Spinouts may win out in a post-covid market

New managers with senior GPs and strategies spun out of brand-name firms may have an edge even in a pandemic-battered market.

While the covid-19 pandemic created more fundraising challenges for emerging managers, it has done little to stem the tide of first-time offerings.

Private equity fundraising has slowed across the board since the pandemic’s outbreak and is unlikely to reach the record levels of the past couple of years. Emerging managers are expected to absorb the biggest blow, as many limited partners have narrowed their focus to incumbents.

Buyouts has recently reported several fund closings and launches by newly minted PE firms, indicating the downturn did not completely halt this activity.

Some general partners are persevering with inaugural vehicles launched before the crisis, while others started up only recently. In both scenarios, there is evidence of successful fundraising.

This is perhaps not surprising in the case of pre-crisis funds, which may have developed early traction with LPs. It is more surprising in the case of first-timers who began marketing, or ramped up marketing, after the outbreak. For example, Knox Lane in June collected nearly half of the $500 million target set for its debut fund less than three months after filing Form D fundraising documents.

It helps to be a spinout

A quality common to many of these PE firms is seasoned leadership. Knox Lane was founded by John Bailey and Shamik Patel, both former TPG Growth partners. At TPG, Bailey led consumer sector investing, while Patel led services sector investing, experience they are now leveraging in Knox Lane’s niche mid-market strategy.

Similarly, Long Arc Capital, which recently rolled out a $500 million debut growth-oriented offering, was launched by an ex-Goldman Sachs principal, while Twist Capital, which unveiled a $500 million inaugural tech dislocation pool, was formed by an ex-Blackstone executive.

This suggests emerging managers featuring senior investment professionals and strategies spun out of big, brand-name PE firms could have a fundraising edge.

Nik Shah, managing partner of Cohere Capital, says this factor was key to the May close of his firm’s $200 million Fund I. Cohere gained pre-downturn “momentum,” he says, because the viability of its low mid-market, tech-enabled services strategy was proven by him and principal Daniel Gedney while at HIG Capital.

LPs also developed a “level of comfort” about Cohere, Shah says, owing to his and Gedney’s history of working together. This, he says, demonstrated the team’s “cohesive ability to execute.”

Veteran GPs like Cohere’s sometimes leave PE firms once they have built a track record and feel a firm’s strategy has grown outside their comfort zone, says Mark Hoeing, a managing director and head of private equity at Commonfund Capital. Often, as firms expand, the size of companies they acquire also expands, moving the focus out of the lower mid-market or even mid-market and into larger opportunity sets.

“To raise capital in this environment, you have to prove your differentiation”
Mark Hoeing
Commonfund Capital

Because of their extensive backgrounds, the inaugural offerings of these GPs are appealing to LPs, even in a pandemic-battered market. “To raise capital in this environment, you have to prove your differentiation,” Hoeing says. “That means having operational and investing experience in particular sectors that are more resilient, including tech, software, services and healthcare.”

Spinouts without LP ties

However appealing emerging managers with seasoned leadership are, their debut vehicles could still be beset with challenges in today’s fundraising market. Challenges are also expected to multiply if the downturn is prolonged.

Veteran GPs who launched funds after the pandemic’s outbreak may believe they can be successful “whatever the constraints,” says Kelly DePonte, a managing director with Probitas Partners. This perhaps owes to an “awful lot of confidence” on the part of GPs with long records of achievement and who might have been planning spinouts for some time.

Attractive reputations, however, are not enough at a time when LPs are distracted by portfolio issues and feeling uncertain about the future, says DePonte. While LPs are still looking to deploy capital, many are not willing to vet unknown PE firms using virtual means such as video conferencing apps like Zoom.

For this reason, DePonte says, the best-positioned emerging managers will be those with pre-existing LP relationships.

If they lack LP ties, the focus of GPs with inaugural offerings will be on “catching the attention of LPs” who are open to new strategies, DePonte says. In this case, the goal is to “get yourself in the queue now” and secure initial pitches in anticipation of “normal” face-to-face meetings with LPs when the market recovers.

To do list stopwatchTiming a spinout

There’s always good talent leaving and forming new PE firms.

The downturn represents a great opportunity for emerging managers to show their talent, as good companies, large and small and across sectors, need capital to help them operate through the turmoil, says Mina Pacheco Nazemi, a managing director with Barings Alternative Investments: “I think there’s more to do now than ever.”

Not all veteran GPs mulling a spinout from a large PE brand will agree that now is the right time. Some may decide to hold off until deal and fundraising markets further stabilize. Deal activity, for example, is not expected to return to anywhere near pre-covid-19 levels until at least the fourth quarter, sources tell Buyouts.

“Any number of managers that might be contemplating a spinout today might be a little more reticent to do so until they know which way markets are trending and they have more visibility around what LP appetite is for emerging managers,” says Brian Rodde, a managing partner and co-head of private equity at Makena Capital.

Those who do take the plunge, Rodde says, are likely to have a “relatively clear path to a successful fundraising if they have reasonable fund-size expectations and reasonable terms.” Less known or more marginal first timers will face greater challenges.

Other factors, such as how economics flow through an organization, will often motivate senior investment professionals to leave comfortable roles for the uncertainty of launching their own ventures, Nazemi says.

“It’s always a complex discussion about economics,” she says. “That’s why, when backing an emerging manager or an established manager, we spend so much time on what is the economic make-up of the firm: how is [carried interest] distributed, how do people get promoted, how do people get on the investment committee?”