Overview
From the capital allocator’s perspective, emerging managers can be a double-edged sword. Their funds have unique structures, approaches, and flexibilities that allow for a differentiating risk / return ratio when compared to established fund managers. Outsized performance can be achieved from the different perspectives emerging and established managers independently contain. However, understanding the risks of investing in emerging managers from an allocator’s perspective is not as intuitive without the presence of a recognized firm brand, track record, and polished operations that many established managers possess. At its core, fund managers are individuals with unique perspectives and experiences. The underlying work, network, and execution comes from individuals who ultimately are not attached to a firm; however, many allocators get lost amongst brands and reputations. The value provided by an established manager’s reputation and operations is not to be overlooked, as it can provide stronger access and efficiency that emerging managers do not have.
The following thoughts are based on conversations with various investment ecosystem participants, who on the one hand, highlight what is attractive about emerging managers, and on the other hand, highlight issues that stand out relative to established managers. Investing in an emerging manager requires higher underwriting standards and increased scrutiny, yet can pay-off tremendously long-term.
To set a baseline of the fundamentals of managing an investment fund, below is an output from ChatGPT on a guide for an emerging manager that lists the basics of managing a fund:
Develop a strong investment thesis: Define the specific areas of focus for your venture capital firm and develop a clear investment thesis that will guide your investment decisions.
Build a network: Establish relationships with entrepreneurs, other venture capitalists, and industry experts to stay informed about new opportunities.
Conduct due diligence: Carefully research and evaluate potential investments to ensure they align with your investment thesis and have the potential to generate strong returns.
Develop a strong portfolio: Assemble a diverse portfolio of investments across different stages, sectors, and geographies to spread risk and maximize potential returns.
Provide value-add: Actively work with portfolio companies to provide strategic guidance and support to help them succeed.
Stay current: Stay informed about industry trends and developments, and adapt your investment strategy accordingly.
Fundraising: Build a robust fundraising strategy to secure capital from investors.
Always be on the lookout for new opportunities: Continuously scan the market for new investment opportunities and stay alert to emerging trends and technologies.
Be prepared to take calculated risks: As a venture capitalist, you will need to be comfortable with risk and be prepared to take calculated risks when the potential for high returns is present.
Be patient and persistent: Building a successful venture capital firm takes time and patience. Stay persistent and stay the course, even when faced with challenges or setbacks.
The above is good general advice, but nothing that most managers are not already aware of when starting out. As there are varying levels of sophistication among managers, some points in the below may be more relevant or less relevant. There is also a wide degree of generalization since it is otherwise difficult to capture all the unique attributes that differentiate Capital Allocators or otherwise known as Limited Partners.
Part 1: Attracting the attention of Capital Allocators
Unique Theses
Capital Allocators many times do not have the bandwidth and in house resources to be experts in all asset classes, sectors, or geographies they wish to have exposure to across their entire portfolio. In balancing the level of control they wish to have, a focused thesis allows for controls over the broader portfolio’s exposure. The thesis focus allows for flexibility in navigating certain trends rather than leaving full discretion to underlying managers.
New funds can be the most innovative, as they have less to lose than an established fund pivoting their approach. A strategy drift is a larger risk for an established entity with their Limited Partner’s committed to a (usually proven) strategy. There are countless approaches to investing; a creative manager can find a unique edge or capitalize on trends that will be higher yielding than incumbent approaches. The inventive tactics can be seen on both the investment side and the operational side. If there is a long enough track record to prove it out, the uniqueness is likely to be a big attractor.
Capital Allocators can also approach an investment opportunity for access to information or certain communities and insights. With hopes of not falling behind, an investment in a differentiated approach provides Capital Allocators with visibility and connections that can prove fruitful in their build-out of a core position/strategy in that sector (or even deciding to avoid that sector). Becoming an early backer to a certain space can create further long-term partnerships and network opportunities as the strategy expands to a larger addressable universe of investments and pools of capital.
Scale and Governance
A smaller fund size, assuming all else equal, has to be more selective in how they participate in the market. There is a certain degree of flexibility that can be scaled up or down for a given strategy. As for those that seek to be more active in their investments, check sizes can only go so low. The active involvement, either through higher ownership, board participation, or other forms of influence, indicate more control to the General Partners, and thereby pass through to the Limited Partners, of the fund. This is welcomed by many Capital Allocators (not all), that would prefer the dedicated exposure over a spray & pray approach. It is helpful to know that managers are not just intermediaries but rather acting as value creators for the underlying companies. In theory the added value creation should lead to further realized returns for fund participants. However, more concentrated portfolios are also perceived to come with higher risk. This creates a need for more thorough underwriting to ensure that no one position can put a hole in the portfolio.
Maintaining the same level of investment discipline and focus becomes increasingly challenging as portfolios grow larger. While smaller funds may be able to maintain a coherent investment thesis, Limited Partner investors, too their own detriment, generally prefer to see their funds grow in size. As a result, successful firms often seek to raise progressively larger funds, primarily for the purpose of generating greater management fees and greater potential upside. However, scaling up can lead to difficulties in maintaining the original approach, limited by check sizes and team bandwidth, resulting in a strategy that may resemble what came before, but with differences in terms of diversification and portfolio construction. Over time, the returns of larger funds tend to normalize, with lower thresholds resulting from increased deployment needs. This often leads to the departure of key members who seek to launch new funds with the disciplined approach that originally helped grow the brand. Looking back across fund cycles, this trend of normalization of returns is apparent in many firms that have experienced tremendous growth in AUM during the prior decade-long bull run.
The Drive
There are unique characteristics in managers working on their own startup, that have a different fire driving their actions than do those at more established firms. There is a certain hunger to prove themselves to their investors and portfolio companies. Many emerging managers have already demonstrated their capabilities at leading firms, excelled as founders or operators, or achieved success in angel investing. Now, with the launch of their new fund, they have the opportunity to showcase their independent execution abilities. There are high risks in the early funds, as these become crucial to driving subsequent fundraising. The right motivations can be evident through the extra hustle that is many times apparent in the individuals involved.
With (usually) smaller funds, the management fees received by emerging fund managers can be quite low, leading to leaner operations. Unlike multi-billion funds with tens of millions in annual fee-generated inflows, smaller funds need to return capital to Limited Partners for the manager to benefit, and ultimately stay in business. This drives incentives to be more aligned the Limited Partners. At their essence, humans are always pushed by certain incentives, and it is always important to know how to peel off the layers to understand what will drive the manager actions and building through the inevitable tough times.
Small teams offer a level of flexibility that larger firms cannot match. With fewer committed resources, they can more easily divert resources, adjust their operations, pivot their strategies, and adopt new technologies. This flexibility also allows them to be more opportunistic in their decision-making. However, straying too far from their core expertise and mission can increase the execution risk. Nevertheless, if managed properly, embracing innovation can be a key factor that sets them apart from established competitors in the eyes of Capital Allocators.
Portfolio Construction
Portfolio construction is a telling sign to a manager’s use of resources and risk management. A larger portfolio with more investments can help diversify the risk and reduce the impact of individual company performance. Too few investments, on the other hand, increase the concentration risk and can expose the portfolio to substantial downside if one or a few companies underperform. However, it's important to strike the right balance between portfolio size and engagement with portfolio companies. Too many investments can lead to less engagement with each company, as the manager may not have the time or resources to properly underwrite and monitor all companies in the portfolio. Having the bandwidth to conduct thorough due diligence and engage with portfolio companies as appropriate is critical to achieving long-term success. Investment managers should ensure they have the resources and team in place to properly manage the portfolio and maintain a level of engagement that maximizes returns.
Determining a fund's fee structure is a challenging process that requires aligning incentives with the market's supply and demand dynamics. Typically, management fees are about 2%, but new funds often have higher start-up costs and lack the support of existing funds to generate additional income. As a result, fees may be slightly higher or front-loaded to address this shortfall, placing an additional burden on capital allocators supporting emerging managers. For GP carry, the standard long-term incentive is 20%, which is paid only after all capital has been returned (European waterfall). However, if a manager is oversubscribed and delivers high returns, they may justify higher fees. For emerging managers, concessions on carry may be necessary to attract capital.
The alignment of incentives of investment managers is a critical component to driving superior performance. Fund budgets are a clear indicator of how resources are being utilized. If too much compensation is fixed and not driven by returns, it won't push managers to outperform. GP carry is a clear long-term incentive that should be appropriately allocated to the team and any others that have an influence in driving returns. Firm ownership is another indicator of motivators that could drive the team to perform better. Proper use of time and resources are indicative of the right incentives being in place. On the contrary, high fee SPVs, such as 2/20 on co-investments, signals external incentives separate from the focus of the fund. Properly aligning incentives can ensure that investment managers prioritize driving returns and working towards the best interest of the fund and its investors.
Knowledge and the Perception of Knowledge
Investing in private markets poses various challenges that managers may be unprepared for. Apart from understanding the technical and scientific risks associated with underlying industries, they must possess knowledge about fund structuring, deal structuring, co-investors/competing investors, and ecosystem participating companies that could offer synergies or create portfolio company competition.
Simply having the right expertise to meet the investment needs of a capital allocator is not sufficient. In some cases, the perception of knowledge can be more potent than actual knowledge. Although this may seem irrational, effectively communicating the comprehensive solution that a manager provides through their fund is not a straightforward task. A proficient salesperson, compelling marketing materials, and robust branding can sometimes be the deciding factors for some capital allocators. For other capital allocators, agreeing on an investment thesis or having a manager lead a desirable strategy may be a result of timing rather than skill. Comfort for investors can be established in various ways that may not necessarily indicate a manager's ability to replicate returns.
Value Add
An investment manager’s “superpower” or unique way to add value drives capital allocators to invest and founders to open up their rounds. Emerging Managers can add value by leveraging their unique perspectives and networks to identify investment opportunities that established players may overlook. These managers may come from diverse backgrounds, with experience in a specific industry or geography, allowing them to identify trends and opportunities before they become mainstream. In addition to their investment acumen, they can provide value through their relationships with other investors, founders, and service providers. These networks can provide access to deal flow, due diligence resources, and potential strategic partners for portfolio companies. Investment managers can also provide value by actively supporting their portfolio companies with operational expertise, strategic guidance, and access to additional capital. By building strong relationships with their portfolio companies, investment managers can help drive growth and maximize returns for their investors. There are various creative actions and platforms managers have found to be a differentiated value driver.
Performance
For most capital allocators, the bottom line is the most important consideration - which investment will generate the highest return. While other factors, such as impact (for which the argument can be made that it is ever becoming more aligned with returns) are important, the fiduciary duty of the manager is to deliver value to investors. Interestingly, emerging managers have demonstrated some of the strongest accumulated returns. It is worth noting survivorship bias, whereas the lower-performing managers fail to raise subsequent funds and are no longer in existence, which can skew the results.
Investment decision-making can take various forms, but the desired outcome is always an expected return that considers the risks and probabilities involved. When the expected return, after factoring in all relevant considerations, is highest, it should be the clear choice. The onus falls on the manager to convince capital allocators that their strategy represents the optimal path. While smaller, emerging managers may face headwinds compared to their larger competitors, they can differentiate themselves through innovation, flexibility, and a strong work ethic. These qualities give them a competitive edge that the best emerging managers can leverage to generate significant returns.
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While the significance of these connections and opportunities may be apparent to a hands-on manager, some capital allocators may require more guidance in recognizing them, particularly when they fall outside their current targets or areas of focus.
Part 2: Added Risks Emerging Managers Should Address
While important to highlight the differentiators and advantages, it is more important not to have unaddressed risks that are deal breakers.
Operations
Whether the manager is new to the industry or has spent significant time as an investor at another firm, there should be no underestimating of the requirements of setting up the operational side of an investment fund. Even when outsourcing the bulk of the items, including legal, tax, fund admin, custody, and others, the manager is ultimately responsible. The absence of proper management of compliance, regulatory, and cybersecurity risks are seen as a red flag for many capital allocators. Structuring the right team to undertake that responsibility is not always easy.
Post investment, the relationship between the General Partner and the Limited Partners, for many, hinges on the reporting. When time is taken up by investment opportunities and fundraising, many times the reporting aspect can get neglected. Beyond the Capital Account Statements and quarterly financials, context on the underlying investments (topline growth, margin expansion, KPIs, runway…), fund operations, and value-add activities helps LPs not only stay informed, but also engaged and supportive.
New funds have startup qualities, particularly evident in the budgets they are working with; particularly in smaller sized funds. The initial management fees, without layers of multiple funds, drives for lean operations. Decisions must be made on team pay, spend on advisors/partners, and other operational costs. The allocation of fees can be telling as to the driving incentives for the fund’s operations.
Many Institutional Limited Partners run what is called “Operational Due Diligence” which ensures the proper operations are in place within a Fund/Firm prior to making an allocation decision.
Fundraising
In the past year, fundraising has become a more significant constraint than it was in the previous cycle. The allocator markets have transitioned from being extremely open to becoming increasingly closed, particularly in higher risk asset classes. It has been surprising for some highly qualified and capable firms with strong track records and investment thesis to go beyond their expectations, taking the full period allowed to them by the limited partnership agreement to close out the fund. The fundraising timeline for these groups continues to lengthen as capital allocators become more restrictive and diligent, removing the pressure on the manager’s desired closing timelines.
When it comes to getting capital allocators across the line, there is hesitation to be the first to commit. The incremental risks of the fund not being raised usually requires additional incentives to be offered. Some fund managers offer ownership stakes in the General Partner as a way to entice investors to become long-term partners. The GP carry share is a sacrifice the manager can be willing to make to lock in a long-term partner for future funds. Without these anchor investors in place, smaller investors may be less motivated to invest. Other incentives that may be offered include seats on the Limited Partner Advisory Committee (LPAC), special economic terms through a side letter, co-investment rights, or other creative motivators. From the perspective of a potential investor, it is generally safer to wait until later in the fundraising process when there is more transparency about the fund's portfolio performance before committing funds.
Although not as frequently used by emerging managers, lines of credit can be a useful tool for fund. They can even be used to manipulate a fund's internal rate of return (IRR) by delaying the timing of capital calls. However, as interest rates rise, this practice may become less common. In addition, lines of credit can help finance short-term capital needs for investments, reducing the frequency of capital calls to Limited Partners (LPs). Frequent capital calls can be costly and burdensome, so having a line of credit in place can be beneficial. Without a line of credit, fund managers may need to make higher upfront capital calls based on anticipated capital needs.
Underwriting
Achieving a lean operation while avoiding material sacrifices is a complex task for fund managers. While many discussions between General Partners (GPs) and Limited Partners (LPs) focus on investment strategy, approach, sourcing, and execution, theory alone cannot replace practical experience. The quality of an investment memorandum can reveal the level of diligence performed by the manager in evaluating an investment opportunity. While it's understandable that managers cannot know everything themselves, having access to the necessary resources to gather expertise is critical. Skipping proper due diligence can be disastrous for fund managers. Especially when participating in party rounds or competitive opportunities, proper review should not be compromised. The diligence process may differ based on the stage and manager, but failure to consider all relevant factors can be inexcusable. The additional, tedious work of due diligence can be a worthwhile investment in CYA (covering your assets) and serve as valuable insurance.
Macro conditions
Macroeconomic conditions have a significant impact on various aspects of the fund. Firstly, in fundraising, the opening and closing of capital allocator’s checkbooks are largely influenced by macro conditions. Some non-institutional capital allocators may exhibit retail mentality, being more enthusiastic during peaks and less during troughs when pricing is more favorable. Secondly, macro conditions can challenge valuation discipline. Prior to 2022, many managers invested in highly valued companies due to the limitations of fair priced options amidst high demand. This is now hurting many as down rounds lead to dilution and lower returns. As portfolio companies grow, macro conditions can limit subsequent financing options, highlighting the importance of managing burn rate and runway considerations. Lastly, in exit strategies, many options can dry up (as have the IPO and SPAC markets recently), especially for higher growth/risk assets, when there is less available capital to sustain valuations. While macroeconomic conditions do not dictate a good idea or team, failure to consider them in the short-term can be fatal to a business.
As market conditions change, so do the interests of capital allocators. They may have little patience for poor performance, particularly in liquid strategies. In less liquid investments, improper marking of investments in reporting to limited partners is brought to light during changing tides. It is safest not to mark-up investments without independent third-party validation (no marking up your own rounds) and to avoid applying subjective valuations. As comparable valuations fall and KPIs weaken, markdowns will be more scrutinized than markups.
Deal Warehousing
Warehousing deals present a risk-reward situation that may benefit both parties involved, yet potentially posing one-sided risks. Essentially, the manager assumes the risk by providing the necessary capital upfront, which may be a substantial amount for them, and is subsequently exposed to the performance of the investment. Incorporating deals into the fund prior to fundraising can be advantageous in persuading capital allocators to invest, as it offers visibility into the portfolio, deal types, and access. However, if an opportunity in the fund made prior to LPs performs poorly, it can have an opposite effect, leading the manager to withdraw the investment from the fund to avoid negative repercussions, and thereby taking on all the risk. Conversely, if the investment appreciates, the manager usually contributes it at cost to future LPs as an incentive to join the fund already at a mark-up, passing on the upside to be shared by the fund. These opportunities consequently prompt the manager to assume lower risks than core assets at a later stage.
Battle Scars
It is prudent for fund managers to support founders who have experience and understanding of the industry they are building in. Similarly, it is easier for capital allocators to evaluate a manager who has a history of participation in the ecosystem they are investing in. The manager's track record can come from their investment or operator experience or unique blend, which can help demonstrate their ability to execute their strategy. Often, capital allocators will run references on a manager’s network to confirm the investment history and/or operating track record. The manager's prior returns, particularly those with actual distributions, have a significant impact on capital allocator sentiment. The returns are often accompanied by a story that provides context, which can be useful in interpreting them.
Previous experience not only provides insight into return potential, but also mitigates execution risk. Some lessons can only be learned by doing, and capital allocators prefer managers who have learned from prior experiences. While there are always continuous learning and evolutions to be had, unique situations can arise that are not foreseeable. Hence, the "you don't know what you don't know" adage is particularly relevant.
Partnerships
Investing should not be viewed solely as a capital transfer. It entails a broader partnership, relationship, network, and liability inherent in the investment transaction. For managers aiming to build a long-term platform, the anchor LPs, initial fund investors, and underlying founders are essential team members. As capital allocators often scrutinize General Partners, these managers should reciprocate by conducting diligence on their prospective Limited Partners. Who invests signals more about an investment's quality to the rest of the market than is immediately apparent. It is easy to overlook the critical aspect of finding the right long-term, value-aligned partners when easy capital is available.
The right partnerships can manifest themselves into early founders referring other quality entrepreneurs or giving priority on their next venture. Limited Partners could be a source of follow-on capital for companies or corporate relationships that contribute to the sales pipeline. The extended network or compensated part-time partners could highlight risks that prevent a mistake that that non-experts in a particular field would not have foreseen. As a fund comes together, the value of all collaborators must not be underestimated.
Risk focus
For emerging strategies, early performance is critical, and capital allocators may not be forgiving if it is not strong. The success of a platform in the long-term hinges on the first fund(s), which means that risk management must be of the highest level. There are countless risks beyond those outlined above, and it pays off to be aware of and respond prudently to even small issues. Particularly focusing on the importance of incentives, an illiquid strategy that experiences early failure may raise concerns about the manager's motivations once the upside is limited. On the other hand, a liquid strategy that falls well below the high-water mark may face liquidation when the manager's upside is uncertain.
The past year has brought to light various other risks, such as funds lost by custodians and exchanges, detrimental leverage due to market shocks, and undetected fraud by key individuals. Staying informed and learning from the mistakes of others can help prevent these errors from being repeated.
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Next Steps
Most decisions and actions are not binary, and the same is true for the scenarios described above. There are a variety of options available, and the important thing is to consider all relevant factors in the decision-making processes that will come in the start-up of a fund.
Further input from additional capital allocators and fund managers regarding their experiences amidst starting-up investment platforms is always valuable. It is not to be understated the opportunities that arise in this emerging manager space, but also the added risks. The benefits include not only returns but also the potential for early partnerships with exclusive and competitive platforms. However, the downsides extend beyond returns to include potential reputational impacts and additional liabilities. These risks can be mitigated through careful review and education of managers.
Disclaimer: The information provided in this article is for discussion purposes only and should not be considered as investment advice. The content of this article is based on personal opinions, observations, and research, and it is subject to change without notice. Readers are advised to conduct their own due diligence and consult with a qualified financial advisor before making any investment decisions. The author and the publisher of this article are not responsible for any actions taken based on the information presented herein. Investing in financial markets involves risks, and past performance is not indicative of future results.
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