The Separate Account for Middle Market Managers

Outstanding investment opportunities come in all shapes and sizes, but middle market managers know that it can be difficult to pursue some of these opportunities if they do not conform to the return parameters of a typical private equity fund. Private equity as an asset class is structured to broadly target a 2x MOIC and 20% IRR over a 5-year term, and the pools of LP capital that invest in private equity funds do not look favorably upon investments underwritten to a different return profile. For example, a GP trying to implement a long-dated, MOIC-driven strategy will find it difficult to raise capital from their traditional sources. Given this reality, private equity managers may want to consider turning to Separately Managed Accounts, or SMAs, to allow themselves the freedom to make investments that would not fit under the mandate of a private equity fund. This is an initiative that our team has been working on for quite some time — and is ready for prime time.

There are a number of scenarios in which an SMA can be an attractive structure for middle market managers. One example, as mentioned above, is if a GP finds a company that requires long-term strategic and operational initiatives to unlock outsized value. Such an investment may have the potential to return a multiple of the 2x/20% base case model, but needs an 8 to 10-year hold in order to fully reap the benefits of growth initiatives implemented by the managers. Alternatively, a manager might own a portfolio company that has been held for 3-5 years, but still shows massive potential for value creation. Under pressure from LPs to sell, it can be hard to justify holding on to the asset to grow it further. If either of these scenarios seem familiar, an SMA or like structure might prove to be a good alternative.

Of course, the freedom afforded by LPs through SMAs does not come without its own set of asks. Firstly, LPs will not be willing to offer the same fee structure that they would to a private equity fund. GPs pursuing SMAs must be amenable to zero fees on committed capital and reduced fees on invested capital. Additionally, LPs will usually demand an outsized GP commitment in order to ensure proper alignment of incentives. GPs trying to create an SMA alongside a traditional fund will also have to navigate their dynamic with existing LPs. It is crucial to give existing LPs comfort that the SMA will not impede your ability to effectively deploy and manage your existing fund strategy. Furthermore, if a GP is below their deployment threshold to raise a new vehicle, they will have to get formal approval from their LPAC before raising an SMA. A good way to steer through this issue is to present your thesis for your proposed SMA to your existing LPs and offer them a pro rata share. LPs that have programs which allow them to commit to such alternative vehicles will appreciate the offer.

The next logical question is to identify the types of LPs that will be open to committing to a non-traditional SMA. Typically, LPs that are driven by wealth preservation and long-term, steady returns will look more favorably upon SMAs compared to LPs that demand quicker harvesting and high IRRs. In the past, we have seen family offices, insurance companies, direct secondary investors and strategic-minded consultants commit to non-traditional SMAs. What’s more, such LPs are also willing to offer value beyond just providing capital. We are increasingly seeing that LPs involved in such SMAs are willing to partner with GPs and work side-by-side in their diligence process rather than waiting until the deal is under LOI. On the other hand, there are certain types of LPs that are not set up to commit to SMAs. Fund-of-funds will find low-IRR strategies unattractive, while public pensions, corporate pensions and endowments are unlikely to have robust enough programs to seek out SMAs.

At the end of the day, SMAs are not for everyone, both on the GP side and the LP side. If you would like to learn whether an SMA is appropriate for your strategy now or in the future please don’t hesitate to reach out.

Next on 60 Seconds with Sixpoint: “A La Carte” Fundraising: How to Economize and Maximize your LP Outreach

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