The first priority for most newly launched funds is typically in the front office. In the back-office, new technology and outsourcing capabilities are providing comfort to them…
Though fundraising may be the greatest challenge facing a new or first-time fund manager, it is often back and middle-office considerations that make or break the business over the long-term.
At each stage, from debut fund to a fourth vehicle, about one-third of emerging managers don’t raise a subsequent fund. How their team is structured is usually a major factor.
In Private Equity Wire’s emerging manager survey conducted in September, the second greatest hurdle identified by respondents, after fundraising, was recruitment. Raising a new fund will typically take two to three years and it is often a difficult journey for a small group of individuals who may not have worked together previously and, who ultimately may have different ideas about how to grow the business.
While there are many recent stories of fundraising success, there are also examples of failure post-fund closing.
Set-up in 2016 by three principals from TPG, Centerbridge Partners, Platinum Equity, the implosion of Novalpina Capital was widely reported last year with news reports acknowledging disagreements between the founders over how to deploy the remainder of the fund.
LPs in a first-time fund are reluctant to take management risk on top of strategy risk, say sources.
Yet while the temptation to build out a team quickly can help to build trust with investors, it can also add to an emerging manager’s cost base.
“Most professionals who set up an emerging manager will have worked at larger private equity firms,” says Paul Newsome, head of investment solutions, Unigestion. “When they set up their own shop, they want to do the right things from the start and aim for a very cost efficient set-up. Indeed, since most emerging managers bootstrap their firms, they are very cautious in building a strong foundation at the best possible cost.”
Tech solutions
There was, of course, an extra layer of caution for many of the first-time funds that reached close over the past 12 months, given the restrictions on travel and in-person meetings during lockdown. Avance, which closed its debut fund this year at $1.1 billion (more than double an initial $500 million target) started with two offices and a team of around 30 vendors and partners, but the fund’s two managing partners weren’t able to see each other in-person for over six months during 2020 and only met one of the roughly 40 institutional investors in-person, they told the Wall Street Journal last month.
Not surprisingly then, emerging manager business models are increasingly relying on technology solutions.
In a survey by Private Equity Wire in June, almost half of more than 50 respondents said they had outsourced part of their firm’s operations over the past 12 months and around three-quarters of this group believed the decision had “added value” to their business. The trend has accelerated over
the past three years, driven by new fund managers coming to market but also due to a new generation of technology platforms which specifically cater to private equity firms.
“The availability of third-party providers, for back office and otherwise has dramatically changed the level of difficulty in setting up [a first-time fund],” says Clay Deniger at Capstone. “You just didn’t have the option 10-12 years ago to go and interview third party providers and be in business with a back office built around best-practices in such a short time. It means that an emerging manager can start in business with a very thin staff, attract capital and then build a team with the commitments as opposed to having to go find a seed investor to build the team first.”
Some of these third-party providers can provide a safer way to store sensitive data, meet reporting requirements, for example on ESG, as well as offer new managers a scalable operating model that can take advantage of fast growth in fund sizes.
Prospective LPs are also increasingly interrogating the tech stack of a new manager and what has been outsourced before they commit capital – in order to assess operational risk but also the potential for value creation. Sixty per cent of LP respondents surveyed in the Brackendale Private Equity Technology LP Sentiment Survey H1 2022, said they would be more likely to consider allocating to a fund if the fund manager had a tech-enabled partner to outsource their middle and back-office activities to.
“It can bring great comfort to LPs,” says Deniger, “because usually there are three, four or five high-quality known third-party providers in each category and LPs interact with those providers and have a high degree of comfort with them”.
However, whether an outsourced approach is successful, or not, depends on the solution itself as well as the size of the private equity firm in question.
In Private Equity Wire’s Technology Insight Report in July, one recently established fund manager said: “If you need to be quick and nimble then outsourcing may not be the way to go – we have one fund admin who only checked their emails twice a day, at 11am and 3pm. We were banging our head against a brick wall [when we needed information quickly].”
For others, hiring rather than outsourcing can make more sense.
Paying for an experienced CFO or CIO early-on can also send a powerful signal to potential investors in the fund, says Karl Adam at Monument Group.
“The willingness to dig into their own pocket and pay for that speaks volumes on how serious they are about the fund versus hiring an outsourced CFO or bookkeeper,” he says.
While expensive, building out the team at a senior level early on can also limit any perception of key-person risk where there is only one or two experienced managers involved.
“LPs are pretty wary of ‘star manager X’ leaving with a few juniors to set up his own firm,” he adds. “These days, you’ve typically got to have two or three very senior people, ideally partner level, who had individually good track records.”
But even for emerging managers who want to remain agile, competing with much larger private equity houses for talent can be a challenge. According to EY’s 2022 Global PE Survey, 43% of GPs said that they have increased the scrutiny of their PE firms’ talent management programmes. “There is currently a very candidate-scarce market – that has been the biggest problem we have found. On top of this, funds haven’t lowered their expectations on the quality of talent and just aren’t willing to compromise on their requirements,” said Charlie Hunt, director of UK at recruitment firm PER in July.
LPs, particularly cornerstone investors, can often play a role in shaping an emerging manager’s operational model, especially as a manager with a long and enviable investment track-record may still struggle with recruitment or reporting responsibilities.
“The area that gets most underestimated, but one we want to understand is, are they good fund managers,” says Carolina Espinal at HarbourVest. “We’ve seen individuals who have been excellent investors want to set up their businesses, but they haven’t had much experience in fund management. Maybe they had back office or operational support that might have helped them through these things previously, which obviously they might not be in a position to replicate as you’re building out the team.”
Yet LP expectations are also realistic, and typically mount only with the size of the fund.
“A manager that raises their first fund at $300 million will not have the same operational capabilities as a firm with $2 billion AUM but what we do look for is the thoughtfulness in setting it up and the willingness to have considered best practices and adopt them as and when they’re in a position to do so.”
