The covid-19 pandemic has wreaked human and economic devastation. Even as some parts of the world move out of lockdown, the potential for second wave outbreaks means uncertainty continues to reign supreme. For private equity houses, this means severe restrictions on the ability to do deals and raise fresh capital. For institutional investors, it means intensive portfolio triage and challenges with putting fresh money to work.
The fundraising effects of the crisis have been particularly intense for emerging managers, with LPs tending to prioritise existing relationships, according to the results of the fourth annual Emerging Manager Survey conducted by sister publication Buyouts in partnership with Gen II Fund Services, LLC.
But new funds also have the advantage of being unencumbered by troubled legacy portfolios, allowing them to focus on the buying opportunity ahead. Here are some of the key findings from the survey, conducted in May-June 2020, providing a snapshot of both US emerging manager and institutional investor perspectives on the current landscape.
Almost 90 percent of emerging managers believe the pandemic and international lockdowns will make raising funds at least moderately more difficult. Meanwhile, 66 percent believe fundraising will become “a lot” or “a great deal” more difficult from now on. In part, this is a result of internal firefighting that is forcing some investors to prioritise existing relationships. Overwhelmingly, however, LPs are also citing the logistical obstacles to due diligence as a barrier to making new investments. “The unique restrictions of activity associated with covid-19 makes fundraising activity that much more difficult,” says Richard Spencer, head of funds and co-investment at Barings.
Pause for thought
Several months into the pandemic, business as usual is still a long way off. Indeed, the days of prolific travelling and face-to-face due diligence meetings may never return. In light of this uncertainty, many emerging managers that had been poised to launch vehicles prior to the outbreak have since chosen to postpone fundraising, at least in the short term. Almost half – 44 percent – expect a delay of a few months, while 22 percent expect the delay to be longer. Only 27 percent are planning for no delay at all. A further 7 percent, meanwhile, have abandoned plans to raise a fund altogether.
Neither shaken nor stirred
Despite the global economic shock caused by the coronavirus, 79 percent of investors say their allocation to emerging managers has not changed. The release of Q2 valuations could change that, as could a further deterioration in the public markets. But, by and large, LPs with defined emerging manager programmes remain convinced by the benefits of bringing fresh blood into their portfolios. “Diversification is critical… If you only stick with your existing mid-cap or larger managers you will see a lot of repetition in types of deals,” says Claire Kendrick, managing director of alternative investments and research at Mill Creek Capital Advisors. “We know that, in a downturn, that repetition could hurt us.”
First time’s a charmer
An overwhelming 89 percent of investors surveyed say they will back a debut private equity or venture capital fund. Although there are challenges associated with identifying and underwriting the unproven, many believe the rewards outweigh the risks and so the appeal remains strong. “Supporting emerging managers often comes with strong alignment, a more conviction-weighted investment approach and the opportunity for high returns,” says Derek Schmidt, director of private equity at investment consultants Marquette Associates. Janusz Heath, senior managing director at Capital Dynamics, adds: “It’s about trying to identify energised, ambitious new talent.”
Fear of commitment?
Despite LPs’ insistence that their appetite for emerging managers remains strong, only 17 percent intend to increase commitments to first-time funds over the next 12 months and 28 percent intend to reduce them. This is, perhaps, inevitable given the uncertainty that has dominated the first half of the year and is likely to continue for the foreseeable future. “The current environment hasn’t impacted our ability to back emerging managers, but it has slowed it,” says Schmidt. “We are certainly proceeding more cautiously with due diligence and virtual on-sites, as we would prefer to meet face-to-face. Nonetheless, we have been able to approve a few strategies.”
Follow the money
Family offices, wealth managers and wealthy individuals dominate the emerging manager investor pool, accounting for 60 percent of capital raised – up substantially from 43 percent last year. Sovereign wealth funds, insurance companies and financial institutions remain more conservative. “Wealth managers and family offices are more able to get their heads around emerging managers,” says John McCormick, managing director at Monument Group.
Lindel Eakman of the Foundry Group adds: “A few well-known funds of funds are active but most – including us – have low appetite at this point.”
Investor willingness to make anchor commitments to emerging managers is divided. Fifty-five percent of limited partners – down from 76 percent of LP respondents to our 2019 survey – would anchor a first-time fund. For the fund manager, of course, the anchor investor is crucial. The quality of the institution serves as a benchmark for future LPs. For the investor, there are advantages to coming in early – particularly the opportunity to exert influence on the LPAC, access co-investment, take a stake in the management company or gain preferential terms. But there are risks, including the possibility the manager will fail to hit target commitments, and the anchor investor will become over-weighted in the fund.
Opportunity from crisis
One of the advantages emerging managers have in the current environment is they are not overly burdened by extensive legacy portfolios. As such, they are able to focus on the new opportunities and attractive pricing likely to emerge in the months to come. Ninety-one percent of emerging managers expect to be more active dealmakers as they look to take advantage of low asset valuations as a result of covid-19, while 38 percent expect to ask investors for greater flexibility on their investment mandate.