There’s a quiet revolution happening among sophisticated institutional investors and large pools of capital that could eventually up-end one corner of the private equity universe. A growing number of LPs are starting to turn away from allocating to the largest managers and towards experienced dealmakers who are starting their own shops – many of whom are spin-outs from the giant firms.
What’s driving this growing group of institutional investors is the desire to be directly involved with investments and partner with dealmakers outside of a traditional LP fund structure. Over the last decade, we’ve seen this trend within co-investments, direct investments and separately managed accounts, each of which have experienced a continual rise in interest from institutional investors. According to an estimate from Triago, these three categories of LP commitments reached a total volume of USD201 billion in 2019. Now, we’re seeing a further evolution of more creative and tailored approaches, particularly from a new generation of managers.
In many ways, this phenomenon was pioneered several years ago by a handful of very sophisticated institutions including several Canadian pension plans, The Alaska Permanent Fund and the Texas Teachers Retirement System, to name a few. Now others, including sovereign wealth funds and smaller pension plans, are starting to experiment with this and take it further.
It’s an encouraging sign for the market as this trend can be a “win-win” for all parties. The mega funds will continue to receive the bulk of the capital flows, but some LPs will now have an opportunity to “get closer to the source” of superior performance, exercise more selectivity and control over the deals they invest in, and bypass mega-fund structures that may not work for them. New managers have the ability to build direct relationships with LPs, hold investments for a longer period of time and truly innovate outside of the large asset management complex. As founders and managers of smaller, more focused funds, they also have the luxury of spending more time on deal-making and less on capital-raising.
These spin-out managers aren’t the typical ones that consultants and others refer to as “emerging.” They are known quantities who have established track records at large PE platforms. Many are sector specialists, with deep knowledge of areas such as healthcare, real estate, technology or consumer. And, they have an entrepreneurial bent – combining the aspiration to replicate their prior success with a desire to work in a smaller, more nimble organisation. They relish the opportunity to work with investors who are true partners that can lend expertise, investment ideas and unique insights that drive relative value creation.
The growing interest in this new breed of manager is not hard to understand, given their track record of performance. Data presented in PitchBook’s recent First-Time PE Funds Overview revealed that, “first-time funds deliver outsized returns (more than 25 per cent IRR) more frequently, deliver poor returns (less than 5% IRR) less frequently, and return capital more quickly.”
Although Covid-19 made it tough for spin-out GPs to strike out on their own and connect with LPs, the group may be poised for an upturn. According to Preqin, first-time funds based in North America raised more than USD12 billion in 2020 – a decline from the prior two record years, but certainly respectable given the challenges of gathering funds amidst the pandemic.
This approach isn’t for every LP, of course. Historically, more conservative institutional investors like to “play it safe” by investing in the most widely-recognised firms that have traditional fund and fee structures as well as a huge menu of different strategies to choose from. However, an increasingly larger set of investors are looking beyond the established PE model. These LPs are receptive to opportunities to back veteran investment professionals who are leaving mega-firms and establishing their own firms with more flexible fund structures, more access to individual investments, more optionality on different deals and the ability to earn more returns as the firms grow their businesses.
One driver of this trend is a desire on the part of both investors and dealmakers to return to an earlier era in private equity – where firms were smaller and LPs had direct access and close working relationships with their GPs.
One example of this is the formation of Capital Constellation, a joint venture founded in 2018 by the Alaska Permanent Fund Corporation, the Public Institution for Social Security of Kuwait, RPMI Railpen and Wafra. Constellation was formed by these large institutions to provide “catalytic investment capital” to next generation private equity and alternatives managers.
As they stated in their initial press release, “Constellation’s mission is to assist talented alternative investment managers in breaking through the challenges of initial fundraising, specifically by providing strategic and operational support and an aligned, substantial and long-term capital base.”
Many different types of investors are attracted to these new managers – they include family offices, endowments and sovereign wealth funds – but there are some common traits. They often resemble “asset owners” more than “asset allocators”; they believe performance is derived from “off market” deal flow, and they want to take a more active role in choosing and structuring deals. Investors in first-time funds typically have balance sheets that enable them to hold investments for longer periods. And many would prefer an alternative to the traditional large PE firm fee structure.
These emerging managers and their investors occupy a kind of “white space” between large GPs and traditional LPs. While the interests of the first-time managers and investors are closely aligned, it may be necessary to create a framework that will allow their partnership to flourish.
Partnering with first-time managers allows selective LPs to help build the next generation of successful funds. The investors have an opportunity to deploy their capital closer to the source of their returns, while the managers can focus on doing deals. More importantly, investing in first-time funds can lead to the formation of strong LP-GP relationships that can produce positive outcomes for both parties over the long-term.