Unprecedented barriers of entry — from the uncertainty of Dodd-Frank reforms to the economic downturn — have presented roadblocks to aspiring private equity fund managers in recent years.
Nevertheless, several strategies — involving spin-outs, independent sponsors and search funds — can help managers establish the track records they need to attract investors for a start-up launch.
Over the past several years, aspiring private equity fund managers looking to launch funds have been faced with unprecedented barriers of entry.
First, the impact of the Dodd-Frank Wall Street Reform and Consumer Protection Act ("Dodd-Frank") has been confusing, unpredictable and daunting to many start-up funds. Second, the economic downturn resulted in skepticism from investors, as downward-spiraling portfolio company investments spawned "zombie funds" throughout the industry. As the dust has settled, it has become increasingly clear that the investment adviser and other regulatory requirements introduced by Dodd-Frank are not overly burdensome for many start-up funds. However, market pressures borne from scorned investors who remain wary after the fallout of the economic recession remain an obstacle. As a result, investors generally have begun to put greater sums of capital in fewer funds and have gravitated toward well-known funds with proven management track records.
This update highlights some of the strategies that aspiring private equity fund managers have used to exhibit the management capabilities needed to attract investors to an eventual start-up fund launch, despite the recent "flight to quality" exhibited by investors.
Traditionally, a manager spinning out from an established and reputable private equity firm evoked credibility in the marketplace, enabling the manager to attract meaningful investors. With the changing landscape for start-up funds, this approach has become increasingly less effective. Investors generally do not seem to glean the same assurances from these affiliations as they had in the past. Moreover, further development of SEC guidance regarding the antifraud provision of the Investment Advisers Act of 1940 and its effect on fund advertising has limited an aspiring start-up manager’s ability to use his or her management track record at the prior fund to support a new endeavor.
The nuances of the antifraud provision are beyond the scope of this update, but in short, a manager may not advertise his or her track record at a previous fund unless he or she was solely responsible for all investment decisions relating to the relevant investments and has the financial reporting detail to support the investment results being disclosed. Without having a track record to point to as an illustration of the manager’s proposed investment management prowess, the aspiring manager is left with no demonstrable management decisions to support an investment strategy. Without supportable evidence of sound investment management decisions, investors generally will not invest purely on cache and pedigree. Accordingly, short of having access to capital to raise a traditional private equity fund via friends and family or other connections, a manager spinning out of an established private equity firm will likely need to pursue the other options described below.
The Independent Sponsor
The independent sponsor model has garnered increasing acceptance recently among lower-middle market and middle market investors. Generally, an independent sponsor (aka a fundless sponsor) is an individual or group that sources investment opportunities without committed pools of capital. Once the investment is identified by the independent sponsor, it looks to strategic financial partners to close the deal. To be successful, the independent sponsor should establish relationships with financial partners well before any deal is presented.
Independent sponsor capital generally comes from four potential sources: private equity firms, friends and family, hedge funds and family offices. Depending on the deal, some sources may be more suitable than others. For instance, established private equity firms with capital ready for deployment will be more likely suited for larger deals, play an integral role in the deal closing and insert a representative of the firm in the acquired company in an operational function. However, family offices may be more likely to participate in smaller deals, permit the independent sponsor to run the deal and expect the independent sponsor to handle the operational role.
What makes independent sponsors attractive to financial partners? First, it's the exposure to deals that may not be apparent to the financial partner. The independent sponsor may have relationships stemming from an industry or geographical expertise that exposes a financial partner to previously unrecognized investment opportunities — possibly to companies that are not even officially for sale. Second, independent sponsors can offer operational and/or industry expertise that many investors, established private equity firms or otherwise, find attractive. The skill set the independent sponsor brings to a deal post-closing may increase the attractiveness of the investment and provide operational efficiencies that ultimately accelerate the success of the investment.
A search fund is a structure that may be ideal for the aspiring entrepreneur who lacks ample capital to fund a search for an investment. The lifecycle of a search fund entails two separate capital raising events, the first to fund the search fund principals' efforts to identify a suitable target company ("search capital investors") and a second to close the acquisition. As an incentive to entice search capital investors, search fund principals will offer search capital investors a priority right to participate in any company acquisition and often on an enhanced economic basis. For instance, a search capital investor may receive $1.50 of equity for every $1.00 invested in the acquisition company. Moreover, search fund principals may want to seek search capital investors who are also able to provide some expert advisory services to the principals (e.g., deal and/or operational expertise).
Generally, a search fund is looking to acquire a company in its entirety for a purchase price in the seven-digit range. Accordingly, most likely acquisition capital will be from a combination of search capital investors, seller financed (via debt or earnouts), third-party financed (senior or subordinated debt) and/or new investors. The search fund principals manage the company with the intention of achieving growth that is ultimately realized upon exit. The entire lifecycle of the search fund likely extends from five to 10 years, with the acquisition stage taking anywhere from a few months to two years.
The evolving economic and regulatory environments and an increased wariness from investors has created additional challenges for aspiring fund managers. With the proper approach, a credible and proven management track record can begin to take shape — a track record that will demonstrate a manager’s investment prowess and thereby help achieve the ultimate goal of raising a blind pool investment fund. The strategy employed by the manager should be customized to meet his or her needs and may be a hybrid of the concepts described here.