Appetite for risk-taking automatically diminishes in a crisis. Add in ongoing restrictions for international travel and in-person meetings, and it is unsurprising, then, that the fundraising market for emerging managers appears markedly more challenging than for established firms.
Indeed, almost two-thirds of emerging manager GPs surveyed in the fifth annual Buyouts Emerging Manager Survey, conducted in partnership with Gen II Fund Services LLC, either agree or strongly agree that the market is bifurcated, with established managers getting the bulk of the capital, while LPs display far less enthusiasm for younger houses.
“Large, institutional LPs have little appetite for emerging managers with challenges of scale, risk appetite, staff bandwidth and process challenges,” says Lindel Eakman, partner at Foundry Group. “Many LPs may have one or two emerging managers in their portfolios, where they had an existing relationship with the GP in their previous firm, but few have dedicated programs. Covid has reduced the risk profile even further, pointing investors toward their existing relationships. LPs do now seem ready to engage, and travel, but the Delta variant means, once again, they are having to press pause.”
Despite this risk aversion, emerging managers remain an important component of many investors’ private equity strategies. More than 60 percent of LPs surveyed agree or strongly agree that the risk/return profile for emerging managers is attractive compared with that for established firms.
“Emerging managers may be hungrier and work harder than more established managers that have raised multiple funds and garnered years’ worth of management fees and carry,” says Molly LeStage, managing principal and private market consultant at Meketa Investment Group.
“The advantage of having an emerging manager program is that you can tap into what has historically been a category that generates extremely compelling returns,” adds Scott Reed, co-head of private equity in the US at Aberdeen Standard Investments. “There is a very interesting dynamic at play when you have experienced and talented investors stepping out on their own. That first handful of deals has to be good, or the firm’s very existence will be called into question. Their feet are held to the fire. That leads to arguably the best alignment of interest you can get.”
Enhanced due diligence
Nonetheless, LP due diligence on emerging managers is extensive, and has historically relied heavily on in-person contact. That is why the covid crisis has proved so challenging. Investors need to dig deep into every aspect of a new relationship in order to mitigate the inherent risk.
“The bar is much higher due to the greater counterparty risk,” said one of the LPs surveyed. Another cited more robust walk-throughs of case studies and processes around sourcing and value creation as some of the key differences between emerging manager due diligence and that of more established firms. Other examples included analysis of the interpersonal history of the founders, and detailed track record attribution. Emphasis on extensive referencing was clear.
“In the vast majority of cases, emerging managers don’t have attributed track records from prior firms, so you need to piece it all together,” Reed explains. “That means talking to CEOs, CFOs and lenders, LPs in previous funds – anyone who can validate what they are telling you. There is a lot of heavy lifting involved.”
Power of differentiation
Given the extra resources required for an LP to get comfortable with an emerging manager, the new manager must offer something differentiated and persuasive. Almost half of GP respondents believe LPs are willing to back new managers as long as they have a compelling product. Track record also remains key. Nearly 60 percent of GP respondents say they agree or strongly agree that only new managers with strong experience with top-tier firms will raise easily in this market.
Team spinouts from established firms remain the most popular form of emerging manager among LPs. In fact, 83 percent of LP respondents cited this as their favored option. Individually-led new firms were also considered appealing; less so, those launched by former family office professionals. Firms entering PE from other backgrounds were widely dismissed and deemed unattractive by more than three-quarters of LPs surveyed.
“Each category has its own positives,” says Rick Spencer, co-head of Barings’ funds and co-investment platform. “Spin-outs are associated with full engagement and total alignment with LPs but [there are also] potential resource limitations, questions around fundraising success, more significant key person risks and an operational buildout that requires significant conviction around the investment team, its future and the strategy. The value to LPs, however, is pronounced. It allows for a more influential voice with the GP, longer term partnership possibilities, economic advantages in the fee structure and strategic value through co-investment.
“Development within a platform, meanwhile, can mitigate the operational issues. The GP can focus on its investment activity without the distraction of the operational requirements. The downside, however, is shared economics with the existing platform, potential conflicts in investment allocations and control questions around the personnel, investment committees and strategy.”
“Every LP has its own biases and preferences,” adds Reed. “We certainly look at new spin-outs favorably. Where a team with a documented history of working together has separated from a prior institution, those stories tend to be easier to digest. We have also backed individuals stepping away from firms. However, we are less interested in those with no principal investing experience who are just hanging out a shingle.”