Emerging managers are playing to their strengths and offering a bright spot for their investors in uncertain times.
Emerging manager qualities such as “innovation, unique investment strategies and hunger to outperform” are promising ingredients that will help weather the storm, according to a report from the British Private Equity and Venture Capital Association.
“The things that make a debut fund attractive – such as the manager’s significant alignment to performance and full attention going to sourcing, underwriting and deal-making – those aspects are still intact,” Russell Valdez, CIO of Wafra, told Private Equity International. “Frankly, they may be more exciting in this environment where debut fund managers are geared to the most high conviction and proprietary opportunities to anchor their track record, and existing firms may be encumbered with servicing troubled portfolio companies.”
For LPs looking for co-investment, or those looking for creative ways to deploy capital into dislocation, the emerging manager segment is an interesting way to do that, he added.
The BVCA’s Emerging Managers Barometer, which polled more than 40 private equity investors between January and February before the World Health Organisation declared covid-19 a pandemic, revealed that the lion’s share of investors (96 percent) think emerging managers have an edge over more established funds. The hunger to outperform, unique investment strategies and innovation in deal sourcing and structuring are among the top reasons behind this.
Ralph Buchel, a principal within the private equity team of Swiss fund of funds manager Unigestion, told PEI one of the firm’s reasons for investing in emerging managers is the higher expected returns. In terms of TVPI, returns of the firm’s emerging managers have on average been 0.2x better over a 20-year period than the returns of established managers over a 20-year period.
“Of course there is the team/institutionalisation risk,” he said. “But as an LP you are benefiting from a number of advantages compared to established managers, such as sensible or no use of leverage, low or no legacy portfolio, strong alignment with material personal GP commitments and an entrepreneurial mindset.”
Another important driver for LPs in backing emerging managers is the relative ease of aligning economic incentives. LPs are likely to get a more investor-friendly LPA which means better ability to execute LP rights, compared with more successful managers where it’s more challenging to negotiate LPA terms, Buchel added.
The report also revealed that fund size is not necessarily a core metric for backing new GPs, but all investors are comfortable with investing in an emerging manager they have known for less than two years.
Lisa Edgar, managing director at San Francisco-based venture fund of funds Top Tier Capital Partners, noted that it takes about one to two years from meeting a manager to making a commitment, which could also go sooner or longer if the LP passes on the first fund.
“There’s always interesting new managers coming together, spinning out to create a new firm and we want to make sure we participate. We want to get involved really early to get our spot, to help shape the manager and the terms,” she said. The aim is to create a symbiotic relationship in which the LP has picked well and the manager has been successful and created incredible returns, she added.
Valdez, who also leads Capital Constellation – a seeding platform for next-generation private equity and alternatives managers – added that at the end of the day, the platform wants to back an investor-entrepreneur that can build a firm and franchise. “The key criterion for success, from our point of view, is backing the right management team with the right business plan.”
Asked about how they are advising their GPs during the health crisis, the three LPs agreed that monitoring the portfolio in the current environment is a priority. This involves adhering to best practices for certain geographies including, for example, taking advantage of government support and loan programmes. The LPs are also able to provide liquidity solutions to attractive portfolio companies through their direct investment programmes.
Valdez noted the private equity industry will see a capital formation slowdown during this time. “While new fundraise launches and travel remain relatively muted, CIOs can take the time to examine adjustments to their PE allocation considering the market opportunities and denominator effect.”