Scott Reed, co-head of U.S. Private Equity at Aberdeen Standard Investments, helps lead a team that targets small-cap funds in North America. The team just closed Aberdeen U.S. Private Equity VIII on $425 million, beating its $350 million target.
Reed took some time to chat with Buyouts about the market for small funds, including emerging managers and spinouts.
How are you sourcing opportunities out of the new fund?
We’ve got a dozen folks on our team scouring the landscape and trying to develop dialogue with every manager in our space and ultimately building conviction they have repeatable and differentiated investment strategy. In some cases we develop those dialogues over a period of years. That could be a newer spinout that’s left a firm we know or know of that’s repositioned itself into a mid-market firm with a strategy similar to the predecessor firm. In some cases that’s a fundless or independent sponsor graduating to raising a blind pool. We activated Fund VIII part way through 2019, it’s about 40 percent deployed at this point.
How do you find great spinouts?
That’s the art of our business. Having done it for 20 years, you develop pattern recognition for the character and qualities of newer emerging managers that will lead to success building enduring franchises. That’s what we do on a daily basis. I wish I could boil it down to a simple formula.
How aggressive do you get when negotiating terms with emerging managers?
If you’ve got a new manager that’s hanging out a shingle and trying to raise a fund, we might have leverage to push back on terms, but what we don’t want to do is pinch them too hard on management fees. We want them to have a degree of freedom to build out a firm. If you constrain their economics, you might be cutting off your nose to spite your face. We might look for preferential treatment on co-investments or ratchets where we only pay full carried interest on certain return thresholds.
Are you seeing terms in the market you would consider off-market?
There are plenty of instances where managers are looking to either shift to a more GP-friendly distribution waterfall, moving from European to American, adding premium carry terms … we’re seeing more aggressive terms on fee offsets and things of that nature. At this part of the cycle, the managers that have performed really well, there’s a long line of LPs waiting outside their door.
How busy is the market for small-cap funds?
Against the backdrop of an environment of compressing returns, given how much capital is flooding into private equity, with valuations at cyclical if not all-time highs, investors are having to work a bit harder to get the kind of returns they expect from private equity. One way to do that is to look downstream into less efficient parts of the private equity ecosystem. Investors out there who are seeing valuation pressure at the upper end are deploying more capital into the lower end of the market given the better returns and inefficiencies to capitalize on.
What do you look for in a manager with whom you don’t have a prior relationship?
There’s literally hundreds of smaller managers; there’s a pretty big proverbial haystack to pick through. And there’s unquestionably a wider divergence of quality and capabilities in the lower middle market. A lot of folks have difficulty navigating that landscape.
We’re looking for groups with a clear reason to exit – whether that’s a sector strategy, distinct capabilities, geographic orientation, something that gives us confidence the firm has a repeatable investment model that can generate outsized returns.
What do you like about sector specialists?
There’s been a natural evolution of the PE manager landscape whereby the generalist model that was so predominant a decade or two ago has given way to much more specialized strategies, and sector orientation is one of those points of differentiation. It’s much harder in a more mature and more competitive private equity landscape to generate consistent outsized returns as a generalist … there’s always someone smarter than you. So it’s not surprising we’ve seen a number of managers choose to specialize in one or a number of sectors. There’s been a lot of new fund formation in tech, healthcare and even in the consumer sector, there’s no shortage of things to look at.