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Spinning Out in a Mature LBO Industry: Psst. Did you say you wanted to spin out of your firm and form a private equity group of –

Well, chances are that you’ll be successful if you follow the guidelines of private equity investors who did just that and are happily raising funds and investing without much of the hassles and headaches associated with a first-time fund.

Over the past couple of years, buyout firms have sprouted from such big buyout houses as Kolhberg Kravis Roberts & Co. and Texas Pacific Group. Managers who came from these firms say exposure to such things as clients in varied industries, fund-raising networks, deal sourcing prowess, clearly defined investments and group dynamics have contributed much to their success as a fledgling firm and first-time fund.

What’s the Motive

There are three generic reasons for a group to spin out of larger firms and they are personality, money and strategic reasons, says a source at a West Coast buyout firm. The source says he wanted to become a specialist investor within the technology sector and felt his former firm’s generalist strategy “just didn’t make any sense” to him.

Other groups that went out on their own because they didn’t see eye to eye with their firms on business strategy include Blue Capital Management and Heritage Partners Inc. (Buyouts, Aug. 28, p. 34).

In a recent interview with Buyouts (Buyouts, Oct. 9, p. 48), partners at Blue Capital spoke of their private equity effort dubbed “Project Blue” while at consulting firm McKinsey & Co., which was not well-received by senior partners.

Peter Hermann and Michel Reichert, founders of Heritage Partners, parted ways with BancBoston Capital Equity Partners because of the bank’s inability to “understand the idea of capitalism” on account of the partners’ lack of carry [interest fee] in their deals.”

However, not all firms originated from unease with the parent firm. Saratoga Partners was formed as the corporate buyout arm of Dillon, Read & Co. in 1984. The firm operated inside of Dillon Read before it agreed to be sold to Swiss Bank in 1997 and shortly afterwards merged with UBS.

“At that time, federal regulations were in effect that said banks were precluded from owning 24.9% equity in deals, and most of our investments are controlled share holdings,” recalls Christian Oberbeck, a managing director at Saratoga. “So to own us would have been in bright-lined violation of those regulations. In order to get transactions completed, they agreed to spin us off as part of the application to the Fed and then we were given the two-year grace period to complete the spin-off.” After raising its fourth fund the firm officially completed its spin-off on Sept. 18, 1998.

“Anytime you do a spin-off, there are significant legal aspects to it, especially when you’re spinning off from a regulated entity in the context of a regulatory mandate,” Oberbeck says. “On a business front, getting our next fund raised was the issue that we faced.”

Spinning Out the Hard & Easy Way

Indeed, fund managers say raising the first fund outside of a parent firm can be tough for firms without a track record and a stable team. General partners also say having a clearly defined investment strategy that is uniquely differentiated from other buyout firms – whether they are fledgling firms or well-established firms – can mean the difference between success and failure.

Oberbeck says Saratoga’s spin-off was beneficial on both its fund-raising and deal sourcing fronts. “Raising a fund as part of a larger investment banking firm is sometimes not looked on favorably by investors as when it’s a pure play,” Oberbeck says. “Also, by no longer being part of an investment bank we’ve seen more deal flow from other investment banks. There is clarity about what we’re doing day-to-day.”

Oberbeck says Saratoga was spun off with portfolio companies so that it had the best of both worlds in that it was an independent firm with a 14-year history. He also notes that Saratoga’s infrastructure was in place in terms of leasing its own office space so the firm didn’t have “the distractions” that other firms might have when they spin off and start fresh. “We were able to preserve a lot of the administrative underpinnings – I still have my same telephone number,” Oberbeck laughingly says.

However, not all firms have the luxury of amicable transitions from an administrative or historical standpoint.

“We had no money saved up and relied on the kindness of our friends,” Hermann said. “We had relationships with two law firms, one of which gave us free office space while the other contributed free legal work.”

The source at the West Coast buyout shop says the one thing his firm did very differently from other fledgling firms was that it put together its team, strategy and investment thesis before raising its fund. “And that is unprecedented as far as I know,” he says. “I think that was very wise because that helped in building a culture and sourcing deals. If you can afford to do this, then it makes a lot of sense. A lot of people pull together the top two or three guys and go out on a road show for months, raise money, then sit back and wonder what to do in terms of new hires. That seems backwards to me.”

Being Different is Good

No matter what the conditions were for the inception of a buyout firm, buyout pros say – as in any business endeavor – it’s very important to have a clear and differentiated strategy from all of the other funds that are already in the marketplace. “Something that is going to give you a particular proprietary relationship is very important,” Oberbeck says.

Greg Flynn, a managing director at Hampshire Equity Partners (formerly ING Equity Partners), which spun out of its Netherlands-based parent company ING Groupe in 1996, says Hampshire’s niche is finding companies with good market positions that need the infrastructure to maximize their ability to grow, whether it’s by acquisition or organic growth.

The partners at Blue Capital believe that their backgrounds in consulting add value to their portfolio companies, while Heritage Partners likes opportunities in family-owned businesses, which many buyout shops shy away from because of the financial and personal issues associated with the market segment.

GPs also say having a core group of founding investors before setting out to raise a fund is vital. “It’s always good to show you have enduring relationships that are committed,” Oberbeck says. “It’s like a restaurant, people like to go into one that’s full, rather than one that’s empty. The same goes with a fund because investors like to see a fund that looks like it’s full and on the way to being successful rather than something where they’re the first party to show up.”

Let’s Talk About Issues

GPs say the trick to getting in the door with institutional investors, is to make sure to talk about why the product is so good. “George W. Bush isn’t going to talk about all of the problems with Texas, and Clinton isn’t going to talk about his personal life, rather they both want to focus on issues,” says the source. “You want to talk about who you really are, not about who really did what at your former firm and how involved were you in all of it. Just putting that issue to bed is always powerful.”

Hampshire’s Flynn echoes the same sentiments. “What LPs are questioning is who made what decisions at the previous firm,” he says. “That’s the game that the new person is going to have to play to prove to the LP that those decisions were his decisions.

Flynn says Hampshire Equity was able to address the issue of attribution by establishing a limited partnership format with its fund while the firm was still a part of ING Groupe. “So our track record was within that format, which was auditable, and LPs could look back on the previous fund and see our track record,” he says.

John Podjasek, a managing director at WestAm which invests in first-time funds, says his firm would not invest in three of four guys who are just getting into this industry.

Podjasek describes his firm as “sort of an incubator” and says WestAm has invested in about 55 partnerships, with five or less being first-time funds over the past three years. WestAm is currently a general partner in a fund-to-fund dubbed Special Private Equity Partners. In addition, the firm is currently supporting a buyout firm that recently spun out from a major West Coast firm, and a fledgling firm on the East Coast. Podjasek declined to name the firms.

In every first-time fund partnership team chemistry and a proven track record are key, says Podjasek. “You really have to understand these people, where they came from and their track records,” he says. “The investment world is a people business and how people work together is paramount in your decision process. The other key component is deal sourcing. Will they be able to source the same investment opportunities as a new group as they’ve done in the past?”

Aside from meeting all of the infrastructure requirements of LPs, the fund-raising market has a big impact on the success of the fund-raising efforts of fledgling firms. Over the past nine to 12 months, huge buyout funds such as the much-rumored $6 billion KKR Millennium Fund (Buyouts, Sept. 25, p. 3), Blackstone Communications Partners LP and Thomas H. Lee Equity Partners V LP, returned to the market and have all but depleted the institutional well for new funds.

“If you’re in the marketplace right now trying to raise money, most folks are already done with their programs for this year and are already looking at 2001,” Podjasek says.

However, there are some LPs that are looking for new funds with partners who are more aggressive than the well-established fund managers, says the source.

“There are many capable groups competing in the marketplace right now to raise funds and the differences are so minute that I sometimes wonder if the groups that are turned down appreciate that,” Podjasek adds.