Beginner's pluck

Most enterprises celebrate their humble beginnings once that experience is well behind them. Jokes about threadbare offices and maxed out credit cards only get cracked once the champagne corks start flying. Private equity shops are no exception. First time funds are full of great stories, of blessings in disguise and surprising benefactors. They also get shared around the time their third fund goes to market.

For would-be general partners currently seeking to raise capital, stories of starvation are less charming to tell. Instead, these GPs need to present an image of past and likely future success.

A sentiment echoed by placement agents, GPs, LPs and lawyers alike is that the most important part of the story to square away is that of differentiated strategy: what makes the fund unique in the market? ?First of all, clearly define your strategy and write it down in detail,? says Terry Mullen of Arsenal Capital, a New York-based middle market buyout firm formed in 2001. A great model should be clearly defined and tested to prove if the rationales are in sync with the realities of the marketplace. Being just another ?middle-market fund with operational focus? won't set hearts aflutter in 2007.

?Investors increasingly are seeking more specialized investment strategies and industry expertise,? says George Gaines of Berchwood Partners, a US- and UK-based placement agent. Proprietary relationships or a fresh angle on a hot sector can earn a second look from LPs. Yet having too narrow a spectrum can cause questions of sufficient deal flow to arise. LPs want a specific model, but one that offers flexibility for growth while being able to adjust to the unexpected.

This doesn't mean that the founders need to have a first draft of the PPM ready to hand out, but the group should have an eloquent business plan laying out the type of deals, the size of the fund, and a solid case for the fund's model. This rough rendering of the pitch will naturally evolve with feedback from industry participants and the building of the team.

Making the team
The strategy may be the intriguing notion, but the skills of the team will go a long way to validate the case for raising capital. ?We're looking for the combination of an interesting theory with a team to make it credible,? explains Clint Harris of Grove Street Advisors, a Waltham, Massachusetts-based fund of funds.

Ideally, the team's past experiences are the raw material used to sculpt the investment model. While it may seem obvious, some investors stressed that prior private equity experience is vital. One LP recalls far too many occasions where a team approached him for funding without a single person on staff that has made a dime through the private equity investment process.

How much of the staff needs to be in place before launching into the fundraising process? That's simple: as many as is needed to convince LPs that the present talent can deliver on the promises of the investment case. ?Too many ?to-behired? boxes on an organizational chart increases concerns about formation risk,? warns Gaines.

Once the principals have been chosen, the team needs to agree on the terms of their working relationship. Eric Wright, a partner at the Palo Alto office of Ropes & Gray law firm, recalls: ?There was one venture team that came in ready to hit the road in two weeks, but hadn't negotiated the economics or management of the fund among them. We suggested they do so, of course, and the ensuing debate revealed they didn't actually want to work together.?

Beyond compensation, the team should also iron out the decision making process for hiring and firing, pulling the trigger on a deal and resolving other potential disputes over the life of the fund. Addressing these sensitive topics will do more than comfort investors; it will reveal the intangible qualities of one's team.

?Assembling a talented team with the right blend of skills is essential; however, a prerequisite is that all the team members share and buy into a set of core values,? explains Mullen, who attributes much of the success of Arsenal to the group the firm had assembled.

Arsenal's strategy took the ?core growth buyout strategy? of Thomas H. Lee Partners, where Mullen had worked since 1992, and added a deep industry focus and broad operational capabilities in the lower middle market, describes Mullen.

?That, frankly, raised some questions for investors,? says Mullen. ?We were able to respond to investors' concerns by communicating the benefits of having in-house industry and operational talent, in the form of senior management skill sets and functional expertise, including in supply chain management, Six Sigma, HR, IT, etc. Coupled with the investment and M&A track records we had from our former firms, we made the case we had the talent and experience to execute the model successfully.?

In most cases, first-time funds have no shared track record, so each individual's past performance is scrutinized all the more. The founders need to be ruthlessly honest with each other about their investing history. Firms spinning out of a larger firm need to be aware that they'll need access to the data concerning the transactions they worked on, which often involves proprietary information from the parent. If the spin-out is executed without the parent's blessing, the new firm could be starved of the intelligence necessary to substantiate their claims. However, as Hugh Richards of 3i-spinout Exponent Private Equity explains, the situation in the UK offers an alternative.

?The [UK] government compiles audited accounting data for all private companies, so we were able to retrieve those figures despite the tone of our exit from our former house,? says Richards. ?And our investors appreciated the fact we delved into the sub-deal aspects of any transactions we touched.?

Cornerstone credibility
With the strategy refined and the team assembled and vetted, it may be time to launch the charm offensive. A conservative estimate for the length of a firm's maiden voyage along the fundraising path ranges between 18 and 24 months, according to industry participants.

That said, one of the easiest ways to begin is to obtain a cornerstone investor, one that lends credibility along with jumpstarting the economics. The advantage accrued from having a commitment from a high profile LP can be considerable. In the relatively small community of institutional LPs, precious few regularly gamble with first time funds. When they do take the plunge, they do so with a zest for rigorous due diligence and a deep understanding of the asset class, evident in the returns envy of their peers. ?Seek out a thought leader for a substantial commitment, at least $25 million or more, in exchange for a share in the economics, normally a share of the carry, or in some cases, even the management fee,? advises Gaines.

In lieu of such golden geese, there are alternatives. Sponsorships can come from high net worth individuals who happen to be friends or family, or even senior partners from a principal's former firm. Either way, the economics of launching a fund (see table) demand substantial financial resources.

When the founders are their own cornerstone investor, limited partners take notice. One placement agent told of a relatively green group that sped to a close by offering $75 million of the $300 million fund they were raising. That type of confidence can inspire both awe and ridicule, but it won't be ignored. Sometimes there's no choice but to start with a patchwork of smaller investors raised from the team's collective Rolodexes, so it may be valuable to examine what one firm did from there.

Arsenal Capital began its fundraising in 2001 and watched as 9/11 slowed the economy to a crawl. With $50 million closed of a proposed $250 million fund, the firm decided to capitalize on the sluggish market and acquired a pair of companies in March and May of 2002 at what Mullen describes as bargain valuations. The strong growth and improved operational performance these two companies generated in the first year testified to Aresenal's investment model, spurring commitments from Adams Street, JP Morgan and Wilshire Associates, on the fund's way to closing oversubscribed.

Sometimes first-time funds avoid approaching cornerstone investors altogether. When Exponent Private Equity spun out from its former parent, the founders decided they would go at it alone to maintain a consistent identity in the marketplace. ?We were portraying ourselves as stepping out from under the umbrella of our parent, so accepting a sizable single sponsor contradicted the case we were making for the value of our independence,? said Richards.

First timers should be aware that just as some limited partners can lend credibility, some might erode it. Several hedge funds in the pool can raise eyebrows since they continue to be seen as trigger happy, even though they're subject to the same time frame as the rest of the LPs. When someone like Time Warner commits a chunk of capital into a first time fund dedicated to media plays, other LPs may feel the commitment was made for objectives beyond merely attractive returns. These strategic players or hedge funds rarely make or break an investment decision, but founders should be aware of which backers are seen as assets to traditional LPs.

The cost of the affairHistorically, the organization and syndication costs for starting a debut fund was 0.01% of the capital raised (or $300K for a $300 million fund), though in recent years fundraising expenses have increased. Today it's not unusual for the budget to be $600K or more for a $300 million fund. Below is a rough breakdown of the costs related to launching a $300 million middle market fund over a 24-month time frame, without accounting for salaries drawn down by principals prior to the management fee. Estimates including compensation push the numbers upwards into the $850K to $1 million range. This information was supplied by a US placement agent.

No second chance
Making the right impression with anchor investors.
For a first time fund, a commitment from a prestigious institution provides far more than monetary support. It validates the team's investment case by extending the LP's credibility to the fund. The broader LP community views a substantial commitment by a sophisticated investor as less a gamble than an educated guess. Great reputations are built on an enviable record of LP returns, which demonstrates some savvy due diligence. If a fresh-faced team earns their confidence, what other investors wouldn't take a closer look? Now given the value of such investors, how does a first time fund go about winning them over?

Three factors contribute most to making an early and substantial commitment to a first time fund: talent, trust and a truly novel investment case. A particular industry focus may not be sufficiently differentiated to strike anyone's fancy. Steven Costabile of AIGexplains, ?There's not much space that's underserved by private equity these days. That might have been true five to ten years ago, but it's a hard case to make today.?

What potential anchor investors look for is a specific edge within that industry focus. Whether it is deep and broad relationships in the sector or a unique deal structure particularly apt for that industry, these institutions are looking for a competitive advantage. Mere deal making prowess may also leave them cold. They're searching for original applications of that talent. Intriguing theories may catch their attention, but validating them comes by demonstrating the talent of the team.

The talent of the team should answer the demands of the investment case. There should be a proper blend of experience to argue that the skills to deliver returns are in-house. However, the specific skills need to be substantiated with concrete track records, within private equity, and the target industry. Clint Harris of Grove Street Advisors says, ?One of the most common mistakes new funds make is not having enough experience, or not adequately explaining that experience. Every detail of a partner's prior investment record is relevant, no matter how minor they may be. Some ?personal? investing still counts to us. If you were an angel investor, be frank with us about it. Although not ?directly? relevant to the investment thesis, list them all. Disclose everything.?

For groups spinning out from their parent, it is vital that a partner's role on each and every deal is explained. Did they source the deal, or play some instrumental role in securing the exit? The natural question for any spin out is how much of the track record can be credited to the executive, and how much to the brand? It is vital for partners to accurately assess their own contributions. Some institutions were amused to find executives change their tune from extolling the virtues of size when they were under the roof of a major firm, to trumpeting the value of lean and nimble shops. Regardless of the song, new funds should make it clear they understand the extra energy involved with running a firm. ?If they're coming from a larger firm, we want to know they understand how to balance deal activity with the responsibility of running the firm,? explains Costabile.

Beyond that, new groups should err on the side of candor and accuracy when pitching these investors. They have the resources to reach out to CEOs of portfolio companies and former firms to verify any claims. ?If our due diligence shows you withheld information, that can be the kiss of death,? warns Harris.

Intangibles such as trust tend to weigh heavily when investors bet this early on a team. LPs are sensitive to any signs that the partners are less than committed to the launch. The senior members of the new team often juggle multiple projects, given the demand for proven managerial talent. These anchor investors like to see a real focus by all members of the team, and they want compensation formulas to reflect an equal contribution from all members. Some LPs have seen a split with the eldest of the team taking up to 60 percent of the carry, which may acknowledge the credibility they bring to the table, but also raises questions as to what keeps the younger partners from leaving.

When approached as anchor investors as the cornerstone financing for a new fund, these institutions are all too aware of the scarce resources. They don't expect a full-fledged PPM, or a back office in place, but they do want a thoughtful business plan and a team capable of executing it. According to Harris, ?It's a lot easier for a good team to fix a bad strategy than for a weak team to perform even with the best strategy.?

These institutions dedicate time for first time groups precisely for the thrill of watching a hunch prove true. Inspiring that faith is more art than science, but it's hardly a game of chance.