Two years ago at this time, emerging managers seemed to have survived the challenges brought on by the pandemic and were finally poised to pick up where they had left off prior to the global shutdown. LPs were eager to make commitments to new managers, new entrants were coming into PE every day, and the fundraising market was robust. It has been a very different story, however, in the time since. Significant and seemingly constant winds of change, led by the SEC’s new rules for private funds approved in August 2023, have made an already difficult fundraising terrain that much more challenging for smaller and emerging managers. Investors tend to be less willing to allocate to newer managers in uncertain times, and the pressures emerging managers are facing is reflected in this year’s survey results from both LPs and GPs, who clearly see the universe of private capital fundraising transforming right before their very eyes.
Views on allocations and fundraising
Investors continue to make adjustments to their private market portfolios, with many still taking a more conservative approach to capital allocations and not establishing new relationships. This is being driven in part by both a slowdown in the velocity of capital flow and the ongoing trend of larger firms raising more and more of that available capital. With established firms coming back to market sooner and raising increasingly larger funds, re-ups are absorbing much of the bandwidth of investors. This is making it difficult for emerging managers not only to get their fair portion of the annual capital allocation pie but to even get in front of investors. Investor allocations a year ago were stretched thin, but more than three-quarters of respondents (76%) continue to report that they have formal PE allocation programs. Investors have capitalized so far in 2023 on favorable buying conditions, enough so that the survey revealed an uptick in LPs’ average annual PE/VC target allocations from 47% of their portfolios in 2022 to 50% in 2023.
Fundraising across the board is becoming more challenging, again compounded by the ramifications of the new SEC rules, and this is especially true for emerging managers. However, LPs are still deploying capital and in 2023, progress was made in terms of the length of time it takes to close on a commitment from start to finish. In 2022, 65% of LPs reported that it took anywhere from one to four months from the date of first introduction to signed commitment; this grew significantly to 79% in the 2023 results. At the same time, the expectation of longer closing times fell as only 3% of LPs reported closing periods of 12 months or more, compared to 21% in the prior survey. The most common period, by far, continued to be five to nine months (57%).
The good news is that many investors are confident their allocations for new commitments to emerging managers will remain steady, but with a decline from 66% to 58% of respondents. The data also clearly shows that LPs are seeking to expand their emerging manager positions to drive more diversity through this segment of their portfolios. Those LPs reporting that they hold 0-5 emerging managers fell from 61% in 2023 to 39%, while those with 16 or greater more than doubled year over year.
The bar, as always, is set high
LPs are continuously looking to add new managers and want to invest with newly formed firms with genuine differentiation. Anecdotally, many believe GPs are “hungriest” to perform for funds with Roman Numerals one through three. At the same time, they recognize the challenges emerging managers face, particularly, to not only source investments and create value but to stand up a back and middle office to meet their LPs’ rigorous reporting and compliance demands. So, while there is still space for new players seeking capital, the bar is always set high.
A large majority of investors – 80% compared to just over two-thirds in 2022 cited superior returns and portfolio diversification as the primary reasons for their emerging manager programs, and 92% — up from 79% in 2022 – said they are still most likely to invest in an emerging manager formed by a team spun out from a larger firm. At the same time, LPs continue to put increased pressure on emerging managers when negotiating terms. In particular, the number of LPs requesting access to co-investment opportunities grew from 45% to 60%, while LPAC participation was another common request, jumping from 63% to 72%.
Whether this is the right approach to position fledgling fund managers to thrive – because they’re certainly not reducing their reporting demands – it underscores the pressures facing new managers. In this more risk-averse environment, which seems as if it’s here to stay, it is even more important that emerging managers partner with the right service providers so they can focus on the mission-critical tasks of raising, investing, and growing capital without taking on the back- and middle-office responsibilities that might otherwise create a distraction.
Increased demand for real-time access to accurate, timely information
Given the significant levels of capital invested in the alternative investment space and a larger addressable market of investors, automation, accuracy, and transparency have never been more critical. In fact, the newly approved SEC rules for private funds – the most significant industry reforms in nearly 15 years – are aimed directly at increasing transparency for all investors.
In the private markets, implementing technology is a requirement to handle not only the increasing volume of investors but the growing complexity of the fund structures. Increased competition for emerging managers is driving next-generation technology to fill a critical role in the fund administration process for emerging managers.
Not only are LPs in the driver’s seat when it comes to capital raising and negotiating terms, but they are also driving trends in fund operations. This is especially true around new technology, which is fast becoming table stakes to facilitate improved onboarding through electronic subscription documents, bespoke and more frequent reporting, and more depth and transparency around performance and attribution reporting as well as portfolio monitoring.
Technology is changing how GPs onboard investors by digitizing the fund subscription process from a labor-intensive, error-prone paper process to an automated, digitized subscription process that is more accurate, reliable and customizable. Utilizing electronic subscription documents not only improves the LP experience, but it also gives fund managers immediate visibility into investor activity and fundraising analytics. This visibility is critical in an environment where the competition for capital is heightened.
As the asset class matures, there will be a sea change in reporting frequency, particularly to the extent managers welcome HNW and accredited retail investors. Historically, reporting is done on a quarterly basis. However, some LPs are starting to ask for more frequent reporting, seeking the same access to information that they have for their public market investments. The adoption of technology will likely be required to accommodate the acceleration in the timeliness and accuracy of information LPs are requesting.
Private equity sponsors are also embracing technology around portfolio monitoring. They’re leveraging data and analytics for real-time insight into how they’re generating returns and using these capabilities to optimize decision making. With the growth in private equity as an asset class, we are seeing much more demand for data and precision in analytics as sponsors realize that their data is a potential source of differentiation.
In today’s investing climate especially, LPs want to know that the GP they’re investing in works with a reliable operations partner. Specialist fund administrators like Gen II play a key role in helping emerging managers become stronger operationally, which in turn makes them more institutionally investable.
In terms of data capabilities, Gen II’s tools give sponsors “corner office” analytics and insights into their portfolios and a performance analytics platform that offers both a 30,000-foot view of their enterprise or fund as well as granular details at the investment level. These capabilities through Gen II allow emerging managers to offer best-in-class bespoke reporting for LPs that are increasingly demanding transparency, custom reporting requirements, and real-time access to details of their investments, performance attribution, management/performance fees paid, etc.
At Gen II, we believe that investing in technology and investing in people go hand in hand. We look for a balance and try to invest in technology in areas where we can scale, reduce cycle times and improve quality, but also maintain capabilities to ensure that we can administer and manage these complex structures or even enhance the “operational” alpha embedded within them.
Working with the right partner is key
Scalability, performance, and experience truly matter, and the majority of emerging managers start their life with an administrator relationship. Given the increased complexity of fund structures, escalating stakeholder expectations, and complex regulatory requirements, it is vital that emerging managers team up with a provider that can demonstrate relevant and specialized experience. Equally important considering the long-term nature of these relationships, is a commitment to technology investment, team continuity, and the ability to scale with clients.
Gen II has helped launch more emerging managers than anyone else in our industry. In the process, we have partnered with each of them to build strong foundations for success, and helped them scale as they added new funds, LP types, geographies, and even alternative strategies – from every flavor of PE to private debt and real assets. The private equity entrepreneurs we work with value the confidence our experience imparts, and they can trust their funds will be well-run.
For the remainder of 2023 and beyond, the survey reflects that while capital raising for emerging managers will continue to be challenging there will be opportunities for continued growth over the long term. However, lower capital allocations, economic uncertainty and hesitation to take on greater risk, are causing LPs to diversify their existing emerging manager positions and be more selective in the overall manager evaluation process. A highly qualified set of professional service firms – fund administrators, auditors, placement agents, compliance consultants and attorneys – with deep experience supporting first-time funds will continue to be vital to the emerging manager’s success.