The Spin Starts Here: The Market Opportunity for Spin-out Funds

Dec 4 2015 | 5:24pm ET

Editors Note: Amid a robust market environment for private equity, spinouts from existing firms are becoming increasingly common. In this contributed article, Eric Zoller, co-founder of private equity services specialist Sixpoint Partners, identifies key factors behind the proliferation of private equity firms, gives recommendations on how spinouts can best be accomplished, and explains the “magic number” every GP should know. 

Today’s headlines are dominated with stories of household names in private equity closing mega-deals around the globe.  However, the market environment for raising new private equity funds and spinouts is more attractive and yet underappreciated than any time in recent memory – providing an exciting opportunity for investors and prospective fund managers alike.

Sixpoint defines spinouts as funds founded by entrepreneurs who are typically looking to depart more established groups and are looking to pursue alternative strategies (i.e. specific sector/geography, or smaller deal size) or simply are motivated to “go-it-alone.” 

There are many excellent reasons for starting your own firm, but those dynamics have always existed, so why are we seeing more spinouts now than ever before? Sixpoint has identified three key factors that are driving this historic proliferation of private equity firms.  

First and foremost, we need to look at the robust fundraising market as our backdrop. Record highs in the public equity markets combined with a significant increase in private equity fund distributions drove fundraising activity to all-time highs, as 63% of private equity fund managers are already in market with an investment vehicle or are planning to launch a vehicle before the end of 2015, according to Preqin. Through the second quarter of 2015, 243 funds have raised a total of $113 billion. This, along with a heightened focus on niche and sector-focused funds has created a very competitive landscape for capital at the lower-middle end of the market.  With over 2,300 funds in the market as of Q3 2015, seeking to raise an aggregate of $773 million, GPs face a historically high bar with LPs due to their capital constraints and a record number of funds in the market since 2007. 

Second, it’s important to understand the serious issues being faced by the industry’s better-established private equity funds in recent years. These include, but are not limited to, the following: 

  • Aging founders who are frequently reluctant to cede responsibility or economics
  • Proliferation of “zombie funds” worldwide with over 1300 funds totaling $190 billion of assets, which have not raised a follow-on fund since 2007 
  • Continued expansion of multi-strategy mega-firms and asset gatherers 

And finally, the growing receptivity - and even endorsement - of “new teams” by LPs is playing a large role in the evolution of this market. LPs have identified the value proposition offered by more focused strategies and lower-end of the middle market, which has strongly supported this surge in acceptance of these groups going independent. For example, according to a recent Preqin survey, three quarters of North American LPs have invested in debut or “first-time” funds since the global financial crisis, and 70% intend to invest in spinouts over the next 12 months, which is a dramatic increase in LPs validation for these groups seeking independence.  In fact, the proportion of investors that stated they will never consider allocating to a first-time fund over the next 12 months has decreased from 56% heading into 2014 to 40% as of the beginning of the current year.

THE CHALLENGES

LPs are increasingly looking for the best investment opportunities for their portfolios by seeking exposure to managers that offer the greatest potential for attractive returns regardless of whether they have a prior relationship or an established brand. There are, however, several important pitfalls or challenges of which first-time managers need to be keenly aware:

  • Attribution for investments at prior firms may be difficult or impossible to attain
  • Significant first close support is critical to successful fundraising outcomes
  • Core investment professionals need to be in place prior to securing new capital commitments 

In order to properly leverage these favorable fundraising trends, Sixpoint recommends that entrepreneurs partner with experienced fundraising groups that are equipped to deliver strategic solutions that go far beyond simple matters of distribution. In the initial stages of a spinout, first-time fund managers need to understand the implications of the decisions that they make regarding:

  • Composition of the limited partnership including governance, economics and structure
  • Securing a strategic anchor investor and appropriate terms of that agreement 
  • Proper positioning and strategy necessary for achieving fundraising goals 

While the LP waters are warm for new fund managers, news of the pool party has spread throughout the private equity neighborhood, so first-time managers should dive in with caution. 

The private equity industry is replete with examples of entrepreneurs that exited firms prematurely without a proper appreciation for the time horizon and financial commitment that launching a private equity firm requires. Broadly speaking, fundraising takes on average 16.5 months from launch to final close, and for first-time funds, it can be considerably longer. In light of this information, it is worth budgeting for three years from date of departure to being completely off the fundraising road. There are a few “simple” ways to expedite this process and ensure a higher probability of success in reaching fundraising goals, but the key - like in all things - is in the execution.

The single most important component of a successful spinout is the team. First-time team risk is often the biggest concern for prospective LPs when considering a fund. Non-solicitation and non-compete agreements can make departures and spin-outs challenging, but teams with a history of working on transactions together or overlapping backgrounds is a huge plus. Often the second and third-tier investment professionals are overlooked in the process of building out a firm. These human resources can be costly prior to completing a fundraise, but they are crucial to showing investors a complete team with depth and ability to manage the proposed strategy and fund size. Too often, spinouts want to hire all of their team after they are able to locate investors. There’s a balance to this process, but LPs are looking for funds to go first and show them a team that’s investable.

The other components involve timing your approach to the LP market and sizing your fund target appropriately. Trying to determine when to present your fund to investors and what support you can expect from first close LPs are closely related, and areas in which Sixpoint frequently sees mistakes. Prematurely meeting with investors is a temptation that takes a lot of discipline for anxious GPs to avoid. 

It is very important that GPs understand the market well in order to position themselves for ultimate success. The development of a clear and concise message to the market about the firm’s strategy and value proposition cannot be overstated in a market with this many funds competing for the same investor dollars. Differentiation is very difficult to get perspective on, and too many funds market themselves with the same message as other funds. It can take three to six months to properly develop the messaging and document a fund professionally. It is only at the last stages of this process that first-time funds should be exploring discussions with LPs outside of strategic or anchor investors with whom they have long historical relationships. 

THE MAGIC NUMBER

Finally, when thinking about fund size, there’s a magic number that GPs need to know: 40%. Sixpoint has conducted extensive research on fundraising outcomes and there is a dramatic difference in the success rate of funds that achieve 40% of their target in the first close and those that don’t. Timing the conversations with LPs well and being realistic about the support that you expect in a first close can generate the type of momentum that first-time funds depend on. 

 

Sixpoint Partners, LLC, is a registered broker/dealer, member FINRA (http://www.finra.org) and SIPC (http://www.sipc.org).


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