Allocate 2018: Risk-return for maiden managers and spin-outs

Private equity firms have enjoyed historically good fundraising conditions over the last two years as 143 vehicles held final closes for a total of €91.3bn in 2017, breaking a post-crisis record of €82.8bn from 131 funds set the previous year, according to Unquote Data.

This would seem the ideal environment for a first-time manager, but geopolitical difficulties, fierce competition and the naturally risk-averse nature of LPs mean that even in fair weather, challenges remain.

The European Investment Fund has backed 85 maiden funds since 2008, director John Holloway told the audience. These have generated a pooled IRR of 7% to date, and 40% of those initially raised between 2008-2012 have since closed a successor fund.

"Despite this, most investors will shy away from maiden funds," said Holloway. "The biggest hurdle is the lack of financial numbers, and hence proving the track record of the team – especially when it comes to assigning successful transactions to individuals. The key here is for investors and the managers to spend a lot of time together to reach the necessary degree of comfort".

International appetite
FPE raised its first institutional fund, FPE Fund II, after spinning out of the Stonehage Fleming family office. It held a final close on £100m in October 2017 after 18 months on the road but had a mixed experience attracting international investors as a first-time manager, said the GP's managing partner, David Barbour: "The US had 20 years of growth capital experience and we found they were much more receptive to what we were trying to do, and required less explanation than some of our European LPs, which drove our first close."

Unfortunately, choosing to launch a UK-focused fund in 2016 ran into complications in June. "Brexit changed everything though – the US took a step back and we had to get some momentum going with a couple of deals before reaching final close," said Barbour. "We did two good first deals in the fund and that really drove interest and the final close."

"Commercial investors just want to see a de-risked deal," said EIF's Holloway, "and a maiden fund is perceived as being about as far from that as you can get." Starting to deploy the fund ahead of a close, like FPE did, is one way of reducing perceived risk. One panellist highlighted other mitigating strategies, such as securing the support of a cornerstone investor: "It helps if you have a cornerstone LP that can take a significant stake in the GP, but even this is not enough to raise a big fund as a first-time manager. We also offered board seats to key LPs."

Other ways of reducing perceived risk were also discussed; one of these was partnering with corporates that would guarantee to buy the best portfolio companies. "This also helped reduce the perceived risk because you have the exit route built into the strategy," said one panellist.

Fresh pastures
However, when an established manager steps into a new strategy for the first time, perceived risk is generally lower. Hamilton Lane's Tarang Katira explored the operational advantages of this kind of diversification during the panel: "For larger managers launching strategies in the lower-mid-market, it can be advantageous in that it's a bit like taking a gun to a knife fight. Often, there are GP-level and portfolio-company-level benefits that larger managers have in terms of value creation capabilities, capital markets presence, etc."

Of course, there are still risks, and it is important to ensure that the investment team is properly focused, Katira said. "Another consideration is that the investment team should have the DNA of a small-cap rather than a large-cap investor, and it's important to get the balance right."

Regardless of the specific circumstances and resources of the manager in question, there is one thing that first time managers will always need: luck. As FPE's Barbour put it: "There's also an element of serendipity involved in the timing of these things. Managing to meet a CIO at a key LP for an airport breakfast was a key moment for us."

Looking ahead, Barbour said that the maiden space is arguably better than ever with outstanding young talent coming in. But another panellist warned that this segment of the market is probably going to see a correction phase. Holloway concurred, noting that the maiden funds successfully launched in recent years were raised in a relatively benign macroeconomic environment, and wondering what maiden fundraising would look like in tougher times.

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