As an economic downturn threatens, limited partners are not abandoning the mid-market. They are, however, scrutinising fundraisers for evidence of differentiation. Tim Chapman reports.

As mid-market GPs contemplate looming economic storm clouds, investors are looking ever more keenly for the best managers for their money. Limited partners need to distinguish the sheep from the goats: to discard the firms which have made their name in recent years by adroit deployment of cheap debt, and back the ones which can genuinely add value.

Fundraising for the European midmarket is set to be an increasingly testing process, despite the increasing amount of money coming in. The number of new GPs in private equity is increasing while existing funds are typically doubling their allocations, notes Mounir Guen, chief executive of placement agent MVision. A large portion of the capital inflow is targeting the European mid-market. “There's completely global interest in European mid-market GPs,” Guen says. “Each one of our clients has investors from around the world.”

In recent times, many GPs found they could comfortably exceed their targets with relatively little effort. Barclays Private Equity closed its third fund at €2.4 billion in September 2007 entirely from investors in its previous fund. “We expected a positive response, but the thing that did surprise us was the level of uplift in their commitment levels,” says Brian Blakemore, investor relations director. “We also had a long line of new LPs who would have liked to be in. If we'd gone out and satisfied all the demand out there, we could probably have raised twice as much.”

North European GP Industri Kapital was also out raising its sixth fund over the same period. Launching at the start of 2007, the fund reached a first close in April in excess of its original target. The final close in October was €1.675 billion, more than double its predecessor. Unlike Barclays, IK made room for new investors, including US big hitters NYTRS and AIG.

Mads Ryum Larsen, head of investor relations at IK, acknowledges that this golden age has now probably ended. “If the present climate continues, it will get more sticky,” he says. “The process will become a little more extended, and new money coming into the asset class might be a little more hesitant.”

The debt crunch has so far had little effect on the mid-market, but there are worries that some institutions are keeping their money in their pockets for the time being. LPs insist they're still hungry for the right propositions, however.

“You can't judge cycles in private equity,” says John Gripton, head of investment management Europe at alternative asset manager and adviser Capital Dynamics. “We're looking for GPs who can demonstrate that when they believe it's the right time, they will put money out; but when it's difficult they will be cautious.”

The credit crunch has created two classes of GP, says Antoine Dréan, chief executive of placement agent Triago – those which made good returns in recent years because of the credit markets, and those which have been genuinely adding value through specific strategies or niche positions. “I think this is what LPs are starting to realise,” Dréan notes. “It was pretty difficult to differentiate between the two in recent years because everyone was making money.”

A solid history of delivering returns remains the biggest attraction for any LP. “Track record is the heart and soul of it,” says Guen. But just having a good track record is no longer enough – GPs need to demonstrate that their numbers came from a proven strategy or niche position, and that their previous performance can be sustained.

“It's about making sure that the track record is attributable to the individuals who are going to be investing in the future,” says Gripton. “We also put emphasis on continuity in the strategy which has generated the track record and that it will remain appropriate going forward.”

A geographic focus can also be attractive, so long as GPs are active on the ground. This tends to be viewed as particularly important in the European market, which is widely seen as much more fragmented than North America.

The last few years have been very strong for private equity returns, and that's made the LP's job more difficult

Brian Blakemore

“In most European countries, you need local people who are there and plugged in,” says Dan Kjerulf, partner at Copenhagen-based fund of funds manager Danske Private Equity. “Mid-market is very much about developing the businesses. You can buy and sell from a distant location as well as if you were there, but you really can't do the development from afar.” Mid Europa Partners closed its third Central European buyout fund in October at €1.5 billion, over twice the size of its previous fund. “It is a little easier when you get into anything with a number higher than two,” notes managing partner Thierry Baudon.

Regional focus was the key draw for LP capital, which included a larger proportion from the US, Middle East and Asia. “The fact we are the number one player in that particular space with a good track record and a lot of stability in the team makes a huge difference,” Baudon says. “If you're a mid-market player, you've got to be different otherwise you don't survive. In our case, being different means being able to do good business in a region where there's very little intermediation.”

The flipside is that some LPs outside Europe are wary of the more mature national markets, seeing less competition and more potential value elsewhere. “When they look at Europe from a macro point of view, they see the UK as very mature and worry about the fact it's a much more liquid market,” says Philip Buscombe, chief executive of UK-focused mid-market GP Lyceum Capital. “We had a long discussion with some investors about that, because we believe this macro analysis doesn't really reflect the true market conditions.”

Lyceum closed its second fund at £255 million in February 2008, 25 percent ahead of target. The bulk of the funds were committed before the summer, though Buscombe reports more interest after the credit crunch as LPs looked to shift some allocation from the stalled top end of the market.

As do many firms on the fundraising trail, Lyceum and Mid Europa both used placement agents to help present their case in a crowded market. There is strong competition between GPs to secure the services of the best-rated agents – for instance, Dréan says that Triago sifts through 150 to 200 potential fundraisings a year and acts on just eight to ten. Most players agree that while the GPs should always retain control of the facts and figures, agents can help package and present the data in the way that LPs want to see and, most crucially, engineer connections between GPs and interested LPs.

“It saves time because you don't go to people who wouldn't at this particular juncture be interested in your particular space,” says Baudon, who contracted MVision for Mid Europa's new fund. “It fundamentally boils down to the opportunity cost of our own team – I feel the team here are better at doing deals and finding good companies than at running around the world with slideshows.”

Many LPs also welcome the role of agents as a go-between. “After the introduction, then it's between the LP and the GP as we conduct our own due diligence,” says Gripton.

Tougher due diligence in tougher times mean fundraising is set to be a slower and more arduous task. But the best funds should have their pick of LPs, while weaker firms will struggle to reach targets.

“The last few years have been very strong for private equity returns, and that’s made the LP’s job more  difficult,” concludes Blakemore. “It’s times like we may be coming up to, with tighter economic conditions, that  sort the men out from the boys.”