PE Key Trends Blog

Placing bets on a young fund: why it pays to invest in emerging managers

Feb 21, 2019 3:39:22 PM

We’ve said it before and so have countless other reports in the industry, emerging managers, officially classified as first and second-time funds, outperform time and time again. However, the negative perception of these managers still weighs heavily on their backs, impeding their access to capital distributions from large investors, namely institutional investors. The idea behind the reluctance is the perceived high-risk nature of allocating funds with an emerging manager who has little to no independent track record. In the case of first-time funds, this has stopped roughly half of all private equity investors and, according to Preqin, 60 percent of all institutional investors from investing due to in-house policies barring the action.

Despite the hesitant nature of some investors, the percentage of investors who said they would invest in first-time funds nearly doubled between 2013 and 2016, increasing from 19 percent to 34 percent in that same period according to Preqin. As recently as 2017 Palico estimated that first-time funds represented just over 30 percent of all private equity funds that were currently raising. In 2018 Palico found this figure to still hold true, as approximately 30 percent of the 3,300 funds in market during 2018 were raised by first-timers. Probably most impressive is the fact that first-time funds have outperformed established funds when it comes to returns for their LP’s. According to Preqin’s 12-year comparison of median net IRR, first-time funds, beat out established managers every year between 2000 and 2012 except for 2004.

What do LPs stand to gain from investing in emerging managers?

Specialized strategies may be the key. Amongst Palico’s more than 8000 members nearly 90 percent believe specialization is the future of PE. First-time funds are especially known for their focus on innovative strategies which offers investors access to highly diversified investments in niche sectors. As a result, investors in first-time funds may find an opportunity to enjoy greater alpha due to the lack of competition from other GPs looking to purchase assets in these niche environments.

Although investing with larger more established funds may ensure decent returns they also frequently come with lower hurdle rates and in some cases, none at all. In contrast, LPs who explore emerging managers are more likely to find opportunities in which hurdle rates exceed the traditional 8 percent rate of return. With hurdle rates amongst the biggest players decreasing or in some cases disappearing, the higher than average hurdle rates provided by emerging managers presents itself as a differentiating factor for LPs making investment decisions. Fees, which are quite possibly the most significant point of contention for any LP, are also found to be more competitive amongst emerging managers. Most notably, while 2 percent fees are the norm there are some emerging managers willing to reimburse the 2 percent from their carry.

Another benefit growing in importance within PE is the high level of transparency afforded to LPs investing with an emerging manager. Gaining visibility on key matters such as the investment process, reporting and the break down between expenses and capital used to acquire assets is highly valued in the eyes of many LPs within the industry. First-time funds and emerging managers are more than happy to agree upon creating a more transparent relationship with anchoring LPs, affording them desired capacity rights such as board seats which offer unique visibility into GP process and investing.

Just as providing more transparency helps win the trust of investors, so does providing co-investment opportunities. Heralded by investors, co-investments allow LPs to allocate capital with oversight rather than into a blind pool managed by the GP. This not only lets LPs know what they’re getting themselves into, but in many cases, it also helps emerging managers get that much needed first ticket which is never a cake walk.

As the Saying goes “For every winner, there are a dozen losers”

However, with the good always comes the bad and when it comes to PE fundraising more than half of all funds that abandon their fundraising happen to be first-time funds (57%). The numbers look bleak but nobody said starting your own business was easy, much less starting a business whose strategy is to buy and manage other businesses. Although there is extensive proof showing first-time funds outperform more established ones, the evidence also reveals the risk investors take on when allocating capital to a first-timer. The fact remains that 50 percent of investors simply won’t consider them at all.

While the lack of confidence that investors have in first-time funds and their resulting struggles to raise is clearly documented, one aspect that most reports don’t mention is the lack of exposure to high-quality LPs that first-time funds gravely suffer from. While key members of first-time funds may have connections as a result of their previous experience at more established firms, they still find it difficult to gain traction with the taboo that comes with being labeled an emerging manager. The same holds true for their cap table expectations. Although every GP would love to receive minimum tickets of 10 million, the reality is emerging managers don’t often get them. Especially when one considers that some major funds targeting billions in fundraising are willing to accept less than that.

Palico helps managers achieve their fundraising goals

Palico reduces the costs and time constraints associated with finding investors and managing a new fund. For emerging managers in search of that much needed first investor or looking to reach their fundraising target Palico’s marketplace bridges the gap by giving them exposure to only the most relevant LPs. The marketplace has helped numerous emerging managers bring in investors and attain that highly sought-after anchor investment every emerging manager strives for. With one-third of the capital raised on the marketplace going to first-time funds since its inception Palico has proven itself as an effective tool for first-timers.