Going independent

Exponent Private Equity Partners held its final closing in mid-August 2004 with £400 million of commitments from a diverse group of investors.  It took only a little under five months from launch for this first-time fund to reach its maximum fund size.  I attribute that success in large part to the fact that our fund’s offering differed from that of many of its competitors.

Exponent’s four founder partners previously worked together for many years at 3i, the pan-European investment trust headquartered in the UK. At 3i, we worked together on a number of headline deals in the UK including Go-Fly, the low-cost airline which was spun out of British Airways, Pinewood-Shepperton Studios, which successfully floated on the London Stock Exchange in May of this year, and YBR Group, the telephone directories business recently refinanced through a high yield bond issue.

At the beginning of this year, we decided to leave 3i to establish our own private equity firm focused on UK mid-market buyouts.  In Europe, most spinouts of private equity teams have gone hand in hand with the divestment of private equity portfolios by financial institutions seeking to decrease their exposure to the asset class.  In our case, we were motivated by a desire to achieve greater independence and financial autonomy.  This seemed to resonate with our investors. It is interesting to speculate whether our success on the fundraising trail will lead to teams at other institutional private equity managers in Europe to follow in our footsteps.

In general, a small team of experienced principals spinning out of a large institution to set up on their own makes a compelling story.  Many investors and practitioners share the view that small teams, especially when focused along core geographic or sector specific lines, are able to execute their strategy in a more coherent manner, whilst retaining a more personal degree of accountability to their investors – something which is more difficult for larger institutional managers.

More importantly, the private equity industry is an entrepreneurial one.  It is populated with ambitious, driven individuals who are more likely than most to feel the need to establish their own business, especially when they spend most of their waking hours telling others how to run theirs.

However, the pity is that in practice, it is much more difficult successfully to spin out of an existing private equity business than from a financial institution.  The natural breeding ground for spinout teams, the large investment houses and financial institutions, do not consistently staff transactions with teams with clearly defined responsibilities.  It is more usual for executives to be brought together in an ad hoc manner, and as a consequence, teams of experienced principals with a combined track record are relatively hard to find.

Personal motivation is also varied.  As the Exponent team knows from its own experience, and from its recruiting activity in the London market, there is no shortage of European private equity executives who are frustrated in their present positions.  Common complaints include a lack of management autonomy and a concentration of carried interest among the most senior executives.  However, in general terms, many of these executives are well compensated and carried interest vesting arrangements act as golden handcuffs in preventing executives who would otherwise leave from doing so.  The Exponent team was in an unusual position in this regard because we were able to point to a successful collective track record of senior executives and we were not financially constrained from leaving since, because of the largely historical peculiarities of the institution we worked in, we were generally compensated at levels below the industry norm.

In addition, there are many practical hurdles to overcome in setting up on your own.  Psychologically, the most difficult of these is the inability to gauge investor appetite before making the decision to leave your current firm.  This means that a real leap of faith is required, and perhaps leaves the option open to only the most senior executives who are confident of their reputation in the market and who have the most successful track records.  In addition, English contracts of employment for private equity executives often contain onerous notice periods and restrictive covenants.  It is therefore usually difficult to approach an employer’s existing capital providers for purposes of funding a new venture, and the executives’ existing deal flow is likely to be off limits.

In the UK, detailed information relating to the track record of the team is legally the property of the employer and not the team.  As a consequence, when a team spins out without the cooperation of the employer, obtaining such information can be very difficult.  Indeed, the Exponent team had to reconstruct detailed information relating to financial returns and performance from publicly available data.  This involved analyzing over 6,000 pages of company accounts – a painstaking task to say the least!  And we were fortunate that we were able to do this because limited companies in the UK (where most of our investments were made) are required by law to file audited accounts and details of their capital structure at the UK Companies Registry, which is a public registry.  Managers in the U.S. and some continental European jurisdictions may find reconstructing their track records more difficult, since such data is generally not publicly available.

So, and I think disappointingly, we remain sceptical about the prospect of an abundance of spinout teams from larger private equity houses coming to market in Europe in the short term.  But we remain hopeful for the future, since we believe that the success of our fundraising is evidence of a healthy investor appetite for small, focused teams of experienced private equity managers coming together to offer a value proposition somewhat different to that of the large, institutionalizsd, mega-buyout firms that have become a feature of the private equity market of late.  As in most markets, we expect that supply will eventually find a way to meet demand.

Hugh Richards is a Founder Partner of Exponent Private Equity LLP in London. This article was first published in the Debevoise & Plimpton Private Equity Report, Fall 2004.