RCP Advisors, a money manager whose research suggests that early funds are a good bet, has put its money where its data is, raising $179.4 million earmarked for young managers of small North American buyout funds.
The Chicago firm raised $75 million of the new fund, RCP Small & Emerging Fund LP, from a single investor investing through a “parallel” vehicle, according to two Form Ds filed with the SEC in mid-February. The balance came through the main vehicle raised from a group of 14 investors.
The Form Ds suggest the offering is closed. But citing rules prohibiting the promotion of private offerings through a general solicitation, Alex Abell, a partner and head of research at RCP Advisors, declined to comment on the fundraise.
Still, RCP Advisors has not been quiet about promoting its belief that emerging managers outperform their more established peers. The firm has also found evidence that it may be only Fund Is (and not Fund IIs or higher) that exhibit the higher risk-reward characteristics investors seek from their emerging-manager allocations.
In a presentation at Buyouts’ Emerging Manager Connect conference in New York last summer, Abell and colleague Ross Koenig, vice president-research, showed results of an analysis of 600-800 North American buyout funds — average fund size about $500 million, average fund number 2.5 — pursuing buyout, growth equity and turnaround strategies. By vintage year, about one fourth of the sample are pre-2000 funds, 30 percent 2000 to 2005 funds, 40 percent 2005 to 2010 funds, and 5 percent 2010 or 2011 funds. Most of the return data, at the time of analysis, was current though year-end 2015.
One caveat: RCP Advisors in some cases has trouble getting information on poor-performing younger funds. Managers of such funds may stop sending data to RCP Advisors. This survivorship bias creates a “positive skew” toward better performance for younger funds, according to RCP Advisors. And while other factors produce a counterbalancing skew, the firm says the positive outweighs the negative.
Here’s a few takeaways from the presentation:
- A large opportunity set. Across its entire database of funds raised from 2000 to 2015, RCP Advisors found that Fund Is and IIs account for close to half the funds raised every year. Since early 2008, however, the percentage has fallen to about 40 percent. From 2000 to 2003 some 40 percent to 50 percent of funds raised were Fund Is; since then, the percentage has fallen to the 15 percent to 25 percent range.
- Higher percentages of Fund Is and IIs hit fund home runs. Some 13 percent of Fund Is achieve a greater than 3x net return on invested capital, as do nearly 9 percent of Fund IIs. Funds III and higher? The figure is just 5 percent. Similarly, nearly half of Fund Is achieve a better than 2x net ROIC, compared with just over 30 percent of Fund IIs and just over a quarter of Fund IIIs and higher. Interestingly, about half the funds in all three groups generate net ROICs of 1.5x to 2.5x. At the low end of the spectrum, RCP Advisors found slightly lower percentages of Fund Is and IIs failing to return invested capital, compared with Funds III and higher. Abell said, however, that without the positive skew described above, he’d expect the percentage of Fund Is failing to return invested capital to be higher than Funds IIs or higher.
- Fund Is dominate first quartile. Using Cambridge Associates data, RCP Advisors found that by ROIC nearly half (47 percent) of Fund Is make it into the top quartile, while less than 15 percent fall into the fourth quartile. By comparison, just 27 percent of Fund IIs turn up in the first quartile, as do less than 30 percent of Fund IIIs and higher. The findings are similar for quartiles by IRR. Interestingly, that Fund IIs behave more like more mature funds in this analysis suggests to RCP Advisors that “Fund Is truly represent a specifically different risk-reward profile more commonly associated with the idea behind investing in an ‘emerging manager.’”
- Fund Is dominate first quartile even during tough vintage years. When RCP Advisors narrowed its quartile analysis to vintage years 2004 to 2006, just before the financial crisis, the firm found the same pattern. For example, more than half of Fund Is make it into the top quartile by ROIC those years. That compares to 21 percent of Fund IIs and 24 percent of Fund IIIs or higher. Notably, a relatively high 38 percent of Fund IIIs or higher end up in the bottom quartile in those vintages. To account for this, the firm suggests that many established managers “that had previously benefited from favorable tailwinds during earlier funds fail to adapt ‘proven’ strategies to changing market conditions and performance suffers meaningfully.”
But the outperformance by young firms comes at a cost — a higher dispersion of returns. For fund sizes less than $250 million, for example, the differences are stark. The net ROIC standard deviation is 1.35x for Funds Is. That’s far higher than the 1.11x for Fund IIs, 0.99x for Fund IIIs, 0.73x for Fund IVs and 0.72x for Fund Vs and higher. The net IRR standard deviation for Fund Is of that size is 19 percent. That compares with 21 percent for Fund IIs, 14 percent for Fund IIIs, 9 percent for Fund IVs and 11 percent for Fund Vs and higher.
Concludes RCP Advisors: Debut funds “achieve both highest average return as well as highest variation of outcomes across both Net ROIC and IRR, confirming the widely accepted industry perception that these funds exhibit the highest risk-reward behavior.”