Just 21 percent of LP respondents to this year’s Buyouts Emerging Manager Survey, conducted in partnership with Gen II Fund Services LLC, have a formal allocation to emerging managers. But those that do tend to invest prolifically. 

Emerging managers account for almost 50 percent of the total portfolio for these organisations and three-quarters of respondents typically invest in more than 10 emerging managers a year.

The macro environment is not expected to have any meaningful impact on this activity, meanwhile, with three-quarters of respondents claiming there has been no change in their allocation to date. Furthermore, 20 percent of respondents actually intend to increase their exposure over the next year, rising to 33 percent over a three-year period. 

Superior returns represent the primary objective of an emerging manager investment program, cited by half of all LP respondents. Indeed, over 50 percent of LPs either agree or strongly agree that the risk/return profile for emerging managers is currently attractive when compared with their more established counterparts.

“Funds one and two tend to generate exceptional returns,” says Sarah Sandstrom, partner at Campbell Lutyens. “Having the opportunity to take a seat at the table early also means investors will be able to maximize their allocation in subsequent funds as the manager continues to perform.”

“We have invested in emerging managers for over 20 years,” adds Paul Newsome, private equity partner and head of portfolio management at Unigestion, “and emerging managers have historically made up around 50 percent of our overall deployment to funds. Indeed, emerging managers represent the best performing part of our portfolio.” 

Other advantages afforded by emerging managers include portfolio diversification, access to specialist strategies and access to managers that are owned by minorities or women. 

“Emerging managers lend a different spice to an institution’s portfolio,” says Newsome. “They can also give you access to sectors and deals that you might not otherwise get access to through established firms.” 

Not all emerging managers will be successful, however. The bar is high. GPs believe that a track record is the most significant component of an early fundraising, cited by 84 percent of emerging manager respondents as either extremely or very important.

Investors have a slightly different perspective, meanwhile, with team composition deemed the number one priority, followed by investment strategy and deal sourcing processes, with track record coming in at number four. 

Spin-outs

The combination of coherent track record and cohesive team that is afforded by a whole team spin-out from an established firm makes this one of the easiest forms of emerging manager for investors to get their heads around. 

Almost 80 percent of LP respondents said they were very likely or likely to back a team that had emerged from a larger sponsor, making spin-outs the most popular type of emerging manager. Investors are markedly more cautious, however, when it comes to individual-led franchises, ex-family offices and teams without a private equity background.

“When it comes to de-risking an emerging manager proposition,” says Carolina Espinal, managing director at HarbourVest, “there are clear benefits to backing individuals who have previously worked together and that have a strategy in line with their prior activities.” 

Scott Reed, co-head of US private equity at abrdn, agrees: “Successful emerging managers tend to have the cleanest stories. They are often teams that have spun out from credible and well-known firms, with a demonstrable history of working together. When people come together from different houses, it is harder to determine whether they will work together well. Those fundraisings are more likely to struggle.”

LPs also want to understand whether a new firm can manage a fund, as well as investing capital, says Newsome. “Will they build a diversified portfolio? Will they reserve the right amount of capital for add-ons?”  

Reed agrees. “They might be great as individuals, but how well do they work together? Do they have the experience to build an actual firm? Do they have expertise, not only in making good investments, but in everything that goes into portfolio management? Is there a commitment to building out the layers of the organization beneath them? There’s a lot to unpack with emerging managers,” he says.

A differentiated strategy is another top priority. “We want to see a clear competitive edge,” says Newsome. “Why are we putting money with this emerging manager and not with an established player in the same sector? Asking that question really focuses your thinking on why this team is the best in a particular niche.”  

Espinal says HarbourVest has particularly noticed a rise in the number of emerging managers focusing on ESG and impact themes, for example.

Newsome, meanwhile, cites an emerging manager that Unigestion has recently backed that focuses on mid-market enterprise software companies in German-speaking Europe. “The team includes individuals with operational backgrounds and entrepreneurs. It was very clear that these guys were the best in the space.” 

But differentiation can also be based on execution capabilities, Newsome adds. “Another example in our portfolio involves more of a generalist – a firm that focuses on three different sectors. Their unique skill set is buy-and-build at a micro level. That requires expertise in finding platform companies, identifying add-on targets and then integrating those businesses. It is a very compelling story.” 

Reed agrees: “The world doesn’t need another mid-market buyout fund. Any manager that is going to be successful raising capital for the first time is going to have a point of differentiation – a reason to exist. Sometimes that will involve a sector or industry focus. Or it could be a distinct investment style, such as expertise in buy-and-build or debt-for-control. It could even be
a regional orientation within the US – a group with a deep and differentiated network in a certain provincial part of the states that affords them unique access to dealflow.”

Sarah Sandstrom, partner at Campbell Lutyens, adds: “Being able to articulate what you might be doing differently or what you may have learnt from investments you made in the past is very important. That edge and that sense of learning resonates well.” 

On whose terms?

Meanwhile, just over 30 percent of emerging managers believe that terms and conditions were an important or very important aspect of their fundraising for LPs, compared to 52 percent of LPs themselves. And there is a wide breadth of points of negotiation.

Two-thirds of emerging managers offered investors LPAC participation, while over half offered co-investment rights. A sizeable 43 percent, meanwhile, were prepared to offer a discounted management fee, based on the size of the commitment. 

Less popular concessions included opt outs on certain investments, while selling a share of the GP or management company was deemed the least attractive of all. Just 5 percent of respondents sold a stake as part of the fundraising process, compared with 18 percent a year earlier and 24 percent in 2020. 

However, it is clear that the ground ceded is significantly higher when an anchor commitment is involved. Just over a third of managers with an anchor offered those investors preferential terms. The most common concession granted was a discounted management fee, followed by co-investment. A little over 10 percent extended these terms into subsequent funds. 

Investors prepared to give a new manager the vital capital to kickstart their firm also expect plenty in return. Over two-thirds of investors would provide an anchor commitment to an emerging manager, with the majority, 70 percent, expecting discounted fees. Over two-thirds would look for discounted carry and 58 percent would seek co-investment rights. A significant 42 percent would also look to secure a GP stake.

“There are certainly LPs that want to take a small stake in the GP,” says John McCormick, partner at Monument Partners. “These LPs rarely seek governance rights. They are not looking for a seat on the board or to influence investment strategy. It is more about having a stake in the growth of the firm from an economic standpoint.”

He adds that there are pros and cons to giving into the demands of anchor investors. “If that capital helps the manager get into business; if it enables them to get to that first close and start doing deals, then it may well be worth it. But managers need to go into these negotiations with their eyes wide open. In particular, they need to be mindful of questions from other LPs about the relationship and the rationale behind it.”

Due diligence

Investor due diligence of emerging managers tends to be more time consuming and complex than for a more established firm. 

“There is a lot more leg work to be done when compared to a manager on fund five or fund six, with a wealth of evidence they can point to, to show you they perform well in good times and in bad,” says abrdn’s Scott Reed. “With emerging managers, you have to synthetically create that body of work and then form an assessment as to how sustainable the approach is going to be.”

LP due diligence of emerging managers also tends to focus heavily on referencing, says Carolina Espinal of HarbourVest. “We spend a substantial amount of time in emerging manager due diligence, pursuing on-list and off-list references. We try to build a complete view of what it is like to work with these individuals, particularly if they are coming from different firms.”

Joe Benavides, managing partner and co-founder of emerging manager OceanSound Partners, adds: “Investors are looking at historical experience. Where has the firm come from? What deals have the investors touched? There are a lot of reference calls and massive in-depth interviews. Then there is the operational due diligence. What is the capability of your back office? What are your policies and procedures? There is in-depth due diligence of IT, accounting and tax planning. Investors are weighing up whether you are a team that can make a few investments or if you can really build a business.”