How emerging managers can be counter cyclical for LPs

Emerging manager fundraising is tough at the best of times. Add in the legacy of a global pandemic, coupled with pervasive economic and geopolitical uncertainty, and the prospect of launching a new firm becomes more daunting than ever. 

Indeed, two-thirds of emerging manager respondents to the sixth annual Buyouts Emerging Manager Survey, conducted in partnership with Gen II Fund Services LLC, either agree or strongly agree that investors are hesitant to place bets on young entities.

Meanwhile, more than 40 percent say fundraising has become markedly more challenging since covid struck. Investors appear to have embraced the efficiencies of remote interaction that were forced on them during rolling lockdowns and, despite the removal of travel restrictions, getting in-person meetings remains tough.

“Fundraising dynamics have changed,” says John McCormick, partner at Monument Group. “So much is now done virtually, which makes it that much harder for an emerging manager to forge a connection with an LP. Private equity is a people business. You want to be able to look an investor in the eye and compel them with your capabilities. Everyone is getting more comfortable with Zoom, but it limits the ability to truly connect.”

McCormick adds that the enhanced efficiencies of remote fundraising also means investors have more time for window shopping. “It is more challenging to gauge who has genuine interest and capacity for emerging managers because almost everyone is willing to take the meetings for fear of missing out,” he says. The situation has been exacerbated by a deluge of established managers returning to the market with new funds, making it hard for emerging managers to command attention.

“This has been an extremely busy year for established managers coming back to market,” says Carolina Espinal, managing director at HarbourVest, “and some of those offerings are being prolonged into 2023, given the macroeconomic backdrop. That can make it very difficult for emerging managers to get mindshare.”

And it is not only time that is in short supply; it is capital, too. “There is a shortage of human resource,” says McCormick. “Investors can only review so many managers at one time. But allocations are also coming under pressure due to the denominator effect and, in some cases, reallocation to
co-investment.”

Risk aversion

An element of risk aversion is also creeping in for some investors. “Appetite for emerging managers is often procyclical,” says Scott Reed, co-head of US private equity at abrdn. “When the economy is stable and distributions are strong, LPs are more willing to step out on the risk spectrum and commit capital to newer firms. But history shows us that when markets become more volatile and distributions dry up, a lot of LPs focus their capital on tried and true managers, and appetite for emerging managers wanes. That is what we are seeing today.”

Indeed, 71 percent of GP respondents claim that the market is bifurcated, with established managers receiving the bulk of investor interest. Emerging managers also cite allocation constraints and competition from established firms as the biggest challenges they face in the fundraising market.

Established managers are taking advantage of this flight to the familiar by launching new strategies, which many investors include in their definitions of emerging managers, detracting attention from independent start-ups. “Unfortunately,” says Christine Winslow, managing director at Grafine Partners, “a proliferation of strategy extensions at mega-firms is detracting from appetite for other emerging managers.” 

Outperformance

This may not be the wisest course of action, however. “Mega-firms are generally more focused on asset gathering, while returns have become a secondary objective,” Winslow says. “Emerging managers, on the other hand, are laser-focused on generating high returns on their deals in order to build their track records and firms. They have much more of a vested interest so the alignment with LPs is much stronger.” 

Paul Newsome, private equity partner and head of portfolio management at Unigestion, agrees that, perhaps counterintuitively, a downturn is not the time to pull back on emerging manager risk. “In difficult conditions, many LPs seek comfort with brand names,” he says. “But the irony is that data shows emerging managers outperform during the most challenging periods, for example in the years following the GFC.” 

Indeed, savvy investors with a longstanding commitment to emerging managers, are “keeping their foot on the gas,” says Reed. And, despite challenges, almost half of emerging manager respondents agree or strongly agree that investors are willing to back teams with compelling products. 

The road will be long and arduous, certainly. Most investors take between five and nine months to sign a commitment after an introduction, and for 21 percent of respondents, the time taken exceeds 12 months. Meanwhile, 60 percent of investors take upwards of six meetings with an emerging manager before making their final decision – 20 percent take more than 10. 

But the best emerging managers will continue to successfully raise funds. “There are headwinds, certainly, but there are tailwinds as well,” says Sarah Sandstrom, partner at Campbell Lutyens. “There are many programs focused specifically on identifying the next best great thing. The private equity industry is also in an interesting phase, with many firms dealing with generational succession, which is creating spin-out opportunities and, definitionally, firms are graduating from emerging manager programs, creating space for new names.”

“Emerging managers remain a compelling part of the market at all points in the cycle,” adds Winslow, “perhaps even more so in the current macroeconomic environment. Emerging managers will have no distressed assets in their portfolio distracting them from taking advantage of attractive valuations.”