What are the current challenges and headwinds you’re seeing that are affecting emerging fund managers in this tough environment?
Eleanor Blagbrough: Fundraising is tough right now, especially for first-time funds. Differentiating your strategy is crucial. At Blume, we’re focused on climatetech. Some institutional investors in Europe are reallocating toward climate, which helps funds focus on that theme.
Joanna Ernst: I agree. It’s challenging enough to raise a fund and convince LPs to take a chance on you in any market environment, but to convince LPs to take a chance in the current environment requires some clear differentiation. In the decade leading up to 2022, a record amount was raised in private markets, but we’ve seen that pace of growth slow considerably, leaving us in the most competitive market for new capital I have seen since the global financial crisis (GFC). It’s also a crowded market – many established funds are raising and many funds are staying open for longer, all making it more challenging for funds to differentiate themselves and attract investors. This is also harder in the current market when LPs haven't been getting any distributions, and as we have seen in the cases of some investors, the denominator effect has led to reduced allocations. So, given the bigger picture, we’ve seen LPs want to derisk; they want to see sustained outperformance, which is harder of course for an emerging manager to demonstrate.
|"It’s also a crowded market – many established funds are raising and many funds are staying open for longer, all making it more challenging for funds to differentiate themselves and attract investors"|
Jean-Marc Jabre: You need to have a clear and compelling reason to exist. With thousands of private equity firms in the market, LPs have a vast array of options to choose from, especially considering the numerous re-ups they need to manage. To stand out and gain LPs' attention, you must be relevant. One way to be relevant is by aligning with current market trends. For instance, the field of climatetech is currently topical. Similarly, our focus is disruptive companies, which makes Capital D of interest to investors. Investors are eager to gain exposure to climate-related investments, making it a prime opportunity for an emerging manager. Having some form of incentive based on warehouse facility transactions can make committing to a dry pool more appealing. It's more challenging to commit upfront when there isn't an existing seed asset that people can get involved with from the start.
Nicolò Miscioscia: We view managers primarily as entrepreneurs. These managers must identify the right talent, secure working capital, address data and warehousing challenges, formulate a strategic approach, handle branding concerns, and more – responsibilities akin to those of any entrepreneur. The managers we support have not only proven that their competence sets them apart but also that they possess the capability to establish a sustainable company. One of the most significant risks is whether the manager and his or her team will endure for a decade as a firm. This requires having the right capital, the right incentive schemes, being able to retain their people, and so forth. These elements are of paramount importance for any emerging fund manager, beyond any short-term cycle considerations.
Mark Vidamour: Just to follow on from the point about emerging managers essentially being entrepreneurs. What we've observed, especially in emerging managers, is that individuals transitioning from larger management organisations often face challenges in setting up the necessary infrastructure for their own firms. This can divert their attention from their core strengths, which are in investing and successfully securing deals. We’ve supported a few emerging managers, with advice in respect of what their back-office functions need to be achieving, to assist them with their establishment. This allows them to focus on what they do well – investing.
"One of the most significant risks is whether the manager and his or her team will endure for a decade as a firm. This requires having the right capital, the right incentive schemes, being able to retain their people, and so forth. These elements are of paramount importance for any emerging fund manager, beyond any short-term cycle considerations"
As a service provider, are you noticing any particular trends that emerging managers are adopting to establish themselves?
Ryan Taylor: What's particularly interesting, and aligns with our observations of the managers we've been collaborating with during the past 18 months, is their response to rising interest rates. In light of these changes, there's a growing desire in the market to exercise more control and transparency. Many managers have shifted from the blind pool model to a deal-by-deal transactional approach. They are now favouring capital raises over debt raises, which do not appear as attractive given the double-digit interest rates some are encountering, especially in the context of private credit.
Consequently, managers are exploring alternative fundraising methods. This includes considering online platforms, not only for secondary trading but also for transferring interests. Some partners may want to exit their positions earlier than usual. Additionally, they are exploring digital placement agency platforms. We've noticed the emergence of fintech firms offering solutions to assist managers and LPs in utilising these platforms, which is especially beneficial for emerging managers dealing with smaller ticket sizes.
Roxana Mirica: I’d like to pick up on the point on private credit. With the rise in interest rates, we have noticed a clear shift among the largest asset managers that are deploying capital into private credit. However, it's important to note that the private credit market is still in its early stages of development. What we often see is that large asset managers have limited pools of capital to allocate. As a result, they may opt for well-established firms, believing it's a safer choice, despite earlier vintages yielding decent but not exceptional returns. This situation resembles the journey private equity went through years ago. The challenge is to not become just another player in what's currently a relatively crowded market. Instead, emerging managers need to define their USP. Investors question why they should invest in an emerging manager rather than an established firm. Thus, ongoing education is essential. It may take a few years for large asset managers to fully comprehend the nuances of this market and appreciate the value of a diversified landscape, rather than concentrating their investments on a handful of major managers.
It’s obviously a tough fundraising environment for various reasons. What is your assessment of the landscape for emerging managers?
Paul Newsome: I believe we should consider the current environment from a 'glass half full' perspective. The present situation can be seen as positive in several ways. Firstly, the lack of fundraising has been depleting the excess dry powder that existed three years ago across all market levels, including the smaller end. Now, those who secure capital in the midmarket and lower midmarket segments, particularly emerging managers, have a distinct advantage and can make excellent investments at attractive valuations. So, even if managers aiming for $200m only raise $100m, it's still a success. Those unable to close a fund can proceed deal by deal, which is also a viable approach. In this environment, there are ample opportunities for those who have capital.
Additionally, from our standpoint, this environment benefits us, as it allows us to negotiate better terms and there are more opportunities for us to co-invest in attractive deals. From the perspective of emerging managers, it's a healthy situation, marked by a natural selection process where only those managers with a clear and compelling value proposition can raise capital.
What strategies can emerging managers use to successfully raise capital for their first-time private equity funds? Any unconventional strategies in fund structuring, fee arrangements, or investment approaches that have been successful in capturing investor interest?
Jabre: Whether you're an emerging manager or managing a fund in its seventh iteration, investors always appreciate more favourable economics. For example, offering an early-bird discount on fees and providing priority access to co-investment opportunities are common practices. Some funds also address working capital and bootstrap issues by securing a significant commitment from an anchor investor in exchange for a stake in the GP. This is particularly common, with buyout clauses in place to regain full independence down the road. Additionally, you can contribute seed assets through either a warehouse facility or by structuring individual deals, making it possible to incorporate some of these assets into the fund at the time of closing.
Miscioscia: Offering investors to participate in deal-by-deal arrangements can be highly advantageous for several reasons. One compelling factor is the opportunity it provides to investors for thorough due diligence, ensuring transparency and trust throughout the process. Moreover, there are multiple elements to consider in this approach. Firstly, it enables investors to underwrite each deal individually, mitigating blind pool risks and tailoring their investment strategy. It also showcases the ability of the manager to assemble and lead an investment syndicate, proving execution capabilities.
This, in turn, ticks essential boxes for investors, demonstrating a capacity to deliver results. Furthermore, structuring favourable fund fee arrangements and offering co-investment rights alongside a fund investment with preferential terms at the outset are typically compelling incentives. Moreover, it's worth noting that organisations like the European Investment Fund and development finance institutions can be valuable partners for first-time fundraisers, providing essential support and resources in building trust and credibility. At Decalia, we specialise in partnering with emerging managers with capital and operational support, exactly to help overcome these initial challenges and provide guidance on the best solutions.
|"You can contribute seed assets through either a warehouse facility or by structuring individual deals, making it possible to incorporate some of these assets into the fund at the time of closing"
Newsome: We also consider a few other aspects that we may negotiate. For instance, we are big fans of short-duration funds, which have a two-year investment period. These funds are positioned somewhere between a deal-by-deal approach and a full fund. This approach provides us with improved visibility regarding portfolio creation, shortens the J-curve, and enhances the overall total expense ratio (TER). Another feature we like is tiered carry. For example, the initial carry could be 10% over an 8% hurdle rate, and then it could increase to 15% over a 15% hurdle rate, and finally 20% over say a 25% hurdle rate. This structure promotes outperformance and further reduces the TER for investors. In addition to co-investment agreements, we sometimes negotiate an overflow pool that runs in parallel to the fund, on a no-fee, no-carry basis. Such a setup would allow more discretion and certainty for the manager than straight co-investments.
Miscioscia: When it comes to discounts and GP-stake sales, it's a somewhat delicate matter. On one hand, as an emerging manager, there's a strong incentive to pursue these options. However, there's also a significant risk that the team may not survive. If you remove economic incentives, people can't sustain themselves. On the other hand, as a backer of an emerging manager, you naturally desire special terms, given your unique position. So, investors bear the responsibility to find and propose the right balance.
Mirica: Speaking about fee structures, there was a notable example of an established credit manager launching their first fund in a new market with a zero management fee structure. This move demonstrated the challenge of competing in a saturated market. However, the question at hand is whether it's possible to initiate a first-time fund with reduced fees and then later transition to a more standard market rate. How will investors react to such a move?
Taylor: Over the years, we've observed that emerging managers are often willing to accept a 1% management fee for their first $50m, as opposed to the standard 2%. However, as they raise additional capital, say another $30m, they face challenges in generating sufficient income. This can lead them to consider selling stakes in the GP to secure additional operating cash. In my opinion, it's crucial for your GP fee to be aligned with your capital raise and costs. This fee serves to cover operational expenses and maintain the day-to-day operations. Your source of profit as a GP should come from the carried interest, while the GP fee covers ongoing expenditure. Striking the right balance can be tricky for emerging managers, particularly when they are in the process of establishing a track record. There’s no one-size-fits-all solution, especially when it’s a struggle to attract capital. The landscape is evolving and it will be interesting to observe how it develops in the coming years. Spinouts from larger managers, who may possess a track record but not under their name, could face challenges in raising capital. In some cases, soft commitments from LPs that lead to a spinout and create their own fund may not materialise, leaving them back at square one, having already invested in the setup infrastructure.
Jabre: During the past few years, I've observed the importance of engaging with the right LP on the right topics. For instance, discussing co-investments or tech-based breakeven businesses with traditional institutional investors may not yield productive results as they might not fully grasp such investments. While it's valuable to lay the groundwork for future relationships and trust with investors, it's essential to tailor your conversations to their areas of interest.
|"Your source of profit as a GP should come from the carried interest, while the GP fee covers ongoing expenditure. Striking the right balance can be tricky for emerging managers, particularly when they are in the process of establishing a track record. There’s no one-size-fits-all solution, especially when it’s a struggle to attract capital"
How important is GP-investor alignment for emerging managers?
Miscioscia: What we truly appreciate about emerging managers is the strong alliance we can form with them. When they launch their venture for the first time, they are fully aligned with their reputation, capital, and more. Capital plays a pivotal role in this alignment. There is a balance between alignment through a GP commitment in the fund and the equity investment in the GP for the working capital. Although low management fees are appealing to investors, what happens to managers when there isn't enough to cover expenses? On the other hand, committing capital to the fund as well is important and ‘sweat equity’ might not suffice for investors. Finding the right balance in this regard can be challenging and often constrained by the availability of cash. An asset manager business seems like a relatively low capital-intensive business to start, but when coupled with the need to commit capital to the fund as well, the picture changes significantly.
Newsome: The point about alignment is of paramount importance. In some cases, you can encounter situations where a spinout team forming a new private equity firm is led by one senior, more affluent individual. This individual is usually the one who initially provides the seed capital to fund operations and would also have the largest share of the GP commitment.
Consequently, they might argue for a substantial share of the carry, say 60%, and full ownership of the GP. From an investor's perspective, questions arise regarding the rest of the team. What incentives are in place for them and how will their motivation be maintained? While recognising the founder's significant contribution, it's crucial to strike a balance to ensure that the firm doesn't become overly dominated by one individual.
Blagbrough: When we established Blume, the three equal co-founders personally provided the seed capital. This was a sacrifice in the short term but we were entirely united on the longer-term benefit of remaining independent and today we are very pleased to have made that decision.
We’ve briefly discussed the importance of a track record. The current deal market is difficult. How challenging is it for emerging managers to implement a deal-by-deal strategy in the current environment?
Blagbrough: I see doing deals on a deal-by-deal basis to be quite challenging, as it’s harder to compete with funds that have committed capital and can provide certainty of funding. It is possibly easier in segments of the market where less capital is available.
Ernst: Managing deals on a case-by-case basis can be challenging, especially if you lack a proven track record. The difficulty lies not only in successfully finalising these deals but also in sourcing the necessary capital to initiate them in the first place. Conquering this challenge demands more than just improving your negotiation and deal-closing abilities; it also necessitates addressing the crucial matter of securing the required capital. Building out your network is crucial if you want to pursue this strategy.
Newsome: I agree, it can be quite challenging. We make deal-by-deal investments, among other types of investment, through our direct funds. What seems to work best for deal-by-deal managers are models where they have serial backers across deals. These managers would have a consistent group of, say, five backers whom they can rely on, who consistently support them and understand the types of deals they pursue. This then gives them much more funding certainty when pursuing deals. We have such relationships with a number of deal-by-deal managers.
Vidamour: From an administrative standpoint, a scenario may arise when a manager possesses a relatively short track record, typically spanning two to three years. In such cases, they may return to the same group of investors. These investors might have participated in previous fundraisings, particularly within regulated fund structures. Subsequently, the manager could opt for a deal-by-deal approach with these same investors, typically involving two or three of them. This approach can be cost effective since, from a regulatory perspective, these are often unregulated structures, given that they don't fall under the category of a collective investment scheme, making it a more economical option.
Taylor: We’ve seen what we term a ‘semi-blind fund’ being used. In this setup, an LP softly commits a certain amount, let's say a $50m commitment, which is intended for up to five deals, each with a maximum investment of about $15m. However, the challenge lies in securing this commitment legally, as you would with a traditional blind pool structure where the commitment is firm. In this case, LPs tend to honour their commitment and provide the full $50m. Yet, because it operates on a deal-by-deal basis, the agreement is often more of a mutual understanding rather than a strictly legal one. This informal aspect can be frightening for emerging managers. Nonetheless, from a cost and regulatory standpoint, the deal-by-deal approach can make short-term returns appear more favourable, with the ultimate goal of building a track record and transitioning to a larger, more established fund.
Miscioscia: We've supported several emerging managers who employ a deal-by-deal strategy. Our backing has, at times, alleviated the significant proof of funding pressure that GPs encounter when attempting to close a deal. Now, we're considering evolving this approach into something resembling a search fund model. In this new structure, the manager would request a commitment from investors and assure them that, just like in their past experiences, they won't charge fees for the time spent searching. The focus shifts towards obtaining a degree of funding certainty for a specific fund.
|"Nonetheless, from a cost and regulatory standpoint, the deal-by-deal approach can make short-term returns appear more favourable, with the ultimate goal of building a track record and transitioning to a larger, more established fund"
Another key aspect to consider when adopting a deal-by-deal strategy is that while it offers clear advantages both to investors and managers, such as for the latter an accelerated access to carried interest, there's a significant downside. If a deal doesn't pan out as expected, it can be a setback impacting the entire track record of the manager, given the lack of portfolio diversification benefits that come with a traditional fund structure. This highlights the importance of striking the right balance and continually evolving your company's approach to risk management and strategy to ensure long-term success.
Can doing a deal-by-deal strategy enhance transparency for both the LP and GP?
Blagbrough: Having the support of one of our early investors to complete deals ahead of the first close of our fund was catalytic for us. Investors want to see an emerging manager deliver on their strategy and this helped us to do this.
Ernst: I'd like to highlight that the lines of communication are notably more open when working with emerging managers. In larger funds, as an LP, you can often feel like just one of many investors. However, with emerging managers, each LP holds significant importance due to the fund's smaller size. This fosters open communication and a higher level of transparency.
We’ve discussed the need to stand out from the crowd in terms of strategy. But how can emerging fund managers strike a balance between innovation and risk management?
Taylor: Emerging managers sometimes overlook critical aspects such as establishing policies, procedures and thorough due diligence. Effective risk management begins from day one, even before making an investment. While perfection may be unattainable, getting it right in the early stages can earn the trust of LPs. Even if an investment doesn't turn out as expected, the trust remains because you've delivered on your commitments. Nobody's perfect in their investment choices, but those who handle things correctly tend to gain the confidence of LPs. It's not just about their track record in terms of performance or wealth; it's also about trust. Dealing with investments on a case-by-case basis can be more straightforward, especially when things go as planned. Having well-defined policies and procedures significantly contributes to this trust-building process.
|"Even if an investment doesn't turn out as expected, the trust remains because you've delivered on your commitments. Nobody's perfect in their investment choices, but those who handle things correctly tend to gain the confidence of LPs"
Mirica: In credit funds, effective risk management is essentially our USP, unlike equity funds where the upside potential protects the downside. In a credit fund, what distinguishes a good manager is their ability to minimise the downside. The key differentiator, if you consider it, lies in who can reduce the default rate or minimise losses, as there's limited room for upside potential from excess yield. Any default can wipe out the fixed interest payments received up to that point. For Apax, specialising in specific sectors is vital. We stick to our expertise and excel as asset selectors. Our confidence in this approach is reinforced by our extensive 50-year history in both investment and equity investment domains.
Newsome: Indeed, it circles back to our earlier discussion. Emerging managers need to strive for maximum differentiation to appeal to clients. Specialisation is crucial, but focusing on a strategy or sector that is too niche entails risks. Thus, it's important to strike a balance. In our case, we're constructing a diversified portfolio by investing in the funds of several emerging managers and making selected co-investments alongside them. We aim to diversify by selecting both sector specialists and strategy specialists in different regions. This diversification across multiple funds within our portfolio helps mitigate specific fund-related risks.
Moving to the operational side of things, how can emerging private equity managers build a skilled and experienced team to support their fund's success when the job market is so tight and super competitive?
Jabre: It has been mentioned before that emerging managers essentially function as entrepreneurs. They don't have an established support system in place, so they must build one from the ground up. This environment isn't suitable for everyone, regardless of their level of experience. As a result, a significant portion of my time is dedicated to recruiting. One of the critical factors I assess is whether potential recruits can thrive in an environment with limited support. Will they take the initiative, adapt and tackle challenges independently? This is crucial. Typically, compensation for emerging managers won't match that of established funds. Therefore, individuals must truly believe in a larger purpose, if one exists, or the long-term potential of the setup. They should understand that success may not come in the first two or three years but can be achieved as the venture grows.
Blagbrough: In the establishment of a new fund, one of the most critical strategic aspects is assembling the right team. While capital is undoubtedly a key factor, the foundation of a successful venture fundamentally revolves around the people involved. Hiring the right individuals is of paramount importance, and it's a process that demands a significant investment of time and effort.
Ernst: Identifying individuals with relevant experience that aligns with the expectations of your potential LPs is crucial. As an emerging fund, you lack a track record to lean on. However, you can emphasise the expertise of your team members, detailing their previous roles, experiences and the companies they've previously invested in. This helps bridge the gap and demonstrate how their collective knowledge can seamlessly transition into the new fund's activities.
Mirica: Apax invests a significant amount of time and effort in shaping our organizational culture. Personally, I believe that culture plays a central role in a team's success, which directly impacts the success of the fund. When it comes to hiring, this applies not only at the entry-level but at various stages. Minimizing turnover is crucial, as is Attracting the right talent that shares and strengthens the pillars of the Apax culture. We dedicate considerable time to this aspect.
|"In the establishment of a new fund, one of the most critical strategic aspects is assembling the right team. While capital is undoubtedly a key factor, the foundation of a successful venture fundamentally revolves around the people involved. Hiring the right individuals is of paramount importance"
Finally, what final advice would you give to emerging managers in this current difficult climate?
Ernst: Despite the prevailing sense of pessimism, many investors are genuinely enthusiastic about the opportunities presented in this market. Some of the most successful companies and vintages emerged from past challenges, like the GFC and the dotcom bubble. The key is identifying the right LPs who share this excitement and are prepared to invest in this dynamic landscape.
Blagbrough: Have a clear rationale for why your fund is needed in the market. Build the right team. Be tenacious.
Miscioscia: Despite the formidable challenges, there has never been a more opportune time to establish an emerging manager. In the larger segment of the asset management industry, enormous capital inflows have led to significant dry powder and heightened competition, which has exerted downward pressure on returns. This situation makes a compelling case for creating specialised and focused investment entities.
Jabre: What propels an emerging manager to success is their capacity for innovation and willingness to explore new strategies. My advice would be to keep experimenting. As you raise subsequent funds, you'll develop a formula and your opportunities for experimentation will become more limited.
Taylor: While data holds significant importance for both GPs and LPs, especially for emerging managers, the foundation of success remains interpersonal relationships. Leveraging your network and expanding through your network's network is a powerful way to strive for success. It's important to recognise that, like everyone else, success as an emerging manager demands effort. You can't simply establish your fund and expect $250m to flow in immediately. It requires substantial groundwork and dedication.
Vidamour: One significant challenge we've observed with emerging managers is their proficiency in acquiring investments, but often they struggle with knowing when to divest. The skill of timely selling is critical. Waiting for the ultimate asset value isn't always necessary. It’s essential to build a track record and provide regular distributions to investors, who will in turn reinvest capital back into your business and subsequent funds.
Newsome: We have a deep appreciation for emerging managers; it's an integral part of our DNA. During the past 25 years, we've supported over 100 emerging manager funds, and this commitment has been a driving force behind our best performance. Beyond performance, these relationships have been a source of valuable co-investment and secondaries opportunities. What's remarkable is that even managers we initially backed two decades ago still maintain strong and enduring connections with us, proving that they never forget their early supporters. I know it’s a difficult environment, but with the right strategy, solid execution and aligned investors, I believe there are exciting times ahead.
The article was featured in the October 2023 Real Deals publication on pages 22 to 24, view the publication here.
For more information about our private equity services, click here.
HEAD OF FUNDS, JERSEY
HEAD OF CORPORATE AND FUND SERVICES AT CAREY, A SUNTERA COMPANY