1. Track record
Most institutional investors regard a firm’s track record and how long its investment team has been together as among the most important factors in their evaluation of GPs competing for commitments. This is among the best evidence that a firm can present to persuade investors that it will safely and profitably put their money to work.
The burden of persuasion should not be underestimated. A recent Preqin investor survey found that 41% of investors would not risk investing in a first-time fund; 11% would consider only spin-outs from established firms.
Spin-out teams can put forward their record of investing experience while under the roof of their former employer – typically a bank, established private equity firm or other asset manager.
New fund managers also sometimes start with “fund-less” investing, e.g. making acquisitions on a deal-by-deal basis, or securing capital from individual investors in separately managed accounts. The goal here is to complete a number of investments and exits as a collective before pitching a blind pool fund to existing and prospective investors alike.
Deal-by-deal investing isn’t financially easy for the new manager. Fees are typically structured as one-off transaction fees, as opposed to annual management fees. Transaction fees are payable only after investors make a binding commitment to invest. Upfront diligence costs incurred in identifying and pursuing multiple investment opportunities are typically paid by the new manager, and in most cases recoverable from investors only in the event that the deal closes.
2. Team composition
The teams that do best are those with a history of working together on deals, with overlapping backgrounds and specialisations – for example, idea generation, deal negotiation, transaction execution, people management. Among new managers, spin-outs are arguably best placed to fit this profile – the fact that the spin-out firm is new doesn’t mean that its key executives, operating under another brand name, aren’t battle-tested.
The best firms invest in second and third-level professionals in the process of building out their team. This ‘human capital’ can be expensive to assemble prior to first closing, but a key part of the pitch is being able to present investors with a more-or-less complete team who have the know-how and experience to execute the strategy and manage a fund of the targeted size.
3. Infrastructure and budget
Getting a new fund off the ground also requires the firm to put in place robust infrastructure. New managers may well be dealing with key operational questions for the first time – for example, setting up a back office, fulfilling regulatory capital and filing obligations, recruiting senior and junior team members. Then there are the new fund’s own operational demands.
Many fund managers (not just first-timers) increasingly outsource all or part of their back office functions, but investors will still be looking for reassurance from a new team that it is capable of dealing with practical issues. The new firm’s founders also need to be willing and able to invest enough of their own money to keeping the business afloat, long before they can come to rely on a steady stream of management fees from a freshly closed fund.
4. Cornerstone investor
A new manager substantially improves its fundraising prospects by aligning itself with a cornerstone investor:
- The fact that a big institutional player is backing a new manager and is willing to make a significant capital commitment to the first fund is often a catalysing element of the pitch to other prospective investors.
- The cornerstone can fund initial investments at the direction of the new manager, which helps it to compile its track record. These investee companies can be warehoused for future transfer into a new blind pool fund, which also has the advantage of allowing the cornerstone the option of a partial early exit from those companies.
- The cornerstone may be willing to offer financial support to a spin-out team, for example helping with loans to pay the new firm’s establishment costs or helping the executives to finance their ‘GP commitment’ when closing their first fund.
Cornerstone investors will typically seek some form of long-term economic benefit for their backing, for example discounted management fees in the new fund, a minority interest in the management vehicle and/or a share of carried interest from the new fund. It is not uncommon for a cornerstone investor to want such economic benefits to apply in a successor fund as well.
New managers know that their prospects of raising a second fund depend mainly on the first fund delivering on its promises to investors. (In the 10 years from 2007, only about half of first-time managers successfully closed a second fund.) If the firm’s executives have much of their personal wealth tied to the fund, in the form of GP commitment and carried interest, then the incentive effect is compounded.
Small, new fund managers are often distinguished by a lack of red tape, thanks to a flatter internal hierarchy, the absence of large investment committees or advisory panels, and the existence of far fewer conflicts of interest than would potentially be faced by a large multi-strategy fund manager. In addition, they will not be distracted by legacy assets in predecessor funds (at least, until they raise a second fund!). That enables the team to fully focus its efforts on a single fund.
According to Preqin, first-time funds raised $26 billion in 2017, but that was only 6% of total capital raised during the year, and down on the previous year’s figures. Still, there is good evidence for the value proposition offered by emerging managers. That same Preqin report noted that first-time funds delivered higher median net IRRs than established funds in 10 of 15 vintage years since 2000.