In defence of Emerging Managers

A recent article foreseeing that the PE universe would whittle down to 100 firms goes against the very essence of private equity

The spoils of fundraising have been shared disproportionately by a small number of mega-firms in recent years. The 25 largest PE firms have hoovered up over a third of the estimated $500bn new capital raised in 2023 to date, according to Preqin. But could the convenience of keeping commitments concentrated to a small number of firms, with fewer larger tickets, prove detrimental to the dynamics of the industry in the longer term?

Investors will argue that they are backing known quantities, firms that have delivered sufficient returns over many years, and that focusing their attention on fewer relationships is efficient. Yet are these relationships deeper for being wider? Are “platform” firms transparent on their capital allocation between funds, deals and co-investors? Maybe for a handful of the largest investors, who by the sheer size of their commitments across funds and co-investments may wield power commensurate to that of the firms they are partnering with. But most investors will be on the receiving end.

Witness the recent furore over attempts to normalise the practise of continuation funds and remove it from scrutiny even by LP Advisory Boards. Such terms would provide carte blanche to GPs to re-allocate investments between vehicles, at a value of their choice, crystallising performance fees (carried interest) while resetting the clock on a new management fee structure. Of course investors in the first vehicle have a “choice” to roll over and continue holding the asset, but what has become of private equity’s old adage that the pressure to exit investments and return proceeds to investors before raising fresh capital creates discipline and instils the momentum for active management of portfolio companies?

That drive to improve portfolio companies is what has defined private equity for years. Yes, there have been uses and abuses of high leverage on occasion, but the truly great investments have always come from driving change in the underlying businesses. This requires focused attention and relentless energy, not unlike that required of any entrepreneur founding a new venture. This drive is motivated in large part by the opportunity for outsize financial gains in the form of uncapped upside. In this respect caried interest stands out by its complete alignment with investors.

What a pity to dilute this positive motivator in ever larger teams and firms, where the endless accumulation of AUM and associated management fees becomes the main motivator. “Platform” PE firms seek growth for themselves, above looking to foster it in their underlying portfolio.

PE is all about taking calculated risks to achieve higher returns. Yes it is more risky to back new teams launching new funds, but with more to prove and a demonstrated entrepreneurial spirit, these teams have been proven to generate true outsize returns for their backers. Ironically this is something large platforms have understood, and many have now launched specific “emerging managers” programmes, aimed at discovering the next generation of funds. But terms on offer, more akin to a captive structure with limited upside for the individuals at the coal face, are a deterrent to the more confident starters.

As emerging managers, founders are often confronted with the dilemma of how much of their dream of independence and upside they are willing to give up in exchange for assistance in fundraising. It does not have to be this way: traditional fundraising may be a long and involved process, but dedicated placement teams are on hand to help identify investors who share the same vision and will support the new firm for the long term based on shared values.

If you are still reading but wondering how this is relevant to you, check the typical composition of retail PE products. While various platforms and aggregator funds have multiplied, predominantly they focus on “brand name” larger funds where the combination of market-average standard performance and layering of fees will inevitably dull the excitement that should come from exposure to private markets.

Investors cannot do much about higher interest rates or increasing regulatory costs, the other two drivers of consolidation cited. But they can certainly alleviate the fundraising challenges faced by smaller emerging managers, while aligning themselves to benefit from true value creation and shared upside.

Are you ready to do your bit to keep this industry as exciting and rewarding as it has always been?

Placement & GP Services Team