Unsurprisingly, track record, team composition and strategy are deemed the most critical attributes for investors assessing an emerging manager opportunity. GPs also recognize that these are the most important elements of their pitch to get right.
However, GPs may be underestimating the importance of the back-office functions for limited partners. Over half – 53 percent – of investors surveyed said they considered operations and compliance to be either very or extremely important in their due diligence. Meanwhile, just 23 percent of emerging managers believe operations and compliance really matter.
“First-time fund risk is all about the ability to manage third-party capital successfully,” says John McCormick, managing director at placement agent Monument Group. “Firms need to have the right practices and procedures and they need to have a well-built back office. Great investors are not necessarily great managers of funds.”
Claire Kendrick, head of alternative investments at Mill Creek Capital Advisors, adds: “The biggest concern that we have with first – and even second – time managers is making sure that they have either hired a back-office team, have a shared back office or have outsourced the back office. Even if there are only three people in a team, we want one of those people to be a CFO, who may work on deals but is also overseeing the admin side of things. We are a real stickler for that. My personal preference would be for outsourcing.”
There is also a mismatch in perceptions around terms and conditions. Only 30 percent of GPs recognize that terms and conditions are of high importance to their investors, compared with 51 percent of LPs themselves.
“In addition to a strong investment track record, areas of focus for an emerging manager include alignment – net worth in the firm and carry distribution – as well as team dynamics and a history of working together; operating versus fiduciary experience; strategy differentiation; pipeline; fundraising expectations; and back-office infrastructure,” says Richard Spencer, head of funds and co-investments at Barings.
Differences of opinion
Inevitably, there is some discrepancy between the provisions that investors are keen to negotiate and those that GPs are prepared to offer. Forty-two percent of investors try to negotiate a stake in the general partnership or management company, whereas only 24 percent of GPs are open to those discussions.
“These things are all just mechanisms by which the LP can get comfortable with the GP – it is about establishing trust,” says McCormick.
Spencer adds: “Although some investors look for preferential terms in emerging managers, most investors are interested in being fair long-term partners.”
And while 75 percent of investors believe LPs are pushing harder in negotiating fees, the majority are cognizant of not pushing too far. Indeed, over 60 percent of emerging managers claim they had received very little pressure on fees or no pressure at all.
“We are not greedy when it comes to fees,” says Kendrick. “We are aware that emerging managers typically have little to fall back on, so we are keen not to starve them of cash. They usually have such small teams to begin with and it is important that they have the resources to grow them. We want them to have the working capital to be able to do that.”
Kendrick adds that it isn’t always necessary to push for formal preferential terms in order to exert influence. “In some ways, I think we tend to end up with a unique relationship precisely because we haven’t asked for special terms,” she says. “Our emerging managers talk to me a great deal more than our more established managers. We seem to have influence without really asking for it.”
One area where LPs and GPs seem to align is on LP advisory committees, with 53 percent of LPs saying they look for LPAC participation and 56 percent of managers saying they’re willing to put it on the table.
Interestingly, although the vast majority – 89 percent – of LPs surveyed are prepared to back first- or second-time funds, only 31 percent have formal emerging manager programs. Investors meet with an average of 44 managers per year and conduct an average of nine meetings prior to making a commitment. Increasingly, some investors are also seeking to co-invest in individual deals prior to participating in a fund. “That can be a great way to get to know a manager,” says McCormick.
And despite the disruptive influence of covid-19, investors plan to make an average of three commitments to emerging managers next year – down only slightly from four commitments 12 months earlier. However, only 55 percent of investors would be prepared to anchor a first- or second-time fund, down from 76 percent last year.
The advantage of making a cornerstone commitment, of course, is that it is possible to negotiate preferential documentation. Indeed, 44 percent of managers that did have an anchor say they had provided favorable economic terms.
Of course, LPs prepared to take a risk on cornerstoning a new fund tend to have higher expectations of the reward they are due than the managers of the vehicle themselves. Over 60 percent of investors say they would demand discounted management fees and discounted carry, compared with 53 percent and 47 percent of GPs respectively that would contemplate granting such requests.
There is also a significant gulf between the two parties when it comes to contractual co-investment rights – 60 percent of investors would seek these special terms while only 42 percent of GPs would cede them. Equally, while 45 percent of investors would attempt to obtain a stake in the general partnership, only 33 percent of managers would offer one.
Finally, there is a difference of opinion when it comes to how long these preferential terms should last. More than half of investors – 52 percent – say they would seek discounted fees or carry in subsequent funds (20 percent of GPs thought such demands were acceptable).
It is important that emerging managers narrow this gap in expectations if they are to get their fledgling offerings away. The segment is notoriously competitive and the months ahead are likely to be particularly tough.
“LPs’ time and attention are in high demand when you are competing against the thousands of GP products in the market at any one time,” says Spencer. “LPs have numerous alternative options, an existing portfolio, established GP relationships and a natural bias to the known.
“Established managers, assuming reasonable performance, have the advantage of an existing LP base, a concrete track record of activity as a team and a history of having raised capital with the lessons learned and resources to facilitate the next fundraising cycle. None of this indicates first- or second-time funds cannot be successful in fundraising, but the criteria for success is much more stringent – a combination of alignment, attribution, team dynamics, prior LP exposure to the partners of the new GP, strategy differentiation, anchor investor and pipeline have to resonate.
“Furthermore, in our experience, many emerging managers also face liquidity risk given firms need to have two to three years of operating cash available to endure a prolonged fundraising environment.”