The number of private equity firms globally has more than doubled over the past decade, according to McKinsey’s latest annual private equity review. At the same time, longstanding managers have ballooned in size, with assets under management climbing by $4 trillion in the last 10 years. Limited partners’ portfolio management approaches have in turn become increasingly sophisticated to take advantage of this dramatic proliferation.
“Clearly the private equity industry has grown enormously and so, a couple of years ago, we looked at our historic performance,” says Janusz Heath, senior managing director at Capital Dynamics. “We saw that we have historically generated excellent returns from backing early managers and so, while we don’t have a formal program, we now intentionally have a far more open mind when it comes to committing to emerging managers.”
What is an emerging manager?
Definitions for what constitutes an emerging manager vary. For Derek Schmidt, director of private equity at Marquette Associates, it is a manager raising its first, second or third institutional fund. “We consider emerging managers to be those without a significant realized return track record, without an established team that has deployed capital together, and without an established and supportive LP base.”
For Scott Reed, co-head of US private equity at Aberdeen Standard Investments, “it can be hard to capture the essence of emerging managers in a single definition. Some investors also take into account the background of the GP.” He agrees with Schmidt’s definition, but also often gets involved with pre-fund deals.
Thirteen percent of investors surveyed include ownership by women or minorities in their definition of emerging managers. The most widely held view, however, was that emerging managers are those raising fund one or fund two. Just under a third of investors, meanwhile, take the size of the fund raised into account.
As the biggest names in the industry swell their coffers and establish broad multi-asset-class platforms, the hunger and entrepreneurial zeal that a team starting out can bring to a portfolio is often appealing. So too is the focus on small- and mid-cap assets typical of new managers. “Emerging managers tend to operate at the smaller end of the private equity ecosystem and generally invest in small companies,” says Reed. “Those funds often outperform larger vehicles. Generally, we will back two to three vintages, and then let them go when they become too big.”
John McCormick, managing director at placement agent Monument Group, adds that the desire to re-deploy capital into the smaller deal market has driven appetite for emerging managers. “The big LPs now actively manage their portfolios, using the secondaries market to trim back exposure in some areas, freeing up capital to find interesting emerging managers – who themselves are often coming out of the bigger firms that have grown beyond the scope of the investor.”
Claire Kendrick, head of alternative investments at Mill Creek Capital Advisors, describes her firm as looking for managers that can add a “different twist.” A quarter of Mill Creek’s commitments are made in first- and second-time funds, with an even split between the two. “The appeal is looking at niches that other people are not,” as well as “unique expertise,” she says.
Art versus science
Diligencing emerging managers is not always straightforward and has only been made more difficult by covid-19 restrictions. It is more challenging to collate the necessary information.
“It is definitely simpler if you are looking at a splinter group of what I call the ‘marzipan layer,’ that have decided they are doing all the work but senior partners are getting all the carry,” says Reed.
“But in general, the level of due diligence and the due diligence process don’t vary. It may just be that you need to be prepared to make a few more assumptions.”
Reed’s view is that due diligence with emerging managers is often more of an art than a science. “The work is sometimes more qualitative than quantitative.”
Richard Spencer, head of funds and co-investments at Barings, adds: “Due diligence topics across established managers and emerging managers are very similar but each has a unique emphasis related to their respective risk profile. Consistently successful investors in the emerging manager space have typically developed a more thorough playbook to underwrite their GPs and co-investments, digging deeper in the areas that could make or break an investment thesis.”
Terms of engagement
Terms on offer are also a consideration when selecting emerging managers, which may themselves be more amenable to offering attractive arrangements than more established firms.
More than half of emerging managers surveyed said they were prepared to offer co-investment rights, discounted carry and LPAC participation. However, appetite for providing a stake in the general partnership or management company is far lower at 24 percent. Only 15 percent of GPs said they offer opt-outs for LPs on certain investments.
Perhaps surprisingly, many LPs claim they prefer not to push too hard on terms – management fees in particular. “We always look for the best possible terms and look to leverage our position, coming in early, particularly around co-investment rights and preferential adjustments in the distribution waterfall,” says Reed. “But we don’t push back on management fees because we want the manager to be able to build the team.”
Seventy percent of emerging buyout managers surveyed said they were looking to hire an average of two new professionals over the next 12 months, broadly in line with recruitment plans a year ago, despite the disruption caused by covid-19. Meanwhile, 63 percent of emerging venture managers plan to add to their team.
“We have not stopped building our team, even through the pandemic, adding three in the past six months, with an additional opening for an investment associate,” says Bill Hannon, chief financial officer at technology investor Clearhaven Partners.
“Ultimately, investing in emerging managers is a long-term business, which needs significant upfront investment in order to get the firms off the ground,” adds Spencer. “This upfront investment, which comes from both GPs and LPs, helps emerging managers ensure they have appropriately compensated talent and a robust infrastructure.”