Rethinking LP funds

At a time when fundraising has never been more difficult, forgoing the twice-a-decade foray down the fundraising trail may be a welcome thought. Duke Street Capital recently left a year-long hike on a rocky fundraise with a view to returning next year. It will now pursue something like a pledge club, according to Buchan Scott, partner at the buyout house.

"We know a group of investors very well that are looking to partner on a deal-by-deal basis," says Buchan. "Most are not LPs in our other vehicles because the classic co-invest mandate requires them to invest alongside a fund," he continues, adding that the new investors are mostly family offices that are au fait with private equity. Rather than raise from LPs, Terra Firma is expected to invest €1bn of funds from an (unnamed) sovereign wealth fund.

"Given the increasingly bespoke nature of PE investment, such arrangements often present themselves as a very suitable structural alternative to accommodate individual investor requests," says Sonya Pauls, fund partner at SJ Berwin. "However, most GPs, after reflection and on advice, come to consider such arrangements to be a ‘last resort' solution only."

"This is a sign of the times, where the impact of mediocre performance and volatility in a portfolio cannot be mitigated by brand value," says Warren Hibbert, co-founder and managing partner of Asante Capital. "The move to deal-by-deal is a sign of fundraising failure, obviously, but doesn't have to mean the group fails - the pressure to deliver strong returns on the unrealised investments has never been greater."

Yet there are benefits to such a model, says Scott. "Each fee is organised at each deal, so may vary across transactions. And carry can be static or like management sweet equity. So the incentive can be well-aligned and there is no fee drag. Some of the old funding structures are no longer as attractive to certain types of investors."

Of course there are disadvantages to deal-by-deal, too. "This is the weakest position to be in - you can't raise LP capital readily and don't have the standing within the public markets to list a fund," says Hibbert.

When LP funds don't make sense
Some first-time funds are looking at alternatives to LP funds. "This is completely understandable in the case where you're a first-time fund and in fact it's the most effective and efficient means of getting into business by proving you can do what you say you're going to do," Hibbert concedes.

Indeed Greensphere Capital, a new infrastructure fund co-founded by Jon Moulton, founder of Better Capital, and Divya Seshamani, formerly of sovereign wealth fund GIC, is doing something akin to deal-by-deal. "We did not embark on a long fundraising process as the model was not quite right for what we do," Divya says, referring to Greensphere's infrastructure focus. Instead the firm is working with a few large LPs for the first handful of deals. "Later we might group them together in something like a fund structure; however, we have a collaborative approach and will make this decision with our investors."

So, abandoning the LP model should not be deemed a loser's plight. Some of the best returns of the last couple of years have been from non-traditional funds: Investec Growth & Acquisition Finance had a hat-trick of exits generating IRRs of around 30% investing off the bank's balance sheet; Milestone Capital, which has a small handful of LPs more committed than a pledge fund but without a typical LP fund, made 3.7x money in under three years with Coffee Nation; LDC delivers triple-digit IRRs (perennially) and Matrix and Foresight venture capital trusts have generated a handful of handsome exits in the last year (see page 30). Alchemy Partners, with its evergreen funding structure, used to live up to its name in terms of exits, though that firm's founder has gone on to create another fund with a different funding model.

"When we launched, we knew that permanent capital would be impossible to raise in the UK," explains Moulton. Better Capital operates celled investment vehicles in a quoted guise. Moulton was loathe to pursue a more traditional permanent capital vehicle - where proceeds can be re-invested rather than distributed to backers - because of the high-profile falls from grace of SVG and Candover shortly before Better was set up.

"There remain two main fears with permanent capital," Moulton says. "Firstly, by nature they are inefficient with capital. This is because they either have to have debt or retain frictional cash to ensure they always have access to cash. The other issue is that fees are often based on NAV.
But this is extremely hard to determine and inherently fraught with conflict."

Better's vehicles, on the other hand, don't base fees on NAV and are distributing funds. The fund is channelled through Guernsey, making it very tax efficient. Had you invested £1 at the outset you'd have had £1.28 at peak (at the time of writing) - not bad for a liquid investment.

"Permanent capital is a bit too easy. Managers can get sleepy because they don't have to go to market every four to five years," says Moulton. Better, founded in October 2009, has invested £204m from its debut vehicle. Moulton estimates there are around 650 listed PE funds globally, but with a mixed reputation. "The listed route doesn't make much sense unless you can demonstrate that the portion of the business you list will accrue significant value, such that the shares trade at a premium, allowing the manager to raise additional capital via a rights issue and the like - with few exceptions the data would suggest that this model doesn't work long-term," says Hibbert.

Moulton agrees: "Listed private equity has not been a very successful asset class lately. Many suffer a long run of low share prices and even the best trade at discounts."

Except for Moulton's, which may be why his Capital is Better. Moulton is proud it does not trade at a discount to NAV and quick to point out the GP puts more skin in the game than any other in the listed market. "We put £20m into Fund I and £30m into Fund II." The firm is also very liquid, with a turnover of 31% since inception. "We've traded up to 4% of the fund in a single day with no impact on share price," Moulton boasts.

Though Better distributes its proceeds and raises fresh capital, atypical of listed PE, others re-invest proceeds and so have a more permanent capital structure. This is often to invest in the GP's own fund, providing a diversified LP base for it. Dunedin's investment trust boasted an uplift in NAV and share price for 2011, allowing it to increase its dividend by more than 30%. "We don't have to worry about spending two years fundraising every few years," says Alex Fortescue, CIO at Electra Partners, the manager of Electra Private Equity, a listed outfit. "It leaves us to concentrate on investing and keeps the alignment between us and our investors." He speaks from experience, having spent 11 years at Apax Partners.

Deal-doing freedom
It is not just the hassling distraction of replenishing coffers that make the old LP model seem less sexy, but also the flexibility of operating outside a restrictive limited partnership agreement (LPA). Take for instance the £45.5m Park Resorts deal just done by Electra. It saw the GP take 25% of the capital structure through purchasing the debt off the incumbent banker.

A refinancing scheduled for autumn 2013 should see Electra take on a larger equity stake (it currently has around 5%) and may see the incumbent GP GI Partners exit the troublesome investment. An interesting and probably cost-effective entry point into what could be a very lucrative deal - and more could be on the cards. "Everyone thought in 2008 that banks would sell sound assets for a song, but it did not happen - the banks are very focused on value," explains Fortescue. "That said, there are now deals to be done. Management teams are tiring and need re-incentivisation, and perhaps that is helping to free up some opportunities."

Such deals are not always within the remit of more traditional LP funds, whose LPAs often restrict them to equity stakes in buyouts (assuming the GP in question is not a turnaround or distressed debt fund). As such, the freedom offered outside the reigns of an LPA may be beneficial now more than ever, as opportunities increasingly come outside the typical areas. Despite their apparent enthusiasm to bow out from PE, banks remain top of the radar for GPs, and no longer just from a lending or LP point of view.

"We are actively looking at banks' loan-to-own books," Moulton says, highlighting the fact he's done deals formerly backed by 3i and Barclays PE that had hit hard times. He reckons around 3% of the deals they look at are from banks' books, though they represent a much larger proportion of completed deals. In July 2011 Better spent £16.6m to acquire a majority stake in Fairline Boats as part of an RBS-led recap that saw 3i exit the business, which it had initially backed in 2005.

Most GPs - unless they are specialised debt funds - are unlikely to engage in such back-door deals en masse. "It's a great time to be liquid," says Fortescue. And flexible - investing in debt is something usually limited to specialised funds and off-limits for traditional GPs. But this, as well as other newly tempting opportunities, is within reach of listed firms with looser investment remits. "There are less primary and vanilla buyouts right now, but we can focus instead on secondary fund transactions and debt," he says, explaining that they bought a chunk of Steadfast in Germany for €25m which has already returned 70% of Electra's cash outlay. It also purchased an "accordingly priced" stake of Cognetas before Christmas.

There is also the attraction to investors. It used to be that LPs paid high fees on commitments for the hope of high growth of PE funds. But as returns fall (and are set to fall further as the last crop of deals vintage
2005-2007 are up for exit), those generated by their listed counterparts look increasingly attractive. "People invest in us for capital growth," Fortescue says. He maintains that Electra's £1.2bn in gross assets has yielded 10-15% net returns over the long-term and is blended across cash and investments. While this sounds like mezzanine returns - ie a lower risk/reward profile - it is worth remembering that traditional PE funds struggle nowadays to reach their target returns of low- to mid-20s. And with listed PE, you can get out more easily.

According to Seshamani, "LPAs are very long-lived things with substantial penalties for getting out. LPs want an option to review should managers stray from investment objectives, style and the risk/return profile. For example when GPs take on higher risk to try and achieve hurdle rates through leverage or on riskier business models. LPs are getting smarter and really looking at the contracts they're getting into now - this is a good thing for the industry."

A downside to different
Of course, LP fund alternatives such as pledge funds, deal-by-deal and listed are not all rosy. Says Pauls: "GPs need to ensure that those investors who participate in non-binding arrangements are sufficiently committed and not just strategic ‘deal-flow watchers'."
Deal-by-deal also suffers from uncertainty at the point of execution; something two corporate finance houses told your correspondent is a major concern and one that means they are loathe to show deals to such houses.

The main downside to being listed is one of daily performance. "There is a disjoint between NAV performance and share price for listed vehicles, though it is the same for secondary LP positions," Fortescue says. At the best of times it is single digits but in 2008, SVG and Candover traded at discounts of around 60%. The average now across the asset class is 30%.

"We feel unfairly tarnished by the same brush as other trusts," Fortescue says, pointing to SVG, Candover and 3i, which he says are effectively listed LPs. "We invest directly off the balance sheet so do not have over-commitment driven liquidity issues," he adds, indicating that the discount is not fair across all listed entities.

Better, despite its listed structure, has to test its popularity every couple of years, through a share issuance. Better's second vehicle, BECAP12, held a first close in January and boasts net proceeds of £166m. The second time round was - similar to LP funds - dramatically more difficult. "The marketing period for the first fund literally took a couple of weeks. The second was much harder, but still came up as the largest IPO at the end of last year."

Not only is Better kept in check by its need to raise funds through share issuance every few years, but its listed status means a share price acts as a daily report card. The day your correspondent interviewed Moulton, the price hit an all-time high.

Hibbert reckons that this year and next will be about difficult times, but with success for those that tailor their offering to LPs. "We will continue to see a polarised market - funds delaying launches by 12-18 months while others are pulled and yet another group closed in record time and oversubscribed. We will also see ‘special deals' - managed account relationships being established between large sovereign wealth funds or US pension funds and brand-name GPs."

Indeed, this personal service is what Greensphere is currently pursuing. "The LP model is not dead," maintains Seshamani. "There are still a lot of LPs keen to invest in big brands because ultimately you do not get sacked for investing in a big brand."

Pauls, with her bird's-eye view in fund structuring, backs up Seshamani's view that variations of the LP model are here to stay: "Bespoke arrangements do of course work for particular situations, but we do not foresee such arrangements turning into the standard fund model for the future. Private equity investments are increasingly bespoke, but the requests and demands generally translate well into traditional fund arrangements or managed accounts structures.

"What we are of course seeing as a result of often challenging fundraising processes are ‘mini funds'," she continues, "Funds that replicate predecessor structures but with a sometimes significantly reduced fund size to enable GPs to remain ‘in business' until, on the basis of the new track record, a larger fund may be raised again." Most hope that is sooner rather than later.

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