Wrapping up your reputation

Deal attribution can be a tricky undertaking, especially if GPs who spin out do not have the support of their former sponsor institutions. By Judy Kuan

In an industry that constantly backs corporate spin-outs in search of wealth, it is hardly a surprise that new GP entities seem to emerge on a regular basis.

Many of these new private equity firms have been created through spinouts from other firms. ?You will always see turnover in the private equity industry, says Stephen Culhane, a partner at the law firm King & Spalding who advises private equity firms. ?The whole industry is characterized by folks who go from one shop to another, and then move on to another one.?

Deal attribution is a particularly complex issue faced by individuals leaving one private equity firm and seeking to establish another, given the significant amounts of time and resources spent by LPs and private equity investment advisors to verify a GP’s track record. The fluid nature of the industry puts a premium on information regarding which team or person did what. The emphasis on deal attribution is further complicated by confidentiality clauses and disclosure restrictions in many GPs’ employment contracts.

In fact, because human talent is the key factor in private equity success, the reputation of individuals may be even more important than the track record of their prior firm. Take the example of Michael Kim, who left The CarlyleGroup to form a new Asia buyout firm, MBK Partners, last March. The fact that Kim and team have already raised more than half of a $1.5 billion targeted fund indicates that investors can see through the Carlyle brand to the individual rainmakers who do its best deals.

?We see all sorts of examples in private equity and hedge funds of senior management teams that are spinning off or simply leaving to raise their own billion dollar funds, and they are bringing in institutional investors based, as much, on their own reputation, says Iain McMurdo, a partner at Cayman Islands-based law firm Walkers International.

?These days, I would suggest that the official track record [of a whole firm] is a good thing to have, but not critical, says McMurdo, who advised on the Cayman law aspects of the formation of MidOcean Partners in its $1.6 billion (€1.3 billion) spin-off from Deutsche Bank in 2003 and later represented in the same capacity certain members of the Soros Private Equity team who formed Tower Brook Capital Partners LLC, a spin-off of the Soros Asset Management Group.

To be sure, deal attribution is easiest where a new GP group has spun out from its parent through a management buyout, and most, if not all, of the investment professionals on the pre-spinout team join the new firm. In this scenario, not only is the LP offered the assurance that the members of the newly spun out team have indeed worked together on deals in the past, but it is also clear that some combination of the team did indeed complete key deals mentioned in firm’s track record.

Attributing deals becomes more complicated if former partners decide to go their separate ways, usually by joining other firms or creating new ones. A recent example of this divergent scenario is Avista Group, which was created by Thompson Dean and 15 of his former colleagues at CSFB’s buyout business months after Larry Schloss – formerly the global head of CSFB’s private equity group – led away four other CSFB partners to form Diamond Castle Holdings. Situations like the Avista/Diamond Castle case, where new groups have spun out from the same employer, may create confusion for investors attempting to determine which spinout group was responsible for which part of the prior employer’s track record.

The stringency with which private equity investors and investment advisors examine track records may vary, but on the whole, the GP track record is a key input for assessing manager potential and therefore lies at the crux of most fundraising efforts. ?When we look at a track record, we request all of the underlying data on the investments and exits to date. If they can’t get that to us, then we are not interested in looking at them, says Craig Nickels, co-founder of the Austin, Texas-based investment advisor Alignment Capital Group. ?If we can’t go in and verify a track record, then we don’t have half of the basis for the decision.?

?We’ve got to get comfortable somehow that they were involved with the deal, says Mike Kelly, managing director at Hamilton Lane, an investment manager based near Philadelphia, Pennsylvania. ?The best-case scenario is if you knew the people before the split. While we often will know the people – or at least know of them – we typically will not have full details in advance regarding their level of responsibility for the prior portfolio.?

In general, evaluating and referencing the claims of newly spun-out GP groups requires more legwork from the LP side than for due diligence efforts focused on follow-on funds. ?We have come across very interesting groups that have split up with their parent firm amicably and are able to disclose underlying cash flow data. The problem with these groups is that our next step is typically to go out to the group’s offices and comb through their records – and these groups don’t have the records, says Nickels. ?It doesn’t preclude them from further consideration, but it just makes more work for us.?

Given the importance of deal attribution in LP investment decisions, spinout firms need to consider how best to package and present their track records in ways that attract potential investors without going against the spinouts’ former sponsors. ?Effectively, the two issues [GPs] have to think about are who has the property rights over the track record, and then what are the securities laws regarding misrepresentation and the use of track records, says McMurdo.

According to King & Spalding’s Culhane, using a track record created at a prior employer can be a tricky matter, and how the situation is addressed is a function of regulatory limitations and restrictions arising from an individual’s employment agreement with that person’s prior employer, confidentiality provisions with portfolio companies, the individual’s ability to recreate and document his or her personal track record, and deal attribution issues.

Therefore, knowing the terms of one’s previous employment contract is the first step to taking control of the spinout process. ?Spinouts should take a look at their employment agreements and policy with prior employers, as many times, people moving to a new fund are not fully knowledgeable about those policies, says Dick Langan, a partner at Nixon Peabody and chair of the firm’s business and finance department.

Because having a clear and confirmable track record is necessary in order for GPs to raise funds, the best-case scenario for a GP spinout team is the ability to negotiate a track record with its former sponsor. ?Normally, a departing GP sits down with his prior employer and comes to an agreement with the employer that is a win-win situation, says Mounir Guen, founder and CEO of MVision, a placement agent with offices in London and New York. ?The departing GP cannot overclaim, but the employer still acknowledges his involvement.?

Rarely are all parties totally satisfied by severance terms, but these win-win agreements do occur fairly regularly. ?For spin-offs from private equity funds, we’re starting to see more and more amicable splits where the new groups coming out have a prearranged deal that the parent firm will indeed confirm that those deals were made by the departing members, says Alignment Capital’s Nickels.

One example of an amicable spin-offs was Baring Private Equity Partners’ management buyout of its various regional funds from ING. The new regional subsidiaries that were created under the Baring umbrella gained ownership of their respective funds, including track records. This made fundraising easier than it would have been if the several Baring teams had quitwithout ownership of the funds, but LPs still conducted thorough deal attribution due diligence, says Varel Freeman, managing partner in charge of Baring Latin America Partners. ?Our investors are sophisticated enough to understand the situation and know what questions to ask, he says. ?In fact, investors tend to be hugely sceptical.?

In cases where mutual agreements with the former sponsor are notmade in advance and a newly spun-out GP group begins marketing itself based on its former employer’s track record, the new group could end up jeopardizing its credibility in the eyes of LPs. ?Trouble starts when the departing individual starts printing up activities in a PPM that have not been confirmed with the prior employer, says Guen. ?In the ideal world, there will be an attribution letter for the departing member. If you don’thave that letter, then depending on what you print, you could find yourself in a very uncomfortable position.?

?Whether the severance was mutual or at one party’s initiative, and therefore likely to be unpleasant, is going to play pretty heavily on the former fund’s willingness to validate what the GP is saying, says Charles Jacobs, a partner at the New York office of Nixon Peabody and head of the law firm’s private equity group. ?The LPs will definitely go back to the prior fund during due diligence to make sure what they are hearing from the new sponsor is in fact true.?

?In working with GPs, we find that they are very conscious of this issue and tend not to overstate their track records, says Langan. ?They tend to be fairly concerned about presenting themselves correctly, since they do not want to be in a position where the disclosure of a track record is later used to question their credibility.?

?The private equity business is significantly based on credibility and reputation, and it is a pretty bad situation if word gets around that what is in the PPM is not totally accurate, says Jacobs. ?But the way it tends to happen is that word gets out on the LP side, and rarely have there been cases of legal repercussions or public embarrassment.?

For GPs spinning out of private equity firms, the issue of obtaining rights over prior track records increases in complexity if the former sponsor is not all that happy to see the departure of key partners. Even in spin-offs that take place in a friendly manner,?a lot of people who leave [a private equity GP] will not, as a contractual matter, be able to take their track records with them, says Culhane.

Most private equity groups spinning out from banking and financial institutions will not have rights to an official track record, which is invariably retained by the parent institution. This practice is significant in that many private equity firms are born of bank affiliated corporations. An institutional refusal to verify track records of former employees has hampered many a fundraising effort for spinout groups.

Where a former sponsor does not allow the new group to retain rights to an official track record, some groups need to start from scratch. ?One approach to spinning off is for the new group to finance their initial deals on their own and build a track record that way, says Hamilton Lane’s Kelly. ?Another is to figure out some way to have references lined up to confirm what the group did without divulging data falling under confidentiality restrictions.?

Yet another option is to completely reconstruct one’s track record from public information, such as media sources and filings with financial authorities. Recreating a track record may not be a feasible option for most spinout firms, especially those that are based in jurisdictions where less information is publicly recorded and available. ?You might be able to reconstruct a few deals, but it is unlikely a group could construct a whole portfolio, says Kelly of most US spinouts.

However, if a group can compile a legitimate and detailed track record from public sources, the rewards may well be worth the effort. When four directors from the London listed global private equity firm 3i decided to spin out and create Exponent Private Equity, a UK-focused buyout firm in London, they were faced with the dual challenges of track record attribution and availability of financial information.

According to Hugh Richards, one of Exponent’s founding partners, his team’s departure from 3i was not an amicable spinout, and the new team walked away without formal track record documentation from 3i. However, due to the regulation of limited liability companies in the UK, there is much more public information available to newlyspun out GPs to reconstruct their track records, which is exactly what the Exponent team did.

?It was a very longwinded process to go through and we had to do it ourselves, but it worked well, says Richards of Exponent’s experience in recreating its track record.

Regarding the cash flow information of the underlying portfolio companies, ?That data belonged to our former employer, so we could not use it, recalls Richards. ?We sat down and recreated our financial track record for each month of each deal, and then linked each reference with a third party source. In so doing, Exponent utilized data from Companies House, the official government depository of UK limited liability companies and their associated audited accounting information.

Having reconstructed a detailed and documented track record, Exponent approached the investor community with a PPM in March of 2004, reached the fund’s £400 million ($700 million) ceiling on capital commitments within five months, and held a final close on the fund in August of 2004. Due to the UK-focus of its new fund, Exponentwas able to round up new investors that were not investors of 3i’s pan-European funds, thereby circumventing further strain with its former parent.

Not all newly spun out GP firms are successful in raising independent funds, but LPs found Exponent’s structure appealing. ?One of the key factors that worked well for us was that we were a group of four who had worked together for many years in the past, says Richards. ?A number of spinout teams are put together as a group with different skills sets but not necessarily the experience working together before, which investors have more difficulty getting their minds around.?

Those private equity GPs seeking greater independence and wealth through a spinout should be mindful that certain paths to independence may be smoother than others. The key to success has been the ability to prove skills to new investors while minimizing clashes over attribution with former employers.