["Where Do We Go From Here?"] Questions That Need Answers Before the Private Equity Spin-Out

The history of the private equity industry can be told as a series of spin-outs. Successful investment professionals typically begin their careers working for someone else but eventually quit to have a go at working for themselves, typically in partnership with like-minded co-workers. 

The decision to fire your boss and launch your own fund can bring with it both opportunity and peril, as our five experts can attest. We asked these seen-it-all pros to give their best advice to private equity professionals contemplating defection. 

From its beginning in the mid 1970s, the private equity market has been refreshed by a steady stream of innovative new products and talented new management teams that have brought energy and creative approaches to alternative investing.  

That said, the private equity market today is crowded with existing products, and shelf space for new deals is limited by finite investor resources. In spite of the increased supply of funds, the future will almost certainly be a challenge, especially for a new team attempting to break into the market. Here are some thoughts to help assess your odds for success: 

Build a Real Team 


Simply put, your team has to be fully staffed with critical people. The two-guys-and-a-dog approach has worked for hedge funds, but not often in private equity. 

Point to a real track record 

New funds usually must have a demonstrated prior record of excellence to have any reasonable chance at success. Since, by definition, this will be with a previous employer, attribution becomes a major issue. If you do strike out on your own, do your best to leave on good terms so that you are allowed a fair claim to your true contribution on deals done in the past. 

Show continuity 


It is very important that the team has worked together for some time and is not a recent amalgam. To be ‘new, but not new’ is a very important distinction for a first-time fund. 

Be realistic on fund size 


Size matters, but in this market smaller is better, all other things being equal. The target amount must also be consistent with the team’s resources and its demonstrated ability to get money to work. 

Protect your rep 


A good reputation among LPs who know you is a necessity. Remember that while you can leave an established fund, the investors in that fund cannot. It is very important that you exit in a fashion that is both honorable and considerate in the eyes of the prior fund LPs. Word will get around. 

Consider an agent 


Most new funds probably should use an experienced placement agent in this crowded, competitive market. Since about three-quarters of private equity investors have at least a mild bias against, or even a prohibition, on first-time funds, newcomers need all the help they can get. There are exceptions to the rule, but if you are even remotely in doubt, you need a placement agent. 

Once you’re in the market, your chances of success will depend on successfully answering two pre-eminent questions in the minds of prospective investors, the first of which is, “Why should I care about what you’re doing?” 

This question must be satisfied by establishing that there is a current and compelling investment opportunity in your particular sector of private equity. If the opportunity isn’t compelling now, it won’t matter how good you are. Once successfully over that hurdle, you come up against the second question: “Why should I invest with you?”  

Answering this is the single most important challenge for a new fund in today’s market. 

That is to establish a unique personality, and some distinctly differentiated set of characteristics that will set you apart from the crowd. The challenge is all about shelf space, and it is a life-or-death issue.  

Investors today feel they have too many private equity investment teams and will need to see some serious charisma to justify adding another GP to the roster. Unless you have a truly awesome track record, no charisma will mean no money. 

Getting Ready for the LP Inquisition 

The following are some key questions to ask yourself when preparing for the scrutiny you will receive from LPs and their advisors: 

Who will your departure anger? 


If you are a star at your current firm, a substantial portion of the investor base of that firm may well have signed up based on your continuing participation there. These may well be the same investors you will approach for funding after your departure. Do not be surprised if some of your potential investors would prefer that you stay where you are to do what they believe you said you would do – invest their funds at the old firm. 

Who can understand your story? 


Generally speaking, institutional investors prefer simplicity over complexity. That is one reason why many gatekeepers will not even consider spin-outs, which they term first-time funds. Multiple track records from dissimilar investment disciplines, questions of performance and/or deal attribution, and potential organizational issues associated with partners new to each other make spin-outs and come-togethers much more difficult to assess than follow-on funds. Each additional facet of complexity will add to the difficulties of fundraising. 

What are your real motivations? 


Believe it or not, your true motivations for spinning out will ring true to sophisticated institutional investors and every other rationale will ring false. If you are leaving to make more money, say so. If you are leaving to run your own show, say so. If you are starting over to do the types of deals you’ve always been best at, say so. But if you are leaving to make more money while claiming to return to your historic investment style, plan on endless interviews with skeptical managers and consultants who will be trying to figure out what exactly you’re hiding. 

How well do you know your partners? 


It’s often said in this industry that you don’t know someone well until you’ve done a deal with him or her. This can also be said of fundraising, at best a difficult and lengthy process in the current market. If you’ve never raised funds on your own or if you’ve never raised funds with your new partners, watch carefully for personal and organizational signs of strain and act quickly and decisively to reduce or eliminate them.  

Any personal, professional or organizational issues left unaddressed due to discomfort or fear of confrontation will be sure to resurface at precisely the wrong time in your fundraising cycle. 

If you address these points, your natural market will consist of sophisticated institutional investors who are not investors in your current 

These investors will understand your motivations for spinning-out, will be willing to take the time to understand your track record (or respective track records) and will be able to take a chance on a new organization. Going to your natural market first will reduce the time and effort required to raise your new fund and thus will minimize the strain on both the partners and the partnership. 

Does this all sound easy? If you think so, stay where you are. But if you truly understand the risks and are willing to take them, I wish you the very best of luck.