02 Oct 2019

Are you ready to go it alone?

Authors:

Joe McKenna & Ian Wiese (Investec)

Andrew Frost (Lawson Conner)

Barry Stimpson & Emma Radmore (Womble Bond Dickinson)

 

Eight things not to overlook when setting up a first-time private equity fund.

 

European first-time fundraising hit record levels in 2018, with €7.8bn raised by nascent managers, according to Preqin. Firms such as Bowmark spin-out Apiary Capital have wrapped up rapid debuts. Most recently, new arrival Novalpina Private Equity stormed to a €1bn final close. According to the BVCA, “the time taken to launch and raisea fund is now at just 13.4 months, the lowest since the financial crisis, and 30% of funds are taking six months or less to close.”1

 

Nonetheless, launching a new private equity fund can be challenging, especially as limited partners (LPs) look to streamline their general partner (GP) relationships. For aspiring managing partner it is paramount to establish a coherent team; present an intelligible and compelling track record; and articulate a clearly differentiated strategy. LPs will only consider taking on new managers if they are genuinely able to provide additional value. Apiary, for example, tapped into appetite for lower mid-market buy-and-build. Nordic house Summa Equity, meanwhile, captured investors’ imagination with a strategy built around sustainability.

 

Winning over LPs is only the beginning, of course. New managers must also strike a chord with the management teams of the companies they are looking to back. A pipeline of potential deals is essential. In fact, it is not uncommon for emerging managers to fund their own early investments in order to showcase ability before embarking on a formal fund.

 

But the real decision-making begins at the launch of a maiden institutional vehicle. The to-do list is lengthy – from securing a credible placement agent, to settling on the right domicile. New funds must set their optimal fee structures, arrange fund finance, define a compliance policy, ensure hedging – and resolve a thousand other factors. And the consequences of getting it wrong could be career limiting.

Here are our top tips for getting it right.

  • 1. Don’t automatically go with the status quo

    Its structure and terms at launch can say as much about your new fund as its investment strategy does. There has been remarkably little change to the ‘two and 20’ fee and carry structure since the dawn of the private equity industry, and many first-time firms decide it’s safest to adopt market norms.

     

    However, some new managers are starting to announce their arrival with innovative business models, often focused on improving alignment of interest. McKinsey, for example, cites “LPs’ demand for newstrategies, custom vehicles, access to co-investment, strategic relationships” and more for a slew ofinnovative and often bespoke arrangements by GPs.

     

    For example, new firms are adopting both shorter and longer durations than the typical ‘10 years plus two-year extension’. Shorter durations, with as little as a two-year investment period, a reproving particularly popular with some LPs. Some new managers are introducing staggered carry schemes, and management fees based not just on commitments, but on the amount invested. Other examples of innovation include a combination of deal-by-deal and blind pool commitments.

     

    Sticking to the status quo can seem like the judicious choice when starting out with a new firm. Butoffering a differentiated structure or terms can help you stand out from the crowd.

  • 2. Don’t underestimate your commitment

    LPs consider the GP commitment to their fund to be an integral part of alignment of interest. So it is critical that the investment team has adequate skin in the game. GPs expect to commit an average of 2.9% to their next private equity fund, according to Investec’s 2019 GP Trends survey3 – a significant increase compared to a decade ago.

     

    Yes it’s an investment up front – but if and when the fund succeeds, team members will find their stake a source of considerable wealth. Properly handled, that makes them a powerful recruitment and incentivisation tool.

     

    But in that GP Trends survey, one-in-eight GPs – rising to one-in-four for those below partner level –admit they don’t know how they are going to finance their next personal commitment. That’s a problem that virgin funds, in particular, should try to address up front.

     

    Ability to rely on carry or co-investment proceeds will depend on leaver status and the performance of previous funds. For junior team members, those avenues may not be applicable at all. A debut vehicle might possibly secure a management commitment waiver – but LPs are increasingly sceptical about this approach.

     

    External financing is one pragmatic solution. This usually takes the form of a personal loan, with thebank taking a long-term view on the individuals’ prospects. This will typically involve collateral such as a house or liquid stock portfolio. And it can be beneficial to work with lenders who consider boththe fund manager and the fund. It is possible to borrow against the corporate balance sheet, for example, based on the collateral of contractual management fees. The corporate can then on-lend to the individuals making their GP commitments.

     

    The advantage of borrowing at a corporate level is that there is limited recourse to the partners themselves – and the general partnership can retain control over how to on-lend, allowing the financing to be tailored to different levels of employee. It is also possible to obtain higher advance rates, providing there is sufficient collateral available.

     

    Don’t assume the management commitment will sort itself out or can be dodged simply because it’s a new fund. There are solutions – and the commitment can be a motivator.

Ian Wiese
Ian Wiese , Investec’s Fund Finance team

It is important to select a banking partner that understands the mandate, appreciates the rationale for the facility and is willing to create tailored solutions.

  • 3. Be smart about your use of fund finance

    Fund finance isn’t restricted to supporting GP commitments, of course. New managers should familiarise themselves with the use of capital call and NAV-based financing solutions – as well as how to broach this potentially sensitive subject with their investors.

     

    Inflammatory headlines surrounding the use of fund financing lines can make first-time GPs nervous, particularly when they’re early in the fundraising process. Cornerstone investors, meanwhile, tend to strongly influence how the gearing provisions in the constitutional documents are drafted and, in somecases, these can prove restrictive.

     

    But these funding lines are increasingly prevalent across all alternative asset classes and, structured smartly, can provide a critical competitive advantage. As long as you are transparent with investors and ensure that leverage does not negatively impact the risk profile of the fund, most LPs appreciate the advantages fund finance brings. Indeed, many have similar facilities in place themselves.

     

    Not all lending institutions will provide financing lines to first-time fund managers. This is not only due toa lack of track record, but also because the size of a debut vehicle may not meet their thresholds. “It is important to select a banking partner that understands the mandate, appreciates the rationale for the facility and is willing to create tailored solutions”, says Ian Wiese from Investec’s Fund Finance team. “GPs can save significant time and effort with candid and upfront discussions with potential lenders to narrow the field of potential providers”.

     

    Open and honest conversations with LPs and lenders at the outset can ensure your first-time fund hasvaluable additional financial flexibility.

  • 4. Know the value of flexibility

    The value of flexibility should not be underestimated when selecting a finance partner. For example4, some lenders’ will be less willing to provide a facility if a manager’s ability to disclose the identity ofinvestors is restricted. A first-time manager should take this into consideration when talking to investors.

     

    Knowing early on in the process what conditions a banking partner will impose will also give the new fund manager insights into market practice relating to limited partnership agreement (LPA) provisions, covenants and pricing. Managers can then evaluate and compare facilities that are cheaper but more rigid, relative to more flexible alternatives.

     

    Some facility providers are only relevant in circumstances where there is excess undrawn capital to be secured against. Such facilities can quickly become maxed out, particularly in periods of rapid deployment.

     

    A facility that evolves as the fund matures – taking the NAV of the underlying portfolio into account, not just undrawn commitments – might be much more useful to a GP over the entire lifecycle of the fund.

     

    Some institutions may also only offer fund facilities if they also win the mandate for the fund’s transaction banking services. It is worth bearing in mind that this may not be in the best interest of the fund.

     

    In practice, a funding line is generally to the advantage of both GPs and LPs, and there is no reason for a first-time fund not to benefit from this attractive tool.

     

    Find a reliable provider willing to back a new fund manager, supply financial firepower to seize opportunities – and evolve with them as their fund grows, without imposing onerous restrictions.

Joe McKenna
Joe McKenna, Investec’s Fund Finance team

It appears managers are neglecting FX risk, not because of a lack of exposure, but because of a lack of time and resource, aswell as concerns around a perceived impact on capital efficiency.

  • 6. Choose the right domicile

    Where a GP decides to set up home will have significant regulatory and fiscal implications – and can also impact fundraising prospects. Reputationally sensitive LPs are increasingly pushing managers to base their funds onshore, and new managers keen to secure commitments will be particularly susceptible to these demands.

     

    In Europe, Luxembourg has been the overwhelming beneficiary of this trend, which has been further exacerbated by Brexit. However, some managers are going further and are domiciling in the country where the bulk of their fundraising and/or deal activity will take place.

     

    New firms must also consider regulations and service provision. For example, a fund set up in the UK will usually not require any form of authorisation – but its parent firm will need to consider whether it is operating a collective investment scheme and acting as alternative investment fund manager (AIFM). Any separate portfolio manager employed may be carrying on discretionary investment management, and may also be both arranging and advising on deals. Any investment adviser, meanwhile, will be giving investment advice – and be regulated as such.

     

    The locations of the fund manager and advisory functions are among the hardest to change. But if presence in a particular location is important to investors, a host manager can be retained and the role of investment adviser sub-contracted to the individuals driving the fund’s launch.

     

    It is also important to consider what you are investing in and where your investments are based, in order to ensure tax efficiency. While reputational risks are increasingly a priority for investors, tax efficiency is also paramount and will need to be taken into account even if this results in higher running costs for the fund.

     

    Consider LP sentiment, regulations, tax and even the status of individual fund managers – as well as prospective deal activity – before settling on a ‘home’.

  • 7. Be clear who you are marketing to

    New managers should think carefully about who they intend to market their fund to. This will have a significant regulatory impact and may also affect domiciling decisions.

     

    “It's well worth taking the time to work through the financing, regulatory and tax implications of your proposals early in your planning.” 
     

    Barry Stimpson, head of Womble Bond Dickinson’s investment funds practice.
     

    “Changes to plans once implementation is underway can add significant time and money to your fund launch.”

     

    Most private equity (PE) firms set themselves a limited field: only 3% are registered to market in more than three countries . Just three states – Switzerland, the UK and the Netherlands – represent two-thirds of European PE fundraising, according to Preqin. So you might not require access to all jurisdictions offered by the Alternative Investment Fund Managers Directive (AIFMD) passport; bilateral agreements may suffice.

     

    Established and well-regarded offshore jurisdictions such as the Channel Islands also remain popular PE domiciles. They offer supportive regulatory frameworks and the ability to sidestep AIFMD in favour of more cost-effective national private placement regimes. 

     

    New managers need to be aware of the regulatory requirements of each country where they market their fund. For example, the Financial Services and Markets Act 2000 (FSMA) and other legislation control the marketing of funds both into and from the UK. If the fund and its promoter are outside the UK, it can only be marketed to specific categories of potential investor – unless a third party is engaged. Even then, a promoter who is not UK authorised may breach FSMA by giving investment advice in the course of a marketing roadshow.

     

    The requirements of the AIFMD mean that, although the UK’s pre-marketing regime is one of the more permissive, before an investor is provided with the final offering documents and is able to make a decision to invest, the regulator must be notified and fund managers meet ongoing compliance requirements. Similar considerations apply in each target jurisdiction. Additionally, if the promoter is back in the UK, it will need to be authorised under FSMA and comply with relevant Financial Conduct Authority requirements.

     

    It is important to know at the outset who the target audience is as this may be relevant to the decision on domicile of the fund and its manager.

  • 8. Call in the experts

    Increasingly complex country-specific, regional and global regulations mean resources can quickly become stretched, particularly in a fund’s launch phase. The burdens of compliance can be overwhelming for a nascent manager facing so many demands on both time and money.

     

    Outsourcing allows firms to hand this burden over to experts who can manage regulation effectively and efficiently, allowing new managers to focus on making early investments count and generating returns that will lay the foundation for future growth.

     

    “An investment manager platform can drastically increase a fund’s speed to market.”

     

    Andrew Frost, executive director at Lawson Connor.

     

    “A start-up or emerging fund can be set up on a service like Discovery [his firm’s own compliance platform] in as little as three to five weeks. It also offers the benefits of a structured governance programme, so resources are not diverted to the onerous task of sourcing compliance talent and keeping on top of a hefty compliance and reporting burden.”

     

    LPs are placing a growing emphasis on operational due diligence, too. Most now take a keen interest in underlying governance and process – and this extends to the use of third-party providers. Increasing numbers of investors are pressing managers to outsource compliance and regulatory support as a condition of commitment. This will particularly be the case for new teams with immature internal functions.

     

    Data analytics and artificial intelligence are transforming onboarding and compliance tasks, too, enabling a faster route to market for firms. This technology can also be provided by outsourced service providers, giving a manager access to capabilities that might otherwise be beyond its reach. And cybersecurity is now paramount for private equity firms and their investors. Working with an outsource provider with dedicated cyber resource can provide a level of comfort to all parties.

     

    “Harnessing technology to manage compliance is also a huge part of establishing a fund in the current climate, and an investment manager platform has the potential to reduce the reporting burden, assist risk management and improve the oversight process,” says Frost.

     

    Outsourcing can provide a depth of expertise to your team that will potentially allow it to grow at a faster rate. It offers flexibility, saves on both time and costs, and is increasingly the strategy of choice for even the largest and most sophisticated private equity houses. 

Help your funds flourish with a tailored solution, from a fund specialist who understands your sector

Sure steps at the start of the journey

 

Leaving behind the infrastructure, resources and processes of an established firm to a launch a new private equity fund can be an exciting – but daunting – time.

 

From defining a compelling and differentiated investment story, to building a team and even choosing a name, the scale of the task is immense.

 

It’s all too easy to see how business critical decisions around areas such as fund finance, compliance, insurance and hedging strategies, can slip through the cracks.

 

But getting the basics right from the outset will lay the foundation for your future, ensuring success and longevity for your fledgling brand.

 

 

 

 

Sources:

1 British Venture Capital Association, First-time fundraising barometer 2018, citing Preqin data
 

2 Private markets come of age: McKinsey Global Private Markets Review 2019

 

3 Investec GP trends 2019,www.investec.com/en_gb/focus/gp-trends/2019/how-to-finance-GP-commitments-as-fund-sizes-near-record-highs.html

 

4 Usage has risen from 50% of funds globally five ears ago to around 90% of funds now, according to Validus Risk Management,see www.privatefundscfo.com/qa-investecs-tom-glover-future-fund-finance/

 

5 For more detailed analysis, see Harris Jenkinson and Kaplan Private Equity Performance: What Do We Know?(Chicago Booth University, 2013); and Larocque, Shive and Stevens, The private equity return gap (University of Notre Dame 2018).

 

6 Source: European Parliamentary Research Service