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Media Coverage

Private Equity Preps For Spinouts As More GPs Look To Fly On Their Own
By Sabrina Willmer
3/1/2011

A healthier fund-raising environment and internal pressures prompt more teams to fly the coop and limited partners finally appear willing to help them feather their new nests.

When a group of executives left Golden Gate Capital in May 2010 to set up their own shop, the odds were stacked against them as even well-established firms struggled to gain traction in a contracted fund-raising market.

But in little less than a year, the firm, known as Altamont Capital Partners, managed to sail past its $300 million target to close its debut fund at $500 million.

Success stories such as Altamont's have been few and far between in the wake of the financial crisis of late 2008 - partly because few new groups have been brave enough to go it alone in such a dire fund-raising market.

However, that may change over the next few years, as several different forces converge on established groups that stand to drive more spinouts, both in the U.S. and Europe. In the past two years alone, at least a dozen new firms have hung out their shingles, although some are further along in the fund-raising process than others. Meanwhile, limited partners, encouraged by improvements in the economy and their own portfolios, are more willing to add new names to their GP rosters, even as they clear out some old ones.

"Investors are reexamining everything they have invested in so this opens the door for first-time funds to be considered," said Larry Rowe, a partner at law firm Ropes & Gray LLP.

According to a recent Coller Capital survey, 81% of the LPs expect to add new general partner relationships during the next two to three years.

"Although the old guard is still very important to industry, if we want a really powerful tool then we will mix old blood with new blood," said a principal at a fund-of-funds manager.

Part of the appeal for LPs is the perception that spinout teams are considered hungrier and more entrepreneurial because they are building their own firms. These groups also tend to have smaller funds so there may also be a perception that they are putting money to work in a less efficient market.

There may also better alignment of interest as these new teams tend to commit a lot of their own capital, said Susan McAndrews, a partner at Pantheon, which is one investor that will look at spinouts as it puts money to work this year. For example, the GP commitment to Altamont's debut fund takes up 10% of the vehicle.

Limited partners should have plenty of new names to choose from, thanks to a variety of factors. First, regulatory pressures are forcing some financial institutions in the U.S. and Europe, particularly banks, to shed their internal private equity teams.

Meanwhile, hedge funds that built teams to invest in private equity through side pockets during the market boom are less able to retain those illiquid portfolios as investors seek redemptions. Some hedge funds that suspended redemptions in 2008 and 2009 now must meet requests by raising capital quickly through the sale of securities such as debt and private equity, according to Bryon Sheets, partner at Paul Capital.

"These firms also now have the room to take discounts on private equity assets thanks to the recovery in their listed portfolios over the past six to nine months," he said.

At the same time, private equity professionals that feared striking out on their own during the recent downturn may have more confidence to jump ship as the fund-raising market gradually improves.

The trend is expected to increase as junior partners at firms hit severely by the downturn see no carry in sight.

"One of the reasons spinouts didn't happen in last half of the 2000s is that funds were at least doing well on paper," said a managing director at a fund-of-funds manager. "But a lot of carry that was expected is not worth a whole lot today," he said.

In Europe, for example, former executives of Candover Partners have recently started raising a debut buyout fund. Candover struggled to raise a fund in 2008 after its parent company had to back out of its commitment due to liquidity issues. Subsequently, Candover Investments decided against investing in new funds and is managing out its existing portfolio.

There is also a growing belief among many in the industry that private equity firms have become too large, so some professionals are likely to move downstream. "Some clients want to drive a speed boat instead of an ocean liner," said Terence Crikelair, a managing partner at placement agent firm Champlain Advisors LLC.

Make Mine A Spinout
Despite an increased willingness among LPs to make new commitments, many first-time groups will find it tough sledding as they join a torrent of other older firms also marketing funds in 2011.

One thing that can help is if a group previously worked together as part of one team, rather than coming from separate firms. In theory, this strategy can help mitigate the team risk associated with spinouts, since the professionals would already understand each other's working style and personalities. Teams that spin out of more established organizations also may have more seasoned relationships in the deal world.

"Good investors have access to and relationships with CEOs that could generate interesting deal leads," said Tim Kelly, partner at Adams Street Partners LLC. "Oftentimes, better opportunities lie with division heads or general managers of larger enterprises that seasoned GPs can tap into as a result of deeper experience or longer relationships. Spinout teams, given their tenure in many cases in the market, can often take advantage of these latter opportunities easier than less experienced GPs."

Twin Bridge Capital Partners, a Chicago-based fund-of-funds manager, for example, will only invest with first-time funds if the key partners have worked together under the same roof. "If you give me 10 first-time funds where the teams haven't worked together, I will give you nine failures in terms of meeting our return criteria," said co-founder Brian Gallagher.

But that doesn't mean that firms formed by individuals from separate organizations can't win over LPs. Consider the recent fund-raising success of Searchlight Capital Partners, a mid-market buyout firm formed by senior executives from three separate firms: Apollo Management, Kohlberg Kravis Roberts & Co. and Ontario Teachers' Pension Plan. The new firm has managed to raise more than $300 million so far toward the $500 million to $1 billion target for its debut effort, which it started during the second half of last year.

In Searchlight's case, the brand name cache of the senior executives and the firms that they came from likely helped garner LP support, according to one investor that is looking at the group.

Who Owns What?
Regardless of whether a team spins out together or comes together from separate places, investors say that verifying a firm's track record remains one of the biggest challenges they face in evaluating new groups.

"We want to look at who really did what and how the deals came in," said the head of one East Coast fund-of-funds manager.

The issue of deal attribution can be quite challenging for LPs, as in many cases the lines are blurred over which individuals should receive credit for certain deals. In some cases, parent companies and their spinouts can clash over track record attribution.

In a recent example, Arsenal Capital Partners, a New York-based mid-market buyout shop, has refused to sign-off on the track record of some of its former employees that are out raising a debut fund known as SK Capital Partners III LP, according to three prospective investors.

Although it is not unusual for a parent firm to question track record of a spinout, the SK Capital situation represents an extreme case, said one prospective investor, noting the fact that partners at the spinout served at Arsenal during different time periods adds complexity to the situation. In cases where a parent company refuses to sign off, that means it makes "our job more difficult," said this investor, but doesn't scare the firm away from the investment opportunity.

Barry Siadat, co-founder of SK Capital, declined to comment. Terrence Mullen, a partner at Arsenal Capital Partners, couldn't be reached for comment.

While it's unclear exactly how this may impact the fledgling spinout's fund-raising progress, in general, if LPs have a tough time confirming attribution for deals, they might choose not to bother.

"If there is any kind of question mark about attribution, many LPs won't want to spend the time looking at the investment opportunity," said Richard Anthony, a senior managing director at Evercore Partners.

Track record attribution can be particularly challenging for spinouts from hedge funds, which generally tend to be more opportunistic with their private equity investments, according to a partner at a fund-of-funds manager.

"They might have committed $50 million to one deal and $500 million to the next one," this person said.

Shoring Up The Base
Deal attribution challenges may be less likely to occur with spinouts from firms with a sole financial sponsor, as new teams won't necessarily be competing with their parent companies for the same investors.

For most firms, fund-raising success will likely depend on the support of investors that teams had relationships with at their prior shops. These LPs are almost always the first stop on a new team's GP road show.

"We usually invest with spinouts where we have good relationships with managing directors or principals in the past," said a principal at a second fund-of-funds manager. In Altamont's case, for example, 60% of the LPs that committed to its debut fund were investors that the co-founders had worked with while at Golden Gate, including Stanford University and Pantheon.

This means that groups that have historically relied heavily on the backing of a sponsor such as a bank, corporation or insurance company may have a more difficult time, considering they don't have the luxury of relying upon an existing LP base.

Some have turned to secondary firms to help bridge the gap. Secondary players have played an increasingly large role in backing spinouts of new groups from banks and other financial institutions, thanks in part to the vast amounts of capital raised by these firms in recent years. In 2010 alone, secondary firms collected a total $11.9 billion on top of some $19.6 billion that firms raised in 2009, according to data compiled by Dow Jones LP Source.

In 2010, for example, Coller Capital backed the spinout of a private equity team at Lloyds Banking Group. Meanwhile, Paul Capital, which has done more than three dozen bank transactions over the past 10 years, did half a billion dollars in spinouts from banks over the past 12 months, according to Sheets of Paul Capital.

In cases involving the launch of a new firm, the secondary investor will often not only help the group buy out existing assets from its prior owner, but also provide financing for new deals. The fresh capital helps a firm build out its track record under its new banner, which can prove useful when the firm prepares to raise its next fund.

However, relying too heavily on secondary backers can also be tricky as they may not have the capacity or the inclination to write a sizeable check when a newer firm comes back to raise a new fund from scratch. But those secondary firms with primary practices are likely to have more flexibility and capacity to continue supporting a spinout into the future.

Exactly how much LP largesse materializes for the next wave of new managers will become clearer over the next couple of years. Despite improved LP appetite, many new funds will ultimately fail to get off of the ground. But for those LPs that choose wisely, the returns could prove to ultimately outperform the funds of established parent companies.