When American Pacific Group wrapped up its $450 million debut buyout fund in February, founder Fraser Preston, a one-time HIG Capital executive, was feeling lucky. The close, he told Buyouts, came just prior to the covid-19 outbreak, “before tailwinds turned into headwinds.”

This points to a new reality for emerging managers: in a fundraising market hit by a pandemic, the odds are first-time funds will absorb much of the blow.

Prior to the health crisis, emerging managers occupied a small but robust niche, attractive to limited partners as a source of outsized returns. Between 2000 and 2017, Preqin data show, first-time funds outperformed the vehicles of established managers in all years but one.

Even in good times, however, general partners raising inaugural funds face challenges. First-time offerings often take longer than follow-ons to secure commitments and reach initial and final closes.

That is because LPs see them as a risky bet, requiring more rigorous vetting than large, brand-name PE firms. Many investors do not or rarely commit capital to first-time funds. Almost half of respondents to PEI’s LP Perspectives Survey 2020 said they only invest opportunistically in such funds, while 37 percent said they do not plan to back them in the future.

Need to meet

While a coronavirus-driven down-cycle is unlikely to shut down fundraising for viable emerging managers, it has multiplied their challenges.

When evaluating GPs with first-time offerings, LPs are guided by policies requiring face-to-face meetings. On-site due diligence is key to assessing skill sets and team dynamics, understanding PE strategies, and getting a handle on firm-level economics.

Social-distancing measures and travel restrictions imposed to stop covid-19’s spread, however, have made this type of vetting all but impossible.

In response, investors have revised procedures to permit meetings through teleconferencing or video conferencing, Kelly DePonte, a managing director with Probitas Partners, told Buyouts. These remote options, he said, are being used by LPs mostly to communicate with PE firms “they already know.”

This leaves out emerging managers who recently launched funds and have yet to forge relationships with LPs. For them, virtual meetings will not satisfy investors needing “to look in the light of their eyes,” DePonte said.

It may also be difficult for emerging managers to get the attention of LPs fretting about a downturn. Issues like the state of portfolios and existing fund partnerships, DePonte said, are causing investors to shift focus away from fundraising that was not advanced when the pandemic broke out.

“LPs now have bigger fish to fry,” DePonte said. This includes even large institutions with first-time fund programs, such as California Public Employees’ Retirement System and Canada Pension Plan Investment Board.

A long history

The health crisis is generally expected to add three to six months to fundraising. PE firms are making decisions about whether to extend timetables, pause or cancel activity altogether.

For both emerging and established managers remaining on the fundraising trail, the situation is increasingly becoming one of “haves and have-nots,” Natalie Walker, a manager director with StepStone Group’s private equity team, told Buyouts.

Among GPs raising inaugural funds, the “haves” potentially include those with “strong pre-existing relationships with LPs,” Walker said. The most promising teams will also have a long history of working together, she said, as well as experience with PE investing in “both good times and bad.”

Better-positioned emerging managers could include spinouts of large, brand-name PE firms, DePonte said. Team spinouts often reflect a cohesive, seasoned group of GPs with a clear track record. To succeed in a more challenging environment, he said, they must also have ties in the LP community.

PE firms that built track records before launching a first-time fund may also be viable, DePonte said. Deal-by-deal investors, he said, usually exhibit experience, team continuity and sourcing skills. Market upheaval, however, might compel some to switch their focus to trouble spots in the portfolio.

If the downturn is prolonged, Walker said, the result could be a further pullback of fundraising and less capital available for first-time vehicles. In the event, she said, “even the strongest emerging managers might encounter headwinds.”

In the interim

DePonte said fresh challenges created by covid-19 amount to a “perfect storm” for first-time funds. In the months ahead, he said, GPs who delay or abandon offerings will meet with both opportunities and hazards.

Opportunities include room for deal-by-deal investing, especially as pricing improves. Walker said emerging managers without legacy portfolios have an advantage here and can use new transactions to show their return-generating capabilities with LPs once fundraising resumes.

Deal-by-deal opportunities will likely materialize, Walker said, over the mid- to long-term, when there is greater market clarity. At that point, she said, the most executable investment opportunities could reside with distressed PE, special situations and credit strategies.

As far as hazards, liquidity is at the top of the list. Whether emerging managers continue fundraising or adopt interim plans, DePonte said, they must have “cash on hand.” The longer the down-cycle, he said, the more liquidity concerns will determine if GPs are able to keep going.