The seeded portfolio – a fundraising strategy that has been around for a while – has emerged as a popular way for new shops to gain an advantage in stingy fundraising markets as they work to attract capital from increasingly cautious limited partners.

Yet, even as more GPs pursue the strategy, it has begun to attract greater scrutiny from LPs who are concerned investments made a year or 18 months ago, when prices were higher, could be facing steep markdowns that could be a drag on funds.

The strategy of pre-fund seeding is sort of a hybrid of deal-by-deal investing and primary fundraising. A new firm will line up investors for a specific deal, which they close as a way to prove their strategy and complete some activity, even as they contemplate their first fund.

“The pre-fund deals – and doing not just one but at times multiple deals in advance of raising an institutional fund – have become more of a regular practice in today’s market”

Ryan Schlitt, Aviditi Advisors

The deal (or deals) may be warehoused until the fund is launched, at which point they are moved into the fund. And, to add to the complexity, this process can take place after the fund is launched as well.

For investors, portfolio seeding can be a way to get a sense of how the GP invests – what kind of assets it pursues – before committing to the fund. The investors who coinvest alongside the GP get a piece of the deal even if they don’t end up making a primary commitment.

Pre-fund seeding is not a new strategy, but it’s one that is getting heavier rotation – and scrutiny – as new managers look for ways to navigate the harsh fundraising environment.

“The pre-fund deals – and doing not just one but at times multiple deals in advance of raising an institutional fund – have become more of a regular practice in today’s market to both evidence the strategy and the execution of the team and their new firm,” says Ryan Schlitt, chief executive officer of Aviditi Advisors.

The strategy allows the new GP to build trust and co-operation with LPs as co-investors, as well as generate economics for the steady growth of the firm, Schlitt says. “And also simply to show deals to potential LPs who later may become fund partners with them as well.”

The strategy is one of the ways new managers are trying to attract capital from LPs who have become much more inward-looking, sticking with their best relationships. In tougher markets, LPs will stick with what they know while focusing less on forming new relationships, especially with new shops. New managers come with too much uncertainty and too much risk for LPs looking to de-risk.

“Our research would suggest that the small buyout segment of the market outperforms mid, large and global buyouts and has consistently over time”

Natalie Walker, StepStone Group

It’s a problem, because, for a private equity program to grow, LPs need to build new relationships and even back newer managers, at least some of whom will become the industry’s future stars. New funds have also been shown to generate superior returns compared with more established shops (though at a smaller scale generally), and the emerging manager ecosystem is where many women and minority-led firms are being formed.

“Our research would suggest that the small buyout segment of the market outperforms mid, large and global buyouts and has consistently over time,” says Natalie Walker, partner at StepStone Group, who focuses on US-based small-market managers.

In terms of diversity, “the majority of diverse funds are sub-$1 billion. If you are not accessing the lower end of the market, you are not going to be able to build a diverse portfolio,” Walker says.

Partnership and transparency

As might be expected, fundraising for first-timers and emerging managers generally (up to Fund III) has dropped significantly. According to Preqin, first-time private equity funds globally collected $26.2 billion in 2022, down from $64.4 billion in 2021. And the numbers look worse this year, with about $8.5 billion collected year to date, Preqin says. PEI Group, using different metrics, found that global first-time funds collected about $67 billion last year, which dropped to around $8 billion as of Q1 this year.

It’s not just first-time funds that have been impacted. Capital raised by emerging global private equity GPs that closed up to three funds within 2020, 2021 and the first quarter of 2022 totaled about $115 billion, compared with about $72 billion for the same cohort in the years 2021, 2022 and the first quarter of this year, according to Buyouts data.

These numbers are an indication of a few things – some first-timers are plunging into deals, gathering capital with the help of intermediaries like placement agents before launching a debut pool. Other high-profile PE execs known to be ready to start their own thing have decided to wait out the market uncertainty, sources tell Buyouts.

So how are some managers doing it? There are several ways new managers have been successful this year. These key themes have played a big part in successful fundraising: new firms formed by well-known, well-respected dealmakers; teams that have already been together at prior firms who have demonstrated success; an identifiable record of strong performance; perhaps a history of deal-by-deal investing demonstrating strategic savvy; strategies that fill some need in an LP’s portfolio.

“It’s important to be realistic… not testing the market and trying to raise more capital than what’s prudent for their strategy. Be very sober about the types of deals you’re going to be able to do”

Patricia Zollar, Neuberger Berman

Also, an important aspect to an early fundraise is choice of fund size and a sizable GP commitment, according to Patricia Zollar, managing director at Neuberger Berman who leads the firm’s private investment portfolios practice.

“It’s important to be realistic… not testing the market and trying to raise more capital than what’s prudent for their strategy,” Zollar says. “Be very sober about the types of deals you’re going to be able to do and how many, and right-size the firm.

“A first-time fund can be more concentrated as well, people often expect that. It can be more concentrated specifically in the area in which you have some specialization.”

It’s also important for potential limited partners to see a new firm that is building for the future, not just trying to raise a first fund, she says.

Prysm Capital, formed by a trio of executives from BlackRock, closed its debut fund in March on $305 million. Prysm is a growth investor in the technology, consumer and healthcare sectors.

The firm, formed in 2019, completed several pre-fund deals before launching fundraising last year. The firm is laser-focused on its strategy and the ecosystem in which it searches for deals, says Jay Park, co-founder and managing partner at Prysm. The firm understands the founders it wants to work with. “We think about helping them navigate their accelerated growth phase,” Park says. It also was intentional about the talent it brought on, with nine out of 10 professionals having a common history.

“All the investment professionals are people I’ve mentored, so when you talk about emerging managers, team cohesiveness is a big risk factor, and I think we solved that,” Park says.

That resonated with potential investors, along with the team Prysm put together. “For an emerging manager, they’re not just believing in your strategy, they’re believing in the people. There’s no shortcuts: persistence, consistency and consistency of strategy. We launched the firm in a frothy market, but we knew what we wanted to do and when markets overcorrected, people questioned our strategy, but we stayed the course. Partnership and transparency. Capital partners appreciate that.”

Prysm also ran a more targeted marketing process for its fundraising, finding “not just people who believed in your strategy, but people that believe in you and what you’re building.”

Prysm had an advantage in that it was formed by three people who had worked together for years at ­BlackRock. They had formulated a thesis about the kind of investing they wanted to do and had come into the market with extensive networks.

“We launched the firm in a frothy market, but we knew what we wanted to do and when markets overcorrected, people questioned our strategy, but we stayed the course”

Jay Park, Prysm

Seeded portfolio situations can be helpful for LPs to build a consensus on first-time managers, especially if it’s tough to track deal attribution, always a challenge when vetting a new team.

“Especially if it’s hard for somebody to figure out what you do well, doing some of these pre-first-institutional fund deals can actually really help a group do diligence on you,” Zollar says.

LPs are taking much closer looks these days at the deals that are part of seeded portfolios, how much managers paid for them, where they are marked and whether they will grow into those possibly peak-level valuations, sources said. “There’s concern that people bought the asset at the peak of the market,” says an investor relations professional at a newer shop.

“New funds are hungrier. They are incentivized to deploy capital and create a track record”

Sherrese Clarke Soares, HarbourView Equity Partners

In that case, the pre-fund asset could become a drag on overall fund performance. “People could be sitting on an asset that’s going to be marked below cost. We’ve seen a shift from people being excited about that seeded aspect of a fund to now being skeptical,” the person says.

Another fund of funds LP said LPs are performing a more careful assessment of what a manager has done so far, with an eye toward valuations. “If there are a bunch of assets that were negotiated prior to last summer, I’m going to be more skeptical,” the fund of funds executive says.

Why care?

The philosophical question around emerging managers is why should LPs care? Fund investors are giving more capital to their established relationships, and in that case, why do they need to look at new shops?

“New funds are hungrier,” says Sherrese Clarke Soares, founder and CEO of HarbourView Equity Partners, which is raising its debut fund. “They are incentivized to deploy capital and create a track record. In order to do so they must create differentiated lanes with a sector, thematic or niche focus.”

Part of it is performance – studies have found that smaller and newer managers tend to outperform larger and more established shops. And opportunities for outperformance look robust in the future, as smaller firms have a vast universe of potential buyers for their assets, once they grow them beyond their scope.

25.6%

Return that US small buyout funds generated as of September 30, 2022, compared with 22.2% return for large and global buyout funds

“Especially at the lower end of the scale, for small and emerging managers, there’s an incredibly large overhang of capital that needs to be put to work in the next three to five years. That will force transactions to take place and exits to occur and probably the best positioned segment of the market is the small-cap space that’s selling into that overhang,” StepStone’s Walker says.

According to Burgiss, US small buyout funds were generating a 25.6 percent return as of September 30, 2022 compared with 22.2 percent return for large and global buyout funds.

However, manager selection at the lower end of the market is key, Walker says, because performance can vary so much. “It’s essential to have access to the best-performing firms and avoid the bottom quartile,” she says.

For LPs, it’s also a question of building a PE portfolio for the long-term. Simply sticking with blue-chip managers can be a way of achieving stability, but investors also strive to grow with younger managers, committing in the early days so that, a decade on, they will still be a trusted partner with access to all the GPs’ products.

And exposure to small and emerging managers likely means more exposure to diverse firms. “You’re seeing many more corporations, many more endowments and foundations, that are having much deeper conversations about emerging managers, especially as it relates to making sure they have a diverse roster of private equity firms in their allocation,” Zollar says.

Emerging managers promote diversity, drive returns

Many institutional investors have stressed that, in this volatile economy, they will focus on their existing relationships, usually with managers rolling out their latest billion-dollar-plus fund, writes Gregg Gethard

This makes LPs with emerging manager programs vital to promoting diversity and the next generation of leadership that has specialized knowledge.

Several institutional investors – Teachers Retirement System of Texas and New York Common State Retirement Fund, for example – have had emerging manager programs in place for years. Over time, these programs have produced both financial and broader results.

TRS Texas has committed $5.9 billion to 204 emerging managers since starting its program in 2005. According to TRS Texas, the initiative had a net three-year return of 12.9 percent at the end of 2021, the last time data was available. “The benefit to beneficiaries is performance,” says Kirk Sims, head of the program for TRS Texas.

TRS Texas’s program has also been beneficial to its PE managers, with five “graduating” with investments to its larger fund because of their growth.

NYS Common’s emerging manager program started with a heavy tilt to PE-focused emerging managers. But as of March 2022, the private equity component of the portfolio is valued at $2.75 billion, or close to 30 percent of its EM program. “A lot of the growth in our program has been due to alternative investments,” says Sylvester McClearn, NYS Common’s interim director of emerging managers.

Both TRS Texas and NYS Common Retirement Fund also report great success in leveraging their programs in developing diverse managers. TRS Texas says 54 percent of its committed capital in the EM program went to diverse managers. NYS Common values diverse private equity holdings in its general fund at $11.2 billion.

Institutional investors source and support emerging managers in multiple ways, either investing in EMs directly (and frequently gaining an LPAC seat along the way) or working with external managers to help with the selection.

TRS of Texas has an advisory board made up of senior members of each represented asset class to develop emerging managers. “This strategy allows the program and the asset class to be in lock step. This communication is key as we look to build the program with profiled firms that have the possibility of graduation,” Sims says.

Not to be outdone, MassPRIM has launched its FUTUREE Initiative, which includes a new emerging-diverse-manager program, and intends to invest up to $1 billion annually in support of this program. The system has put its money where its mouth is, having committed more than $400 million to diverse-owned private equity managers in 2022.

“This is real and tangible progress that reduces barriers and expands opportunities for diverse investment managers,” says Massachusetts State Treasurer and MassPRIM board chair Deborah Goldberg.