Sponsors Launch Smaller Funds To Bridge Tough Market

With fundraising still wobbly from its post-recession funk, buyout firms are turning to bridge funds to provide interim capital and perhaps tide them over until the market becomes more favorable.

Gryphon Investors Inc. is one that is raising a bridge fund with a planned $350 million target. It is to invest in two portfolio companies from its 2004-vintage Gryphon Partners III LP, a $415 million pool, according to a source with knowledge of the firm’s plans.

Across the pond, London-based Terra Firma Capital Partners Ltd is seeking to raise up to €1 billion ($1.33 billion) from a sovereign wealth fund so it can continue to do deals when its current fund’s investment period expires next year, sister news service Reuters reported, citing the Financial Times.

The moves could be a harbinger of a new phase in the industry’s response to the financial turbulence that has wracked global financial markets since the end of an economic boom period in 2007. Hammered by a fast-moving financial crisis, and now facing the threat of a renewed crisis, buyout firms first reacted by asking investors to extend their investment periods to deploy committed funds.

Gryphon Investors, which may call the bridge fund Gryphon Partners 3.5, already has established a fairly complex structure for Fund III. In addition to the main $415 million fund, its components include the $31.5 million Gryphon Partners III-A LP, which closed in 2004, the $7.5 million Gryphon Partners III-B LP from 2006 and the $100.9 million Gryphon Partners III-C Annex Fund LP in 2007, according to the Thomson One private equity database.

San Francisco-based Gryphon Investors invests mainly in small-cap and mid-market companies, targeting business services, consumer services and products, health care and education.

The British Terra Firma is currently investing out of Terra Firma Capital Partners III, a €5.4 billion pool that closed in 2006, according to Thomson One. The firm is said to have €700 million of dry powder, and founder and chairman Guy Hands is confident about deploying it before its investment period expires next May, the FT reported. The €1 billion bridge fund could tide the firm over as it begins raising its next fund in the spring of 2012.

Terra Firma has notably stumbled, though, with portfolio company EMI, a British music publisher on which the firm lost £1.7 billion ($2.7 billion) when creditor Citigroup seized the deeply indebted company last spring. Such a black eye could complicate Terra Firma’s efforts to raise a full-blown successor fund.

Given the economic conditions of recent years, the use of tools such as bridge funds should not be surprising, said Siobhan McBreen Burke, a partner at the law firm Paul Hastings LLP in Los Angeles. “The market has been very turbulent.” The volatility has made it difficult for sponsors to achieve successful exits from their investments, Burke said. “Without having realizations, it’s hard to raise the next fund.”

And even though cash may run low in a fund, sponsors may still need capital to continue to invest in portfolio companies. Potential conflicts arise, however, if the bridge fund’s structure is not the same as the original fund, Burke said, but sponsors can minimize that risk by turning to prior LPs and investing the bridge fund into existing portfolio companies.

Another way to free up capital is by recycling at least a portion the proceeds from exits back into existing holdings, if the partnership agreement allows such arrangements, she said.