you.
One GP who closed on a debut fund last year suggested doing some basic research to find out if an LP has first-time funds in its portfolio. “If they don’t, there’s a good chance you won’t get funding,” said the GP. “Have a good feeling about who your anchor is going to be… So much of fundraising is about momentum.”
While LP sources recommended, unsurprisingly, that GPs offer investor-friendly terms with their debut funds, other sources caution new managers not to cut themselves off at the knees in pursuit of an anchor investor.
“It’s very tempting when you’re raising that first fund … to go, ‘I’ll take it’ on terms,” said one GP. “But in reality you’re setting a precedent that’s difficult to break out of with future funds. You come across as desperate to LPs. They’re running a business as well, and if they feel like they can get a break, they will.”
It’s easier said than done, but expanding the investor base as much as possible in the early stages could save GPs headaches with future funds.
“The bigger a check you get from the anchor, the more it’s going to look like you’re a subsidiary of them … and they want you to put their money to work,” said Mastrobuoni. “If they decide they’re done with you, now you have to start fundraising from scratch.”
Morse facetiously described his decision to launch Strattam as a “mission from God,” but it takes a certain amount of fervor to push through the challenges that will undoubtedly arise during a debut fundraise.
Sources described driving scrambling with contractors to complete renovations on a new office before an LP’s onsite visit, haggling with attorneys, and pulling their hair out over the logistics of running their own business for the first time.
“That’s why having an idea that you couldn’t do under an existing framework is so important, because it keeps you going,” said Morse. “It’s a full-body experience.”
Perhaps more importantly, embracing those challenges will prepare you for Fund II.
“I think there’s a perception that, when you get started, you’re going to reach a certain milestone where the light turns from red to green,” Gord said. “It was really a learning process, and I don’t think we ever stopped learning how to run a firm. I’d say we’re still learning. It’s a process of little milestones you get under your belt, that get you to a point where you’re a real institutional investment fund.”