Heritage funds: Large-cap players explore mid-cap opportunities

Many established private equity investors have gradually moved up through the deal bands that they can target, raising bigger funds to do bigger deals, and gradually developing their deal sourcing and value-creation strategies. However, some players are seeing the advantages of expanding their strategy to cover smaller or mid-market deals, too.

The first few weeks of 2021 have offered more examples of larger GPs going back to their roots. Astorg is on the road for Astorg Mid-Cap, its first mid-market fund, with a final close anticipated in summer 2021, as reported. Triton held a final close for Triton Smaller Mid-Cap II in March 2021 on €815m, as reported. And PAI Partners held a final close in March 2021 on €920m for its debut mid-market fund, as reported.

Richard Howell, a managing partner at PAI who also heads the firm's investor and capital markets teams, says the strategy appealed to both new and existing LPs: "We ended up attracting a broader depth of interest than we had forecast, with many new investors joining. It suited people to whom the mid-market appealed; they saw the compelling cross-border consolidation that we could bring and were keen to get involved."

Large-cap players raising mid-market funds to target more opportunities is by no means a new development, of course: brand names including EQT have raised several funds to target the mid-market alongside their large-cap strategies. Carolina Espinal, a managing director in the primary team at HarbourVest, says: "There have been quite a few funds that have done this; it is a type of franchise extension that has existed in the global market for some time, but we've seen a trend acceleration over the past few years. They are also commonly known as heritage funds and have been used not only as investment vehicles but also as talent retention tools."

LPs have needed to ask themselves questions before committing to funds that are an expansion of large-cap players' existing strategies. Till Burges, a managing director at HabourVest in the firm's primary group, says: "Going back a couple of years, there were a lot of questions when the first heritage funds came into the market: how are they managed? What happens with dealflow and what happens to the attention of the key partner? There is now a lot more understanding of heritage funds as they've become more established in the market."

Building on success
Howell attributes the success of PAI's first mid-market fundraise to the fact that the vehicle is an extension of its pre-existing strategy. "Part of the success of this strategy for us is that it is not a bolt-on, a diversification, or just hiring a team and moving into an alternative product. It has been driven by a goal to be more impactful across the sectors and countries that we focus on by extending our core strengths into the mid-cap segment, which was part of the reason it was a successful fundraise. We are building on what we do well."

LPs are well aware of these factors when committing to these funds, Burges argues. From an LP point of view, these extensions are often seen as a way to expand the exposure with a manager that LPs understand well and have a good experience with. "So, it's about backing a strong and well-known GP, sometimes even with the potential for better outperformance than what would be found in the LP's flagship fund," says Burges.

Such strategies are helpful for LPs that are subject to certain restrictions, Burges adds: "It could be a way to put in more capital with an access-restricted manager, too. Some LPs are restricted in terms of manager count; fund extensions enable them to commit more capital with mangers, but without increasing the manager count."

Safety in numbers
The focus on fewer but larger relationships with name-brand GPs, combined with a flight to quality and institutionalisation, has been reshaping fundraising dynamics for years. The pandemic has clearly turbocharged this phenomenon, and large-cap GPs raising mid-cap vehicles can offer LPs a tried and tested strategy and team at a time when the appetite for taking a risk on smaller or less established GPs is arguably even lower.

The perception of heritage funds as benefiting from the institutional qualities of a larger organisation does resonate in the case of PAI. Howell notes that, while the fund and strategy themselves are newly established, PAI's mid-market team is able to take advantage of pre-existing structures within the firm. "Compared with a more independent, new mid-market offering, this was an advantage, as the infrastructure was already in place, allowing the mid-market team to become operational immediately." While the GP built a framework with a separate fund and team for its mid-cap fund, it also provided economic incentives to the broader team to be part of the overall success, and its central functions can be used by the mid-market team, Howell adds.

"Another positive side effect is smaller funds sharpening up with the cascade down of operational best practice from the parent GP," Burges says. "You see operations teams that are standard on the large-cap side (HR, IT, investor relations) being introduced as part of a 'trickle down' effect and as part of the increased pressure from competition."

As highlighted by Espinal, raising a mid-cap fund can also be a useful talent retention tool for large-cap players in a competitive market. "As GPs continue to build large funds they simultaneously invest heavily on talent and capability, building dynamic and ambitious teams that can tackle large and complex transactions," she says. "Heritage funds help the GPs retain talent, redeploying the amazing teams they have built and allowing them to continue to grow and nurture their people and portfolios. By building mid-cap funds with a home-grown team, the GP can work with a management team it understands, who shares the same investment strategies and expertise. This leads to high returns and stronger partnerships."

Trickle-down impact
The topic of talent – and specifically how to staff up these funds with the right profiles – highlights how larger GPs moving into the mid-market will impact other players in that space. Investors at established mid-market managers have usually spent years honing their craft in this market segment, making them a prime recruitment pool for funds venturing down the value range. "The advantage that the mid-market managers have is the sourcing network and contacts with intermediaries in the local market – this can help them unlock deals and is generally different from how larger managers will source dealflow," says Espinal. "Generally, we see larger managers looking to attract this talent."

Existing mid-cap players might not welcome raids on their workforce, but the more pressing concern usually lies with dealflow and increased competition, in what are already heated processes for the best assets. "It clearly increases competition by and large. There might be heritage funds that focus on specific countries or industries, which some managers don't have as much exposure to, and hence these don't impact their deal pipeline, but the overall competition still increases," says Burges.

Funds that have historically focused on the mid-cap space can rely on their undeniable track record and closer proximity to other stakeholders in that segment in order to prevail in tight processes. However, mid-market funds raised by large-cap or international GPs can also offer differentiated opportunities to appeal to business owners, management teams and co-investors – such as access to an alternative network of operators or portfolio companies in other regions.

And while it might take some time for newcomers to crack a more relationship-driven corner of the market, each successful deal can contribute to an image shake-up that further boosts the credentials of heritage funds, particularly when it comes to international firms looking to conquer Europe, Burges argues: "Because of the increase in transactions, they often transform their brands in certain markets. They go from three to four deals done per year in Europe to 10-15 deals in Europe per annum by making additional platform deals and add-ons from the heritage fund. This increase really transforms their brand with advisers, as well as the skill set of the investment team."

On the flip-side, larger GPs that come to fish in a smaller pond can generate new exit opportunities welcomed by traditional mid-cap managers. "Some of our portfolio companies were previously owned by single-country funds that did not have the capability for the next phase of their development, particularly pan-European expansion," Howell says. "It does not mean they have not performed well, but it means that we can take the journey from there. There is a clear role for specialist funds with a niche in one particular sector, and that will continue."

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