Hard knocks for first-timers

(Photography by Laura Tillinghast)

When John Bailey made the decision to leave his stable, well-paid job and start his own shop, Knox Lane, he never anticipated the total shutdown of society.

Of all the challenges faced by first-time fund managers, a global pandemic was probably low on the list.

And yet, as he and partner Shamik Patel brought their debut fund to market in 2020, with all the hopes and concerns that accompany any new fundraising, that’s exactly what happened. Their fund launch coincided with the beginning of the covid-19 pandemic, which abruptly closed schools and businesses, and, for a few months, much of American life.

Private equity fundraising also effectively stopped for a time. LPs and GPs were unable to travel, virtual fundraising had not yet been widely adopted, and active processes in the market were put on hold.

This is perhaps one of the most extreme examples of the pitfalls that come with launching a new firm and a first-time fund. More routine obstacles are daunting enough – convincing LPs to back a new team, figuring out how to articulate a strategy that will resonate with potential investors, wrestling a track record from a former firm, even finding a deal pre-fund that will illustrate the strategy.

“There were plenty of people who thought we were crazy, to put it simply. You have to have a tremendous amount of conviction” John Bailey, Knox Lane

Here’s the shocker: amid all the chaos, funds still got raised. Processes evolved; executives with existing LP relationships were able to lean on their contacts to bring in capital; and some commitments that had been worked out prior to the lockdown simply had to be closed.

Knox Lane, pushing through the turmoil with its first fund – and learning how to do it remotely – earlier this year closed the debut pool on $610 million, beating its $500 million target and even its $600 million hard-cap.

“There were plenty of people who thought we were crazy, to put it simply,” says John Bailey, managing partner and founder of Knox Lane, about striking off on his own. “You have to have a tremendous amount of conviction.”

While Knox Lane’s experience was unique, many of the challenges that the firm faced in the extreme are shared by other first-timers who decide to take the leap and start their own thing. Even as the pandemic fades into the background, and fundraising is happening live and in person again, the irony is that the process has become even tougher for new managers.

The job has gotten no easier, but LPs maintain they want to find the next great firm and are always on the lookout for new talent. All that means is new managers have to find their optimum position to get on an LP’s radar, and potentially push an existing relationship out of the portfolio. It’s not an easy job, but there are several firms this year that have made it happen, and this is their story.

Still attractive

“For many of our investors, we were the first, or one of the first, underwritings they’d done virtually. That wasn’t an insignificant hurdle for LPs to get over,” says Gilbert Klemann, founder and managing partner of GHK Capital Partners, which closed its debut fund earlier this year on $410 million having raised it through the pandemic.

“That was step one of overcoming a challenge,” says Klemann. “The other aspect, which frankly is still going on, is the degree to which existing funds are going back to the well. The re-ups are absorbing so much of the bandwidth of the investors, asset allocators, LPs, that their ability to even engage or look at a new manager, even if they are interested, is quite limited.”

This is the dynamic that is perhaps most frustrating about private equity fundraising, given that many firms figured out the challenge of virtual fundraising. Having made it to the other side of the pandemic, fundraising for emerging managers has only become harder.

First-time fundraising faced a two-pronged assault over the past two years. The pandemic made fundraising much harder for new firms, for the simple fact that LPs did not know them and were reluctant to form new relationships with managers with whom they had never even shared a handshake.

“We all want to find emerging managers and have our clients investing in them. We know performance-wise they are often very high-performing funds. The big challenge is the log jam in the overall fundraising process”
Ethan Samson, Meketa

And because of the uncertainty, LPs were more willing to stick with their long-time relationships rather than form new ones. Established managers took full advantage of this preference, raising larger funds and creating new parallel products to absorb more LP allocation.

As always, there were a few exceptions – certain well-known veteran executives who came out of larger shops were able to continue attracting capital. But most managers do not have that kind of pull in the LP community.

It seems the market balance toward established managers continues to lean away from the newbies. Fewer LPs are set this year to back first-time funds. Private Equity International’s LP Perspectives 2022 Study found that 42 percent of respondents said they are “just as likely” or “more likely” to commit to these funds, down from 51 percent in 2021.

Last year, some 553 first-time funds collected more than $46 billion globally, Preqin reports. That was down from the $52.8 billion raised by 572 funds globally in 2020. The peak was in 2017, when 924 funds globally raised $196.7 billion, according to Preqin’s information.

This sentiment exists even though a majority of respondents to Buyouts’ Emerging Managers Survey last year – 62 percent – believed the risk/return profile for emerging managers was attractive relative to established firms. Indeed, return is often cited as the main reason institutions look for newly formed shops, where the belief is that managers are hungry to prove their strategies and show their talents.

Past performance has been strong. As of Q2 2020, 17.7 percent of first-time funds were generating a more than 25 percent internal rate of return, compared with 11.3 percent of funds that were Fund IV or later, according to PitchBook.

“Year in, year out, it continues to be a crowded market.” [As a first-time fundraiser,] “you’re competing against a wall of re-ups for LPs, combined with a changing macro backdrop. Not to mention some LPs who are running up against their allocation limits” Chris Webber, Monument Group

Certainly, risks can be high in the emerging manager world. Over the past few years, at least two newly formed partners melted down after only a short period of time. Perhaps the most infamous is that of Novalpina, a firm formed in 2017 by Stephen Peel, former head of Europe at TPG; Bastien Lueken, a veteran of Platinum Equity and TPG; and Stefan Kowski, who formerly worked at Centerbridge Partners and TPG. The partnership fractured over issues of investment competence and the future structure of the firm. One of the firm’s major investments, NSO Group, is controversial because of the company’s spyware product Pegasus, which has been the subject of accusations that it has allegedly been used by oppressive governments to spy on political opponents and activists.

Limited partners in Novalpina’s first fund, which raised €1 billion, eventually booted the partners and brought on Berkeley Research Group to manage out the remaining assets.

Another first-time firm, Eaglehill Advisors – formed in 2014 by ex-Citi executives Jason Cunningham and Mike Zicari – closed its first credit fund on $250 million in 2017 with anchor backing from Koch Industries. Zicari abruptly left the firm in 2018 for undisclosed reasons, after which the firm sold its investment portfolio at a discount to Centre Lane Partners.

In an attempt to mitigate partnership risks, LPs tend to focus on first-timers formed in spinouts from big, brand-name PE firms. Probitas Partners’ 2022 Institutional Investors Private Equity Survey found 71 percent of respondents are focusing on spinouts, up from 64 percent a year earlier.

“We all want to find emerging managers and have our clients investing in them,” says Ethan Samson, managing principal with consultant Meketa. “We know performance-wise they are often very high-performing funds. The big challenge is the log jam in the overall fundraising process.”

Overall fundraising hit near-records last year, with 854 North American buyout, growth, venture and other PE vehicles taking in about $475 billion, up 19 percent from the $399 billion raised in 2020, according to Buyouts data.

Last year’s fundraising results surpassed those of all prior years, excepting 2019, when an all-time high of $505 billion was brought into the market, Buyouts previously reported.

Many LPs this year have told Buyouts that they are running up against their allocations for the year and expect to be finished by Memorial Day. With the exception of some reserves for funds they know will come back later in the year, this leaves little room for forming new relationships.

“Year in, year out, it continues to be a crowded market,” says Chris Webber, senior vice-president with placement agency Monument Group. As a first-time fundraiser, “you’re competing against a wall of re-ups for LPs, combined with a changing macro backdrop. Not to mention some LPs who are running up against their allocation limits.”

As an emerging manager, “you have to have the mindset that you may be in the market longer than you thought you’d be,” says Webber. “It could take potentially longer, but there are more and more emerging manager programs; specifically, some of the larger allocators have carved off pieces of their portfolios specifically for emerging managers. If you can tap into those pools, that can lift your fundraising off the ground.”

Relationships are most important, and those first-timers who have established a network of investors over the years are going to have an easier time of it, even if they choose to go the deal-by-deal route for a few years before raising a commingled fund.

Different flavors

Knox Lane launched and moved into fundraising right away (the firm’s name comes from a road in Bailey’s hometown in Wheeling, West Virginia). Firms with well-known teams, with identified strategies and opportunities to start investing out of the gates can find reception with LPs who are familiar with their past work.

The firm had some LP relationships already developed by Bailey and Patel, and found traction with new investors who were impressed by the pair’s track record at TPG Growth. That resulted in nearly half of Fund I’s target secured in the first half of 2020, Buyouts previously reported.

Knox Lane made its first investment in December 2020 in health and wellness marketing agency Fingerpaint, which the firm got to know in advance. Last summer, the firm invested in Any Hour, which provides home services in the Mountain West region. It then led a $225 million investment in Pattern, an e-commerce and marketplace acceleration business, Buyouts reported. The firm completed eight add-on acquisitions across its portfolio.

This investment activity allowed the firm to show off its themes and focus to potential investors, who came out big for the firm in 2021. A strategy of raising some capital, and then going hard into investing, helps to build confidence with potential LPs, according to Katie Moore, managing director in fund investments with Hamilton Lane. Moore leads the firm’s emerging and diverse investment programs.

LPs are getting “a more funded portfolio,” Moore says about first-timers who put money to work as they fundraise. Once a new manager makes an investment, a consultant like Hamilton Lane can “look under the hood at some deals… that’s great for us, understanding the deals they’ll do, the track record.”

GHK Capital started out as a deal-by-deal shop focusing on investments in industrials. Klemann had built up a track record at Goldman Sachs where he led the general and diversified industrials focus in the principal investment group. For his own shop, he zeroed in on investing in industrials businesses where GHK was likely the first institutional capital.

The firm completed two pre-fund deals, tapping a group of investors Klemann assembled through his network of contacts.

GHK in 2020, after launching fundraising, worked for several months through the early days of the pandemic on closing an investment in Hasa, which makes chemicals to treat pools. The deal required about $100 million, $40 million to $45 million of which GHK moved into the debut pool as its first investment. The balance of the deal was taken up by co-investing LPs who also committed to Fund I, Buyouts previously reported.

After Hasa, “we went more broadly out to market for more traditional fundraising,” Klemann says. “By the time that deal came along, it was clear that was the perfect opportunity to seed the fund with an asset and build on that.”

Starting out deal-by-deal is a good way to solidify a reputation and build a track record, especially if the former firm is not willing to share deal attribution with departing executives. However, the deal-by-deal life can be challenging.

“It’s hard to hold a deal together when you’re out raising money or trying to convince people you can raise the money, which is the issue that many independent sponsors often face,” Klemann says.

The independent sponsor model allowed Boyne Capital the flexibility to “be selective and work on opportunities where we had the opportunity to get to know entrepreneurs really well. The model allowed us to spend a lot of time with them and give them a lot of our time,” says Derek McDowell, founder and managing partner of Boyne Capital.

Formed in 2006, the firm in 2020 closed its second fund on $247 million.

The challenges with the deal-by-deal model are attracting talent to the team without the stability of a fund, as well as funding working capital on a deal without a consistent management fee. “Those are the two reasons we went from an independent sponsor to funded,” McDowell says.

Looking ahead

Going forward, the job of a new manager to attract capital from LPs looks like it will remain a tough prospect. The economy is more uncertain than ever as inflation drives up prices, supply-chain disruptions make life hard for manufacturers and geopolitical shocks in the form of Russia’s invasion of Ukraine causing even more hardship across the global economy.

None of that bodes well for LPs’ appetite to explore relationships with newly formed shops. Yet, as has happened in the past, even in the wake of the global financial crisis, new firm formation will continue, and LPs out there will provide the funding. And new programs focused on emerging managers continue to launch.

New Jersey’s $95 billion pension system announced in April it was carving out its inaugural emerging managers allocation with $250 million into a separate account managed by Barings.

That program is part of a network of public pension allocators with a focus on new managers, with a special emphasis on diversity. Other programs include those run by the Teacher Retirement System of Texas, New York State Common Retirement Fund, Illinois’ pension system and the big California systems CalPERS and CalSTRS.

Despite the challenges, there is capital available for those with the chops to back up their strategies and the courage to take the shot.

Correction: A previous version of this article misstated Gilbert Klemann’s past experience at Goldman Sachs. He was in the principal investment area. The article has been updated.