Celebrating difference

Private Equity International

“It turned out that hurling cash at people who got a lot of press was not a good idea,” a mid-market private equity professional reminds PEI. A reference to the perils of investing through the dotcom boom and bust, the opinion is nonetheless expressed within the context of a conversation about today’s clamour to invest in mega-LBO funds. Implied in the remark is a conviction that investors haven’t stopped believing hype; all that’s changed is that the hype surrounds a different type of private equity fund.

The same professional continues:

“It’s fair to say that higher brand awareness gets you an audience [with potential investors]. People are keen to know what the Blackstones of this world are all about. It’s another question whether they actually merit the attention, but they’ll get a foot in the door because they’re in the newspapers every day.”

A barely concealed sense of frustration informs this view, emanating perhaps from the conviction that fundraising is an easier task these days if you’re raising a vast pool of capital than if your fund size aspirations are more modest. Of course, it should be conceded at the outset that such a sentiment is also a generalisation: numerous are the examples of brand-name mid-market funds whose biggest headache is catering for an oversubscribed level of demand rather than an inability to hit target. Private equity is a popular asset class these days, and the best of breed in the mid-market space are not failing to gather up their share of the spoils.

Nonetheless, some compelling statistics serve to underline the extraordinary pulling power of the larger funds. According to the PEI 50 survey in our May 2007 issue, the world’s largest 50 private equity firms have raised a colossal $551 million since 2002, accounting for 69 percent of all funds raised globally. According to Prequin, of the $204 billion raised by buyout funds in 2006, $96 billion was accounted for by just ten mega-funds greater than $5 billion in size.


Some of the reasons behind this gravitation of capital to the larger end are of a practical nature. Resources at many limited partner groups are stretched, and the ability to conduct meaningful due diligence on the plethora of funds in the market at any one time therefore limited. The likes of Californian pension giant CalPERS and Canada’s Public Service Pension Plan are cited by market sources as examples of influential investors focused as much on managing the number of their GP relationships as identifying superior fund managers.

A consideration for investors such as these is whether a commitment to a smaller fund can be meaningful enough to move the needle of a portfolio when it is normally stipulated that one investor should not account for more than typically 10-15 percent of a fund’s total capital.

Another factor relevant here is the accelerated speed of distributions from GPs back to LPs enabled by a benign exit environment and, in particular; a preponderance of re-financings. Says Erin Sarret, director of marketing at Paris-based fund of funds manager Access Capital Partners: “Many investors have been getting their money back far quicker than they expected. But because they have a long-term commitment to the asset class, they want to get that money back out the door as soon as they can.” This need for speed predisposes investors toward established relationships – and larger funds.

Mid-market GPs can arguably do little about this state of affairs: they can’t influence the rate of distributions by LBO funds any more than they can dictate the level of resource at a limited partner group. They in effect serve to distract attention away from the mid-market rather than implying anything fundamentally unattractive about the space. But that’s not to say LPs don’t have reservations about it.

Robert Coke, senior investment officer at UK charity The Wellcome Trust, says there are still plenty of larger investors keen on investing smaller amounts in smaller funds. But: “If the fund is much below €200 million I would say it does become a struggle to attract their attention. At this size there is also a question as to whether the fee income is too small to attract high quality individuals.” Coke also observes that the stellar returns delivered by the larger funds recently mean “it just hasn’t paid to be at the smaller end”

In addition, there is a view that the mid-market has become saturated with -me-too’ investors. Says Kelly DePonte, a partner at San Francisco-based placement agent Probitas Partners:

“The number of middle market buyout funds out raising is huge. A number of investors, when looking at this crowded field, consider many of them JAMMBOGs [Just Another Mid-Market Buyout Group].”

Balance, delegation

The ability to differentiate from the competition is therefore a vital quality for mid-market funds; and one that this article shall return to in more depth later.

At this point – having considered some negative characteristics – it’s important to underline the point that mid-market funds will always have their supporters. However attractive the larger funds may be – particularly when assisted by favourable capital markets tailwinds – limited partners are unlikely to abandon the hunt for diversification. Says John Gripton, Birmingham, UK-based head of investment management at Swiss asset manager Capital Dynamics:

“Our goal is always to achieve a balanced portfolio. You have to bear in mind that during the fund’s life around ten years, economic cycles may change.”

This helps to ensure that sources of capital for mid-market funds are never likely to diminish significantly. Given the tendency mentioned earlier for large pension funds to plough profits back into mega-funds, this might seem counter-intuitive. But in many cases, allocations to mid-market funds don’t evaporate – they merely get outsourced. Speaking of the lower mid-market, DePonte says:

“Some of these pension fund investors – though by no means all – have hired separate account managers to invest in the sector for them.”

Nonetheless, there is widespread acknowledgment among sources close to recent mid-market fundraisings that they have never had to shout louder to get their voices heard. It’s an environment in which attracting new investors is particularly demanding. Says lan Simpson, a London-based director at placement agent Helix Associates:

“With GPs coming back for money every two to three years rather than three to four, LPs have a lot of re-ups to do before they will consider adding any new funds.”

Consolidate to accumulate

What this means is that consolidating existing relationships becomes a priority. In May, Stamford, Connecticut-based Olympus Partners closed a new $1.5 billion fund. Prima fade, the fundraising cast its net wide, with first-time investors accounting for around 25 percent of the investor base. In fact, this figure concealed a rather more conservative approach.

Explains Olympus managing partner Rob Morris:

“Of the 27 investors in the latest fund, 20 are existing and seven new. Of those seven, five are headed by people who used to work for one of the 20 existing investors before moving on, and they know us well. Two are genuinely new, but they have spent the last several years getting to know us. We wanted to make sure they had a long-term commitment and that they were comfortable with our style.”

But whether the emphasis of a mid-market GP is on working hard to keep existing investors happy, striving to winkle out new sources of capital – or, more likely, both – one thing is for sure: fundraising professionals find themselves at the heart of the action. And, to return to the point made earlier about the need for differentiation in a market where so many funds are jostling for attention, it could be argued that rarely before has the pressure on them been so great.

There will always be certain standout funds that make the job of raising money look rather easy. But for most, it will never been anything other than a tough slog. Simpson suggests why this is the case:

“It’s a mature market, there are a lot of experienced people, and the differences between funds are often minimal. Superficially, all hatchback cars look the same because that’s the way aerodynamics work; mid-market buyout groups look the same because people know the way mid-market buyouts work. You have to look under the bonnet to find out how they’re different.”

So, the million-dollar question: how do you differentiate? Erin Sarret says that, in an environment where “LPs see so many people that they all blend together”, one thing that fundraisers should have at the front of their minds is the need to “boil presentations down to the salient points”.

What’s more, these “salient points” need to be genuinely meaningful not, blurs or fudges. George Gaines, a Chicago-based partner at placement agent BerchWood Partners, says some fund managers have an alarming tendency to substitute clarity with cliche when asked to identify their unique selling points:

“Ask them what differentiates them and some will say “great relationships and great proprietary deal flow” and they will say it in hushed tones like it proves they’re one in a million. They don’t have any sense that they’re reciting the most hackneyed phrase in private equity marketing history.”

Know thy LP

To avoid falling into this trap, various approaches are relevant. One is what might be termed “know thy LP” – i.e., the ability to identify the nuances of a particular investor’s decision-making process. Of Access Capital Partners, Sarret says:

“We look for what might be termed an ‘old school’ approach: people who grow companies without stripping them. Increase in sales and EBITDA is something we really look at. How many jobs a GP creates is also fundamental. We have a lot of pension funds as investors and that’s a critically important issue for them.”

As a growth capital investor straddling the early stage venture capital and later stage buyout spaces, London-based Palamon Capital Partners is well placed to meet that criterion. Palamon investor relations director Annette Wilson says that, when raising its most recent June firm initially found it was regularly placed in limited partners’ “too difficult” box. However, strategic differentiation won the day: “When people met with us and understood the strategy, they loved it. It was a way of diversifying risk, which they were very keen to do.”

Another way of trying to gamer LP support is offering some form of economic incentive. This may be as simple as devising LP-friendly terms and conditions, though this approach would be unlikely to gain much traction unless offered as part of a proposition also compelling in other ways (it may otherwise be viewed as a way of seeking to distract attention from deficiencies).

Undoubtedly attractive in today’s climate, however, is the prospect of co-investment. “We see more and more mid-market buyout funds offering co-investment opportunities,” says Patrick Petit, managing partner at Paris-based placement agent Global Private Equity. “They are becoming increasingly popular because of the emergence of more family office and high net worth investors, who tend to be very interested in co-investment.”

More often, efforts to highlight differentiation will be more predictable: geographic focus, sector expertise, a deep bench and operational involvement in portfolio companies among those characteristics that mid-market GPs will frequently draw attention to.

However, a word of caution: Kelly DePonte, for one, would wish to remind fund managers of the need to distill down these characteristics to those truly worthy of attention. He says:

“Too many times I’ve seen fund managers present what they believe is a differentiated strategy which seems to me to be a rehash of three other similar strategies that I’ve seen in the last month.”

Perhaps DePonte’s observation is not entirely surprising. More than one market source expressed to PEI the view that, in reality, genuine differentiators between mid-market funds are few and far between. Speaking of today’s emphasis on “interesting new strategies”, Viane Frost, head of marketing at global private equity firm Henderson Equity Partners, says:

“Some LPs seem to get a little frenzied and funds that don’t necessarily tick the ‘identifiable and proven investment strategy’, ‘sensible fund size’ or ‘track record’ boxes are being raised.”

Should differentiation per se form the basis of investment decisions, sceptics would rightly question whether this means LPs are guilty of irrational exuberance. But one thing is for sure: a failure to convince investors that you really do stand apart from the crowd would be damaging to fundraising prospects at any time. But in these days of mega-fund dominance and stretched LP resources, it might just be fatal.