LPs who ignore emerging managers risks losing out on returns, data suggests
Data shows first-time GPs outperform wider market in tough periods
Emerging managers must battle trend of established firms attracting increasing capital share
Focus, dedication, and GP commitment cited among reasons for investment in first-time funds
October 5 (Preqin News) - Investors who avoid emerging fund managers in favor of more established counterparts could miss out on returns, particularly in difficult market conditions, a new study suggests.
In a comparison of the performance of 731 first-time buyout funds of vintages 2000-2020 with 3,300 funds of series two or later, Zurich-headquartered asset management firm Unigestion found that median net IRRs at first-time funds broadly tracked the wider market. But there was significant outperformance among emerging funds in the years immediately after the end of the dot-com boom and the Global Financial Crisis (GFC). Early indications suggest that the pattern will be repeated in the post-COVID-19 era.
The findings, based on Preqin data, suggest that LPs who gravitate to the perceived safety of both established brands and managers could be missing out by steering away from first-time managers, who are often unencumbered by historical investments and whose performance is driven by a greater need to succeed.
‘First, new managers have focus and dedication. They are starting from fresh and can focus on scouting interesting deals, rather than dealing with issues in the portfolio,’ Kim Pochon, Co-head of the Emerging Manager program at Unigestion told Preqin News. ‘Second is alignment of interest. Not only do emerging managers tend to have a higher GP commitment, but their first fund is make or break. If they don’t make it, it’s hard for them to start another business.’
In 2002 and 2003, median net IRRs of first-time buyout funds were 16.3% and 15.6%, versus 12.3% and 13.0% for established managers. After the GFC, first-time funds returned 16.6% in 2010 and 22.0% in 2011, versus 13.1% and 14.7% for their established counterparts. In 2020, the most recent year for which performance can be estimated, first-time funds are reporting a median net IRR of 21.1% against 13.2%.
First time and smaller managers have to fight against the trend of large, established managers pulling in an increasing share of capital. In the first three quarters of 2022, fourth or later generation private equity funds accounted for 80% of total capital raised, compared with 59% in 2012, according to the Preqin Global Report 2023: Private Equity.
’Several factors are poised to further expedite the trend of capital consolidation towards large, established GPs,’ said Cameron Joyce, Head of Private Equity at Preqin Research Insights. ‘Against the backdrop of a challenging fundraising environment, this dynamic is likely to amplify the hurdles faced by emerging managers. However, this comes at a time when the investment case for investing in new managers is likely strengthening. Either way, first time funds will remain critical to the long-term health and vibrancy of the overall private capital market.’
Growth in investors’ allocations mean they are writing bigger and bigger cheques that can only be absorbed by larger, established fund managers. However, many LPs also now have the skills and capacity to add exposure to niche strategies with the potential for higher returns.
Pochon says three drivers are at play: 'First, it’s an access game. If you don’t allocate to emerging managers when they start out, it will be harder to get your desired allocation when they become stars. Second, returns seem to be higher, though perhaps with greater dispersion so experience in manager selection matters. And third, emerging managers tend to be more specialized, giving LPs targeted access to subsectors such as climate-tech or medtech that they don’t get in a very broad, diversified portfolio.'
Investing with emerging managers therefore requires strong conviction and a higher level of due diligence, but Boris Etcheberry, Vice-President at Acanthus Capital, a firm that focuses on raising capital for emerging managers, says it is worth it.
'The emerging manager space is rich and offers LPs an opportunity to generate greater alpha and selectively increase the likelihood of skewed outperformance across their private equity portfolio,' he said. 'Emerging managers usually go back to the fundamental roots of private equity, sourcing proprietary deals, creating their own investment situations, meaningfully partnering with management teams when underlying portfolio companies are at a critical inflexion point, and crucially, unlocking attractive entry dynamics. While these situations tend to showcase some apparent element of complexity, this also means there are more opportunities to drive lasting value and make a profound impact for all stakeholders.'
The opinions and facts included within the above do not constitute investment advice. Professional advice should be sought before making any investment or other decisions. Preqin providing the information in this content accepts no liability for any decisions taken in relation to the above.