iOn a global basis, private equity funds saw a surge in assets under management in 2017, with 921 private equity funds reaching a final close and over $453 billion raised — the largest level of commitments in the past 10 years. [1] These new funds include a significant number of first-time fund managers, with 226 first-time funds reaching their final closing in 2017. [2] Given the continued interest in first-time fund managers in 2017, we expect the figure for first-time final closings to increase in 2018.
First-time fund managers present an attractive opportunity for many private equity fund investors because of the potential for strong returns and the ability to build a strong relationship for future growth with the manager. At the same time, with the number of existing private equity fund managers marketing new funds, competition for investor dollars has been intense, and not all investors have been willing to risk betting on a first-time manager without a proven track record of performance. For instance, in a 2017 Preqin survey, 41 percent of surveyed investors said that they would not invest in a first-time fund because of the importance of an established track record. [3] Yet, at the same time, 33 percent of investors in that same survey showed a preference for first-time funds, a strong indicator of the continued interest in this segment of the private equity industry. [4]
Some first-time managers succeed by presenting a differentiated strategy and limited opportunity to invest at the inception of a new fund. Others succeed by teaming up with one or more institutional investors who seed the manager and/or its fund for its initial fund launch.
In a competitive landscape, the right seeding arrangement can give a first-time manager the boost it needs early in the fundraising process. Not only can a seed investor’s capital be critical for getting the scale sufficient to execute the manger’s strategy, some seed investors have been able to bring a competitive advantage to the manager by virtue of their expertise or industry contacts. A seed investor’s willingness to provide capital and support to a first-time manager can be seen as a significant vote of confidence in the manager’s strategy and investing capabilities, helping overcome the reluctance regarding a first-time manager’s lack of a “fund” track record, while at the same time lending credibility to the manager and the offering the opportunity for institutional mentoring.
In 2017, there was healthy interest from institutional investors looking to enter the emerging manager market for the first time by joining groups of “anchor investors” led by one or more seasoned seed investors. These newer entrants to the seeding industry have sought to reduce the risk of betting on a first-time manager by teaming up with an experienced seeder, with the expectation that this will be an advantage in the diligence process and in the manager’s efforts to reach a successful initial and final closing. We view this as a positive development for both the seeding and first-time manager markets, providing an important comfort level that can lead to increased allocations by these institutional investors to this segment of the private equity industry.
The structure and approach of seeding arrangements with first-time managers in 2017 have been bespoke and customized, ranging from light-touch arrangements to more extensive joint venture-type relationships with extensive governance provisions. At the same time, certain hallmark features remain consistent across seed investment arrangements. The seed investor invariably provides the fund manager with a significant commitment of capital to the fund, typically early in the fundraising process, in order for the manager to reach a successful first closing. Initial commitments from seeders are typically substantial — anywhere from 10 to 33 percent of the overall target fund size. In such instances, the seed investor’s capital provides an “anchor” for the manager to complete an initial launch of the fund.
In return, seed investors have typically received a share of the management fee and other fees (such as monitoring fees, transaction fees, and directors’ fees) payable to the manager and a share of the carried interest allocated to the manager. These revenue-sharing arrangements have generally been structured through a contractual arrangement, an ownership interest in one of the fund manager entities, or a combination of both. Other rights typically granted to the seed investor have included the right to receive favorable economics in future funds launched by the manager, so that the seed investor achieves the benefit of taking the first-time risk on the manager’s success. In 2017, as in prior years, the specific terms and duration of these future-fund seeder rights varied widely, sometimes measured by years and sometimes by threshold level of assets under management.
One approach for addressing the inherent risk in seeding arrangements with first-time managers has been through the seeders’ acquisition of governance and control rights with respect to the manager’s business and the funds being launched. While there is some level of negotiation, the core of these rights typically seeks to define and limit the manager’s ability to deviate from the investment strategy, take on undue financial exposure, and make significant amendments to governing agreements of entities in the corporate structure, among others. At the fund level, this often will include the right to appoint one or more members to the limited partner advisory committee for the fund. Seed investors typically will obtain participation rights on the investment committee of the manager, often in the status of an observer but sometimes as a voting member of that committee. [5]
Given the strong interest in private equity generally and in first-time managers specifically, we anticipate continued interest in 2018 in both first-time managers and in seeding arrangements. In recent years, the universe of investors interested in first-time managers has expanded, and we expect to see investors such as family offices, insurance companies, non-U.S. institutional investors, and fund-of-funds managers continue to invest in this segment of the private equity industry and perhaps expand their exposure to it. While the field for new managers and investors interested in them is becoming more crowded, we believe that there is room for continued growth in the industry.
[1] Figures from Preqin 2018 Global Private Equity and Venture Capital Report.
[2] Figures from Preqin 2018 Global Private Equity and Venture Capital Report.
[3] Figures from Preqin 2018 Global Private Equity and Venture Capital Report.
[4] Figures from Preqin 2018 Global Private Equity and Venture Capital Report.
[5] For a more in-depth look at seeding arrangements, please see the following article available on the K&L Gates Hub.
