The race for funding is challenging. Limited Partners, sometimes also called silent partners, participate with a capital contribution and have restricted responsibilities regarding their daily business operations involvement. With limited liability, they invest their stake with the hope of generating capital returns. Attracting Limited Partners to commit to your fund or investors to back up your business idea is not an easy task. Enumerating all the reasons behind an investors' commitment choice is not the scope of this blog, but rather to grasp some of the underlining motives that drive their consideration.
Sitting on piles of dry powder
Two words: dry powder.
Some, I suppose most of the audience surely knows the meaning of this term. Originally a slang word, eventually coined into a widely spread and commonly used term.
Dry powder is a phenomenon that depicts mountains of unallocated cash. Research and publications from the European Investment Fund state that levels of dry powder in the EU doubled from 2007 to 2019. Today, it is estimated that $1.7 trillion is waiting to be allocated.
Given the outrageous amounts – record levels - of dry powder in the market, there are possibilities for ambitious investors and entrepreneurs to concretize their dreams into solid funds or create businesses backed up by private debt managers or cash-rich equity providers. These last ones are sitting on piles of equity waiting for it to be allocated, and, allegedly, there is plenty of capital ready to be deployed. However, even though it is a "cash-rich environment," capital for emerging entrepreneurs or fund managers is somehow limited and not easily accessible.
The race for funding is tough, and publicly available data from Private Equity International suggests Limited Partner investors' (LPs) inclination towards more mature and established funds up against first-time funds. This is because it generally takes a longer period of time for a first-time fund to raise capital, and embryonal General Partners (GPs), most of the time, underestimate the duration of this lengthy process. This period could last up to two years; thus, one of the chief implications lies in the teams' ability to have enough financial liquidity to sustain their operations for such period of time.
One of the reasons for LPs (Limited Partners) favoritism - if so, we can call it - towards more established and mature funds is correlated to the fund's level of risk. A first-time fund is regarded as a riskier compared to an investment allocated in a more established fund, and these first ones are usually generating higher returns. However, if an investor wants to take part in the investment, he/she must be ready to accept higher levels of risk. Another reason for LPs inclination towards more mature funds resides in uncertainty associated with a first-time fund manager and the team.
For these reasons, and due to the private equity industry's nature, raising capital for the first time is a strenuous – but not an impossible task. Nevertheless, time has passed, and with it, many aspects of the investment industry have changed. Long gone are the days when LPs would invest in funds just by carrying out a light research into GPs. Today's process is enriched with extensive questioning and due diligence (DD), in which LPs' concerns and preferences play a big part.
A dive into LPs' sentiments & concerns: The team's bondage and their commitment
Given these premises, let us dive deeper into LPs sentiments and concerns prior to investing in a fund. Firstly, as briefly shown above, one of the main concerns is the team's commitment and bondage level.
Since many first-time funds have been abandoned and a vast majority of these from first time fund managers, it is more than understandable that LPs want to know the team's level of commitment, their operational dynamics, and past experience. More in detail, they want to know if the team is ready to commit and collaborate for an extended period without jeopardizing the project. Hence, the team has to convince and ensure its ability to sustain the challenges encountered in the journey ahead.
Some of the concerns and questions LPs have towards so-called emerging funds - in respect to the whole teams' commitment levels - are presented as follows:
- Is the team committed enough, or are we going to face the risk of splitting partners?
- Is the team going to survive during the period, or are the people involved going to lose interest and consequently abandon the group and break up?
- Is the management fee enough to sustain the partners and the limited partnership throughout their journey?
*Please notice that we picked a couple of questions out of an extensive list.
Presumably, many emerging funds and VCs fail not because they lack capital; instead, they do so because of internal team dynamics. Thus, proof of solid connection and commitment to the team is highly valued. Furthermore, LPs draw much attention to the GPs history and track record. Most of LPs' reluctance to new funds is grounded on the risk of allocating stake and financially committing with a firm with little or unproven track record of PE fund management expertise. Having said this, track record plays a significant position in the LPs' commitment and decision-making process.
However, it is worth noting that even if we are talking about a first-time fund, the principals tend to have some background information about the team and perhaps might have worked together in the past. These are generally part of the vast network and have extensive and diversified information on funds and managers. Even though some first time funds are spinouts or formed by accomplished individuals who want to establish their firm, there have been, and will be, LPs providing capital commitments to support these investment ideas.
Why is track record of such vital importance to LPs?
Whether it's a first-time fund or a spinout – the group's financial track record is a significant aspect that LPs consider. Although not always - but previous track record and expertise are generally regarded as solid indicators of the funds' future. The fund performance, to some extent, dominates the funds' evaluation. Nevertheless, the only accurate indication of the funds and managers' achievements is in the given industry at a particular time.
LPs want to have a comprehensive understanding of the fund managers' performance and career history, focusing on the investment style, the managerial style, investment methodology, and approach. The strategies and success rate in different types of investments are also essential. Additionally, they want to determine the funds-built value, the acquisition strategy, execution, and the exit strategy. However, they mostly want to see a clear, concise, and detailed explanation of the value creation and cash returns (cash-on-cash).
Thus, LPs want to work with fund managers or entrepreneurs who can demonstrate their past success and achievements. Entrepreneurs are generally expected to have substantial knowledge in their investment area. They contribute with operational expertise and practical know-how to create value for their portfolio companies. On the other hand, accomplished investors are savvy in the investment sector and generally have strong and powerful ties within the industry.
Both features correspondingly presumably underline the investors' or entrepreneurs' ability to effectively increase deal flow, make rational judgments in deal sourcing, and creating value with active asset management. Additionally, LPs want to see that the team has strong bonds and a vast network of connections. Thus, GPs must provide verifiable and objective data to support their funds' strengths and strategies to market-beat future forecasts.
Why spinouts?
In the previous sections, we highlighted some subtle differences between first-time funds and spinouts. Let us dive deeper into their characteristics and LPs' reasons to choose these over emerging funds.
Spinouts are new funds generally formed by individuals that are "spinning out" of other groups. Even though they are first funds, they are formed by people with deep industry acumen. Spinouts have certain advantages over emerging funds, such as attracting commitments from LPs. This is because LPs usually know the management team, its investors, or, perhaps, they committed to investing in the previous firm.
An experienced team with a successful history yet managed by the spin-off members is likely to attract more investors than an emerging group launching their fund without prior record and trackable credentials. The due diligence process for first-time funds with unproven records is lengthy, and the LPs have to go through much underwriting.
However, it is worth noticing that the spinout team is not necessarily formed by the same individuals responsible for the level of deal flow achieved in the previous company (prior to spinning out). It may happen that the level of deal flow yielded in the parent company was acquired by other team members that are not part of the spinout. Thus, investors and financial institutions may question the firms' independence and their reliability.
LPs may decide to establish relationships with emerging funds or spinout teams to grow their portfolio and nurture new connections with GPs. These relationships may also seek to expand and enrich LPs portfolios with niche strategies or perhaps to enhance portfolio alpha.
Curtains close
This article reviewed the amount of dry powder available in the market and highlighted the challenges investors face in the sector. First-time funds and emerging managers face barriers to securing commitments compared to spinouts. This is due to LPs' level of emphasis on evaluating track records, team continuity, back-office activities, operational strategies, and the teams' deal sourcing capacities. Managers seeking capital commitment have to prepare for a thorough interview and due diligence procedure. They can achieve a competitive advantage by understanding what LPs expect, the type of questions they are most likely going to ask, and how to address these. By preparing in advance, managers can stand out and exceed investors' expectations.
The environment is very competitive and rewarding, but challenges are ubiquitous. Whether you are an emerging manager or an acknowledged investor, knowing LPs' requests and their concerns serves as a ground base to position yourself to reach out better and gain the investors' appetite.
The following article will dive deeper into the dynamics of pitching a fund to LPs. We will approach it by providing valuable and practical steps that will give you a better understanding of how to reach out to LPs and, perhaps get that longed-for capital commitment.
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