A volatile macroeconomic and geopolitical environment means many investors are pulling back on risk.
Meanwhile, the denominator effect is creating capital constraints, and an unrelenting wave of re-ups means LPs are being pushed to their limits. All of which is resulting in a flight to the familiar and a punishingly tough fundraising environment for emerging managers, according to the sixth annual Buyouts Emerging Manager Survey, conducted in partnership with Gen II Fund Services LLC.
However, those young firms that display the essential ingredients of track record, team composition and a differentiated strategy will continue to attract attention, because savvy investors recognize that turbulent markets drive emerging manager outperformance. Unencumbered by legacy portfolios and hungry for success, this could be the time for emerging managers to shine.
Nearly two-thirds of survey respondents either agree or strongly agree that investors are hesitant about backing emerging managers; only 15 percent disagree. A degree of risk aversion is understandable, given the macroeconomic and geopolitical challenges that are facing the industry. However, organizations with a dedicated focus on emerging managers believe that a cyclical approach to emerging manager investing is counterproductive. “The irony is that data shows emerging managers outperform during the most challenging periods,” says Paul Newsome, private equity partner and head of portfolio management at Unigestion.
Access all areas
Half of LP respondents say the primary purpose of their emerging manager program is the ability to generate superior returns. Other objectives include portfolio diversification and exposure to specialist strategies, as well as the ability to handpick managers owned by minorities or women. Also key is the ability to secure access to a firm that may limit commitments from new investors when it gains in popularity. “LPs want to discover the next successful franchise,” says HarbourVest managing director Carolina Espinal. “Because, by the time a GP raises its third or fourth generation, it can often be that either access becomes constrained or performance tails off.”
Almost half of GPs believe that investors are willing to back emerging managers with compelling products. However, 72 percent say the market has become bifurcated, with established firms attracting the bulk of LP interest. Meanwhile, 47 percent say the market is more challenging now than it was before the pandemic. Indeed, emerging managers are struggling with the persistence of remote fundraising, even as travel restrictions have eased. “Everyone is getting more comfortable with Zoom, but it mutes that sense of connectivity,” says John McCormick, partner at Monument Group.
People, performance and process
Team composition was deemed the most important factor for investors reviewing emerging manager opportunities again this year, followed by investment strategy. Other key considerations include deal sourcing, operations and compliance strength and, of course, track record. “When it comes to due diligence, it is all about the three Ps: people, performance and process,” says HarbourVest’s Carolina Espinal. Access to co-investment is a significant issue for a third of all LPs, while terms and conditions are deemed important by more than half.
Trying to make yourself heard
The most significant challenges that GPs say they face on the fundraising trail are allocation constraints and competition from established managers. Public market performance means the denominator effect has taken hold. Some investors are also looking to boost returns by reallocating fund capital to co-investment. Meanwhile, a deluge of re-up requests means it is hard for emerging managers to command attention. “It was a lack of bandwidth, rather than a lack of interest, that we were fighting against,” says Gil Klemann, managing partner at GHK Capital Partners, which closed its debut fund this year.
It is perhaps surprising that less than half of LPs said they take ESG considerations into account when reviewing an emerging manager. This could reflect a recognition that emerging manager infrastructure is typically immature. “ESG is an important area, but it is difficult for emerging managers to have a strong program out of the gate,” says Christine Winslow, managing director at Grafine Partners. “It is nonetheless important for emerging managers to incorporate ESG into their strategy and lay out a plan for where they want to go.” Interestingly, only a little over half of LPs said they believe ESG correlates positively with performance.
Getting a strong first close can be critical for a first-time fundraising. But securing an anchor investment can be costly. More than two-thirds of investors open to making an anchor commitment said they would seek a discounted management fee in return. Meanwhile, 67 percent would look for discounted carry and 58 percent for co-investment rights. Importantly, more than one-third would try to secure preferential terms for subsequent funds, while 42 percent would seek a stake in the general partnership itself.
“It is important to limit what you give away as an emerging manager,” says Monument’s John McCormick. “It is also important to make sure whatever is given away is ringfenced.”