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In a spin

There has been an increasing trend for captive private equity firms to seek independence and for established venture capitalists to go it alone and set up their own firms. Richard Rivlin looks at what motivates them to do this and whether their new, spin-out firms are a good investment for institutions.

Mark Phillips was a rising force within the Royal Bank Development Capital team of private equity investors. Back then, if the bank's computer system fell ill, he could phone a man in the IT department to fix it. If he needed to make a dash to London for a meeting with a City law firm, he could phone the bank's travel department who could arrange it all for him. It was all pretty simple.

And then he handed in his notice - along with four other executives. Together, they set up Penta Capital. And life suddenly became rather more complicated.

‘We wanted more autonomy. We wanted to have a go at seeing if we could build our own business as well as investing in other people's.' Mark Phillips, Penta Capital

For the first year, he had to become his own IT troubleshooter, travel manager and office organiser. And that was on top of playing a key role in raising Penta's first fund, plus sourcing its first four deals. ‘We wanted more autonomy,' says Phillips, days after closing Penta's maiden £130m fund. ‘We wanted to have a go at seeing if we could build our own business as well as investing in other people's.'

Phillips and his colleagues are by no means alone. Flick through the chunky handbook of the British Venture Capital Association and you'll see a growing number of these ‘independents' - firms that have either spun out of traditional, captive funds owned by banks or insurance companies, or that have been spearheaded by individuals who decided to go it alone. Leading names such as Alchemy, Apax, BC Partners, CVC Capital Partners, Cinven, Electra Partners Europe in the UK and international funds such as SilverLake and Bowman in the US are all examples of those who have gone it alone.

Evolution, not revolution
So why are so many venture capitalists making a break for independence? You could argue that it's natural evolution. The general pattern is that young practitioners join a firm, learn their trade and sooner or later get restless. Why? Because they're not doing the deals they want in the way they want or they get tired of the original partners taking the lion's share of the carried interest.

‘It is less a break for freedom and more a break for more cash,' says one leading partner in a captive. ‘Ours is a greedy industry. It might appear to be more fun working in a smaller firm with less bureaucracy, but if 3i offered the riches with the same back office, everybody would do it there. Spinning out is principally a financial decision.'

But others disagree. ‘Money is important,' says Jeremy Coller, founder of secondaries buy-out firm Coller Capital. ‘But it's a by-product of what we do. Building a business is fascinating. It's crazy that so many people spend so long advising others on their business without ever having to worry about their own.' Alchemy's Jon Moulton agrees. It's a natural consequence of spending so much time with independent-minded entrepreneurs, he says. Before launching Alchemy, Moulton did stints at private equity giants Apax and Schroders. In both instances he left firms because he grew tired of dealing with the growing bureaucracy associated with larger organisations. With the recent news that Schroder Ventures is looking to break its umbilical chord with the famous banking dynasty, Moulton's quest for independence looks set to be followed by the people he left behind.

Why invest?
But even if spinning out is simply about cash, going it alone isn't necessarily an easy way to make a fast buck. Penta was unusually successful in raising its first fund. It won the support of some impressive big-name investors - Old Mutual of South Africa and Fortis of Belgium, to name just two.

Attracting that kind of funding can be an uphill struggle. Many institutions are wary about investing in first-time funds. And rightly so. They are a far more risky investment than firms with a track record - the team may not have worked together before, it won't have the resources and research capability it used to rely on, and even if the individuals are great deal-doers, it doesn't mean that they have the skills needed to run their own firm. So how can institutional investors decide if a spin-out is worth backing? And what kind of due diligence can investors carry out?

Well, the bottom line is: you can't be certain. You may find it easy to structure more attractive terms as an investor because of the increased risk involved in investing in a first-time fund. But, whichever way you look at it, you're buying into the track record and vision of the protagonists. You simply have to ensure that you are comfortable that these people are capable of generating the returns you need and expect.

Institutional investors debating how much to allocate to private equity will invariably base their decision on a number of factors - track record being the most important. ‘The absolute ideal is the third fund for an established group of investors with a number of years of experience,' says Ian Simpson, director at Helix Associates, which specialises in fund raising for a range of firms.

So why do any investors back a new fund, a start-up? Helix and others who have gone through the process suggest that there are many reasons. One might be that an individual has an exemplary - and easily verified - track record in previous posts. Another might be that the firm is focusing on investing in a niche area and that niche matches the investor's strategy.

Getting a grilling
But thorough due diligence isn't easy. Old Mutual was a cornerstone investor in Penta and committed a hefty £50m. Understandably, it wanted absolute assurance that the people running Penta were top-notch venture capitalists. ‘They talked to all of our contacts around the industry,' says Phillips. ‘They talked to us for half a day each. They hired an ex-private equity investor to interview us about our best investments - and our worst investments. They even investigated our private lives.'

Deal flow is another key issue to explore - poor deal flow means poor returns to investors. If it's not immediately obvious where a new firm generates its deals from, it might be a problem. Old relationships and marketing abilities count for a lot. Make sure that the new firm is using them to its fullest advantage. Penta launched its version of an advisory panel - ‘the network'. It includes 13 entrepreneurs who source deal flow, ideas and suggestions for the firm. Other firms may use non-executive directors to do this, too. But without this kind of set-up a new, spin-out firm that has no reputation as yet may find it hard to source deals.

Risky, but worth it?
Investing in a spin-out may be rather riskier than investing in a captive or established fund, but the returns can be correspondingly better. A venture capitalist's first fund is a make-or-break opportunity. The reputation of the firm and that of its partners rests on their first fund giving investors good returns. The founding partners in a spin-out are likely to be much more motivated to generate great returns than VCs in a captive firm - their future depends on it. (This is partly because they are raising for the first time and partly because they are independent.) In fact, there is an increasing trend for US institutions to invest in independents over captives because of this ‘hunger factor', says Mark Wordsworth of Bridgepoint Capital (formerly Natwest Ventures).

Will we see more spin-outs?
In the current economic climate, some might argue that the trend for spin-outs is likely to slow. With deal flow and exit routes sluggish, you might think that venture capitalists would be less inclined to take the risk of spinning out from an established organisation. But there are other factors at work here. Investors are increasingly becoming interested in being cornerstone investors and taking a stake in a fund's management company. They can only do this if a fund is independent. And, as long as many private equity houses can find the funding to spin out, the urge for independence is likely to win out. Plus, as the industry is always so keen to stress, private equity is a long-term business. Firms raising funds now won't generally be expecting to see returns until after the current downturn is but a distant memory. Spin-outs are an inevitable feature of the private equity industry.

Richard Rivlin works on business development for nothing-ventured.com, part of the Durlacher Corporation.