In a tightening fundraising environment, LPs are favouring emerging managers with an ESG angle and negotiating harder on terms…
Even in a buoyant fundraising environment, emerging managers have it tough. Last year, they accounted for only 11.7% of private equity capital raised globally, a 15- year low, according to PitchBook data, and the level is broadly similar in 2022.
As LP allocations to private equity tighten in H2, established GPs coming back to market more quickly are being prioritised over commitments to new funds.
“If you’re getting a solid return from a brand name firm, why take on the risk of an emerging manager? That’s been the prevailing thought [among LPs],” says Karl Adams at Monument Group. “Covid didn’t help because LPs stuck to the managers they knew as they weren’t able to travel [to meet new managers]. Being a first-time fund, a big part of it is establishing that rapport, and face-to-face contact, which has obviously been trickier in the past few years.”
Yet even with travel and track-records on their side, many emerging managers face an uphill struggle.
In a survey by Private Equity Wire, almost nine out of 10 respondents said fundraising was the greatest challenge currently faced by emerging managers. More than two-thirds said their first-time fundraising plans had already been delayed this year. Respondents blamed LPs who were either cautious over the direction of the economy or limited by the denominator effect from public markets.
Placement agent Rede Partners’ soon- to-published liquidity index, which tracks fundraising expectations and changes in LP appetite, will show an overall contraction in commitments to private equity funds for H2 and an even more pronounced contraction for commitments to new managers, says Joseph at Rede.
“We’ve seen some phenomenally successful people looking to do fast first fundraises with great determination, but we do think those people should be braced for a much tougher ride,” says Gabrielle Joseph at Rede.
Mid-market squeeze
Most emerging managers traditionally head to the mid-market, where entry multiples tend to be lower and gaps have been left by the larger franchises scaling up. But it is in the mid-market where many emerging managers are now most at risk from a more challenging fundraising environment, says Carolina Espinal at HarbourVest.
Those with a more “differentiated offering [or] in areas where investors might have a thematic interest” will capture more attention now, she adds.
“Generally speaking, most institutional investors in Europe tend to look across the market and ask ‘How does this complement my portfolio?’,” she says.
Although fund outperformance is a key motivator for LPs to invest in an emerging manager – first-time funds have exceeded established funds on average every year since 2005, according to Preqin, and they have a higher chance of exceeding 25% IRR – a differentiated investment strategy is rising in importance in the mind of more LPs.
According to Private Equity Wire’s survey, an impact or ESG-aligned fund strategy was considered to hold the most opportunity for an emerging manager.
“With an impact fund or ESG, you’re pushing against a lot more open doors,” says Adams, “compared with if you’re trying to raise something a bit more esoteric where the pool of potential LPs is fairly small.”
Competition from veteran spin-out managers with long track-records in ESG may be also less likely, as the sector is still quite nascent.
Niche within a niche
Francesca Whalen at Integra Groupe believes having a niche (ESG) within a niche (Latin American venture capital) helped her fund shine during the initial fundraising process.
“For your first fund, you call on the people who will fall in love with you and what you’re doing, so there’s that level of trust and looking beyond the markets,” she says. “You want
to have a story, something that is really inspiring. With the institutional LPs especially, oftentimes you are not necessarily judged by IRR and exits – especially when you
don’t have as many quantitative signposts available.”
But emerging managers can also signal their ability to potential investors in other ways. Showing some dealmaking experience as an individual or spin-out team, distinct from a previous employer, and having a fund deal pipeline ready to go will reassure LPs, say sources.
Skin in the game
Family offices may test the water by investing in a deal or platform held by the emerging manager, before they commit to the fund. A manager’s ability to execute and underwrite such deals usually bodes well for the future performance of their fund especially as it can be years until meaningful Fund I IRRs are available, say sources.
Looking at such data can provide clues to how the manager’s first fund will perform too.
“A manager who is prepared to have their own skin in the game represents a more mature emerging manager set-up we like,” says an analyst at a European investor in first- time funds.
According to research by his firm, a first- time private equity fund manager may commit between 2% and 5% of the Fund I capital themselves, but a better performance indicator can be considering this commitment as proportion of the manager’s personal wealth.
LPs will also look to reduce emerging manager risk through alignment of terms.
“As well as LPAC participation and favourable terms, some LPs seek access to co-investment as a further way to reduce costs and develop a deeper relationship with the manager,” says Espinal. “Strong positioning for future highly-sought-after managers is one of the most compelling reasons for having
an emerging manager programme. GPs, meanwhile, covet their co-investment and are using it effectively as a powerful fundraising tool.”
Emerging managers must also beware ‘style drift’ as they grow from Fund I to Fund II or III. Niche investment strategies can often become lost within a larger portfolio or fund size, and IRR volatility can become more pronounced as a manager’s early enthusiasm wanes. According to PitchBook data from 2020, the percentage of funds exceeding 25% IRR drops from 17.7% on average for Fund I to 11.8% for Fund II.
“Returns can be more volatile,” says the analyst, “you can win more money [as an investor] but lose more money. But if you’re able to find where the where are the key KPIs, you need to understand and you need to just check that they have it, it’s easier to be allocated in the top quartile.”
