Deal-by-deal emerges as contender to fund-based investing

In February 2012, news hit that Duke Street, the UK mid-market stalwart, had abandoned fundraising efforts and would instead adopt a deal-by-deal approach. The GP had been out on the road for a year previously as it attempted to raise an €850m fund.

The announcement garnered huge amounts of attention and intrigue at the time, with some industry participants wondering if the entire private equity model was at threat and others assuming poor performance on Duke Street's part.

The impact of deal-by-deal on the team's behaviour has meant there is much more of a direct relationship – they're much closer to each deal as the pay-outs are far quicker" – Peter Taylor, Duke Street

Whatever the causes, the GP pushed on and in June 2013 announced it had signed a deal with Paris-based investment firm Tikehau Group. "During the early days of deal-by-deal there was a fair amount of scepticism of the model, especially in Europe. So Tikehau came in and bought a 35% stake, which gave us underwriting capability," explains Peter Taylor, managing partner of Duke Street.

According to Taylor, following the GP's acquisition of Voyage Care from previous backers HgCapital, the completion of such a large transaction – £375m – stopped a lot of questions around Duke Street's new model. "We've now done five deals outside of a fund. The investors are now more used to the concept and more LPs are doing co-investments. The model is more established in the US and we're now seeing more interest from US LPs," adds Taylor.

Flip-side
In contrast to Duke Street's story, Lonsdale Capital recently closed a £110m fund after using a deal-by-deal approach for six years previously. According to Alan Dargan, one of Lonsdale's founders, the GP would have raised a fund at conception; however, with LPs typically averse to debut vehicles, the team decided instead to prove themselves. "When we set up in 2009 we had done some deals but the company was still in its early days," says another Lonsdale founder David Gasparro. "At that stage, it was about getting people to take us seriously. There was work to be done getting ourselves established in the advisory community etc. So that's what we did."

As an echo to Taylor's experience, Gasparro says scepticism over the deal-by-deal model soon dropped away. But despite investors' increasing comfort around deal-by-deal, for him, the main advantage of moving to fund investing is not having to think about raising equity for each deal – having a level of certainty.
Another positive Lonsdale gained by moving to a fund is the impact on recruitment. Says Dargan: "Now we can recruit staff into a stable environment. We can communicate and invest for the medium to long term."

Behavioural impact
Interestingly, while Lonsdale believes the fund approach has improved the team in terms of stability, for Duke Street, the deal-by-deal model also has a positive impact on team behaviour. "The impact of deal-by-deal on the team's behaviour has meant there is much more of a direct relationship – they're much closer to each deal as the pay-outs are far quicker," explains Taylor.

"We don't want to be too divisive – it's not eat what you kill – there are still some fund structure elements. But it has made the culture more entrepreneurial; the team is hungrier. It is very powerful. Especially given the timings of pay-outs from fund structures," Taylor says.

For the Lonsdale founders, this sentiment does not necessarily ring true. Says Gasparro: "We have done two deals with the fund so far and I haven't detected any change in behaviour because carry is structured broadly the same as it was for deal-by-deal. Behaviour and the level of challenge for potential deals is just how it was before."

But perhaps in the case of Lonsdale, because of its carry structure – whereby all staff have carry as all employees have invested in the fund – that incentivisation mechanic is more apparent than many other funds in the market at the moment, which have seen continued reductions in GP fund commitments.

However, Dargan admits the economics of deal-by-deal investing will be missed: "Our first two exits were very good and the economics of that flows through. The economics are faster on deal-by-deal for good exits."

Collaborative approach
Having been applying the deal-by-deal model for four years now, Duke Street is benefiting from a recent development among LPs: increased demand for co-investments. Says James Almond, partner at Duke Street in charge of fundraising: "From an investor's perspective, deal-by-deal is cheaper. It puts the investment decision in their own hands and they can get much closer to the company during due diligence and ownership. Typically, when LPs invest alongside a fund, it needs a quick response as there are others wanting to co-invest. With the deal-by-deal model, it's more exclusive; they can get closer to the deal."

Duke Street runs its co-investment programme like a club, with Almond explaining that some LPs prefer to support deals early on while others choose to come in later at syndication stage.

According to Taylor, the selection process is still evolving. "We're still learning and the landscape is changing. We had done lots of syndication when investing from a fund. Fund-of-funds were unable to do it at first because they couldn't pay fees and carry. But 18 months later they came back to us as their own needs are changing."

When we were doing deals on a deal-by-deal basis they were often oversubscribed, but coming in on the fund means our investors are exposed to all of our deals" – Alan Dargan, Lonsdale Capital

For Lonsdale however, its focus on the smaller end of the market means there is less demand for co-investment. "At the small end of the market it's more attractive for LPs to be in a fund," says Gasparro. "It would be difficult for them to do all of the admin required for smaller deals. So, to get exposure in the smaller, more specialist part of the market, a fund makes more sense."

Dargan also explains that, with LP commitments into its fund at around £10m or more, it wouldn't make sense for LPs to deploy that amount in the small-cap market through single deals, and therefore a pool is easier. "When we were doing deals on a deal-by-deal basis they were often oversubscribed, but coming in on the fund means our investors are exposed to all of our deals. Our investors encouraged us to raise the fund because they want that lower-mid-market exposure," says Dargan.

While Duke Street and Lonsdale are rare examples of GPs that have adopted both the fund and deal-by-deal approach, their different focuses mean the adoption of each strategy offers different advantages for LPs and target companies. In Lonsdale's case, while deal-by-deal gave the team a chance to build a track record and embed themselves within the market, its focus on smaller companies means a fund model is better-suited for LPs looking for exposure of this kind. For Duke Street, having been in the market for 18 years, it had built up a track record and necessary intermediary relationships. But what is more interesting is how the LP community has developed since Duke Street changed strategy. Back in 2012, who could have predicted the GP would be sitting in such a favourable position?

Further reading

• UK / Ireland

Q&A: Duke Street’s Buchan Scott

• 01 Jul 2013

• Buyout

Lonsdale closes maiden buyout fund on £110m

• 14 Apr 2016

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