By Olivier Keller – PineBridge Investments: The private capital universe has matured significantly over the past two decades. According to PitchBook, private market funds raised US$1.2 trillion globally in 2022. While down somewhat from a record year in 2021, it nonetheless marks an increase of nearly 130% from 2012 levels and nearly 50% over pre-global financial crisis years (2007). The average fund size grew substantially over the past decade as many existing managers raised significantly larger pools on the back of institutional investors’ increasing allocations to illiquid alternative markets. New groups emerged to cover the lower market segments abandoned by those firms, while the number of sub-strategies and specialization areas grew. Areas such as emerging market private equity (PE), growth capital, and private debt or infrastructure grew more prominent, allowing investors ever more nuanced ways to fine-tune their alternatives allocations.
The private capital universe has matured significantly over the past two decades.
This maturity process has influenced today’s market for emerging managers in several ways. On the one hand, a whole generation of investment professionals have built up significant experience across market cycles and now feel ready to branch out on their own. On the other, the growing number of seasoned general partners makes it easier for investors to stick to their existing managers rather than adding new names to their rosters. If limited partners choose to enter new relationships, it is still easier to do that with established managers than with newly formed general partners. In 2021, capital collected by private capital first-time managers accounted for a mere 6% of the total fundraising volume. This share has declined steadily for much of the past decade.
In absolute terms, some segments of the first-time fund markets still seem to be expanding. Developed market private equity managers (in North America and Western Europe) collected a total of US$27 billion across 131 first-time funds in 2022. However, these numbers include new fund lines raised by existing platforms. These tend to enjoy significant advantages over newly formed firms, such as the ability to leverage existing infrastructure and cross-sell to the LP base of their other products.
For investors, emerging managers can present a challenge. Due diligence is often more demanding than with established firms…
For investors, emerging managers can present a challenge. Due diligence is often more demanding than with established firms in areas such as historical performance, team cohesion and firm culture, or deal sourcing capabilities. The majority of spin-out teams do not receive track record attribution from their prior firms, requiring a significant amount of work by LPs to confirm the principals’ track records. In many cases, the partners of a new firm have a limited history of working together, which can raise concerns about team chemistry and personality fit. On the execution side, questions may arise as to whether company owners are willing to transact with new outfits without a demonstrable independent history. These considerations may cause many institutional investors to shy away from emerging managers entirely, particularly in a market where an increasing number of limited partners are looking to reduce their overall number of general partner relationships.
One potential path to overcoming these fundraising obstacles involves the sale of a minority stake in the new GP to an anchor investor in exchange for a significant commitment to the initial (and often following) fund generation. Such a transaction can serve as a catalyst to accelerate fundraising, and the prospect of bringing on board a strong financial partner may be compelling. At the same time, many new groups are reluctant to sacrifice a portion of their independence and future economics out of the gate. However, emerging managers are becoming increasingly creative with ways to attract high-profile investors to their funds.
Despite these fundraising challenges, there are many potential motivations for seasoned yet hungry investment professionals to start their own endeavours. While lucrative financial prospects and the hope of one day taking over the reins may incentivize many junior partners to stay with established players, professionals with a strong entrepreneurial spirit may feel compelled to take full control of their fate. From a strategic perspective, many professionals spinning out of rapidly growing GPs cite a wish to return to a lower segment of the market, allowing for more direct sourcing and interaction with founders and managers. Others see opportunities in specific market segments, sectors, or transaction types. A further source of motivation is the prospect of working with a group of like-minded peers, either from the same employer or leveraging relationships fostered through interactions across firms over the years. In many cases, these new teams seek to replicate success factors from their prior employers while implementing lessons learned in softer areas, such as decision-making processes, communication, or ensuring equitable economics among team members.
The entrepreneurial risk that founders of a new GP assume is often considerable. Significant upfront investments are required before there is any visibility on revenues. Infrastructure must be built up, and service providers such as law firms, administrators, auditors, and often placement agents need to be retained to establish the GP and the fund. While teams will typically enhance staffing after an inaugural fund’s first close, some initial hires on the investment and administration side are a requirement for successful marketing. Beyond these outlays, investors often expect emerging managers to tie up a significant portion of their net wealth via a GP commitment to their initial funds.
Investors often expect emerging managers to tie up a significant portion of their net wealth via a GP commitment to their initial funds. This implies a make-or-break proposition for the outcome of a first-time fund.
This implies a make-or-break proposition for the outcome of a first-time fund. To raise the initial capital, partners tend to rely on track records generated at their prior firms. However, if a Fund I portfolio does not perform well, investors are unlikely to rate the manager on their broader history again. While dealing with this added pressure may be a challenge, emerging managers typically do not have a legacy portfolio to manage, allowing them to fully focus on the fund at hand while simultaneously developing the team.
For many ambitious private equity professionals, launching their own firm will remain an attractive proposition. However, they will need to prepare for significant headwinds in the current fundraising market – and achieving a meaningful first close presents a particularly daunting hurdle. Skill, creativity and resilience will determine how many new GPs will further enrich the universe of addressable opportunities for private equity fund investors over the coming years.
Disclosures
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