First-time fundraisers, almost by definition, offer an antidote to many LPs issues with, and fears about, today’s PE market.
There was something notably different about PEI Group’s second annual NEXUS conference, held in Orlando a couple of weeks ago, compared to last year’s. Many of the major themes were the same, if more pronounced than the year earlier: challenging fundraising, competition from the credit sector, proliferating uncertainties, low investor distributions, pallid exit markets.
And yet, I gathered from the Q&A sessions at various panels and from chance conversations with attendees that there seemed to be a minor explosion of independent sponsors at the event. Even capital providers who actively pursue independent sponsors were at least more vocal, if not greater in number, than last year.
“Independent sponsor is no longer… well, I don’t know that it was ever a dirty word, but it meant something different a decade or so ago than it means today, given the fundraising environment,” said Elizabeth Weymouth, the founder and managing partner of investment firm Grafine Partners, during one of the event’s panels (Grafine does have a program for investing in independent sponsors). “It’s far more accepted, certainly from our perspective, to see someone doing deal by deal for a longer period of time until they ultimately raise a fund,” she said.
Indeed, deal-by-deal fundraising is among the most popular fundraising methods among emerging managers, as Buyouts has previously reported in its own annual survey.
Last week in LP Weekly, I mentioned in passing a bit of data Grafine showed attendees at that panel. That was that the average net IRR of managers’ first funds beat that of their fourth and later funds for every single vintage from 2000 to 2021 (it didn’t show data for Funds II and III).
Weymouth was far from the only one suggesting emerging managers are where the real alpha is at. Data presented from software and data platform Addepar showed that the 10 percentile of emerging managers’ funds with vintages between 2005 and 2018 outperformed the equivalent group of established managers’ funds (with an average IRR of 26.2 percent vs 24.7 percent, respectively). The 90 percentile, however, did underperform their established manager peers (with an average IRR -4.3 percent vs -1.7 percent, respectively)
But the range of IRRs for the bulk of emerging managers’ funds (25 to 75 percentile) skewed to the upside, and their median performance was just a touch better compared with established managers (10.3 percent vs 10.2 percent, respectively).
This all jives with what Cambridge Associates president and global head of investing, Samantha Davidson, told me at NEXUS: if you can cut just a slice off of the bottom of the dispersion range, investing in emerging managers will consistently outperform.
The combination of decades of growing popularity among institutional investors and the fundraising struggles of recent years is materializing what placement agent Kelly Deponte, in a survey of 71 LPs (of which most were pension plans, insurance companies, funds of funds and family offices), found is among their “greatest fears”: getting crowded out of good investment opportunities (at least among Northern American LPs in the group).
Nearly half of those LPs said their greatest fear was increased competition causing decreased opportunities for “significant returns across all core areas of private equity.”
The survey may have a relatively small respondent set, but its other findings are also telling, I think, and paint a coherent picture.
Among their other “greatest fears”: That large firms in the market are becoming generalized asset managers across the private markets and are moving away from their original key investment strengths (37 percent); that management fee levels on large funds are destroying alignment of interest between investors and fund managers (30 percent); that purchase price multiples on mid-market buyouts are too high and threaten future returns (30 percent); that the same is true on large and mega buyouts (22 percent); and that generational transitions at a number of long-lived firms is generating concern about those firm’s future success (22 percent).
All of those fears distinctly relate to the entire universe of managers except for emerging ones. First time fund raisers and other “emerging managers” almost by definition need to stick to their original investment strengths (nearly 70 percent of respondents also said that significant strategy shift from the previous fund was among issues they focused on the most when investing or advising a client – the largest response among the other “issues” listed). They often offer co-investment (and management fee offsets, among other things) to sweeten the deal for new LPs. Unless they’re completely fraudulent or incompetent, they are, theoretically, more naturally aligned with investors’ interests, given they have little or no other sources of capital or reputation to rely on. Successful young managers almost universally home in on specialized strategies where they can identify real value. And, of course, they don’t (or certainly, shouldn’t) have succession issues.
Not a surprise, then, that nearly a third of Deponte’s respondents said they are actively pursuing relationships with new managers (similar to findings in a Coller Capital survey Buyouts recently reported on).
Private equity’s attractiveness among institutional investors has gotten to such proportions as to basically be ubiquitous in that universe, and awesome pools of untapped capital are waiting at the gates to flood in, as we’ve commented before. And yet, not only is alpha harder to find due to historically high levels of competition among managers for scarce assets, new funds aren’t coming to market at the speed they once were, anyway.
In a world like that, LPs afraid that continuously increasing demand will only further water down returns and skew manager/investor alignment are understandably recognizing that the real value is in going back to private equity’s roots: a few people with a great idea, and a great plan.