How will due diligence moving to a more digital format impact emerging managers?
For many years now, LP capital has increasingly been flowing to large, well-known names in the private equity space. This trend of concentrating capital is the result of many LPs allocating increasing amounts to the asset class, with big ticket LPs seeking to forge stronger relationships with fewer fund managers. These managers have also done well for their investors on the whole.
“We’ve seen some larger players be very successful,” says Merrick McKay, Head of Europe – Private Equity at abrdn. “They have had a following wind – if you haven’t been generating strong private equity returns over the past five years, something has gone horribly wrong. We do also see a great deal of herd mentality among LPs that is partly behind successful larger funds getting larger.”
As with so many trends, COVID has accelerated the expansion of larger funds still further. The first half of 2021, for example, saw a record $513bn raised by private equity funds worldwide, according to Preqin. Of this, 67% went to funds raising US$1bn or more, including 47% to managers seeking in excess of US$2.5bn.
It’s clear that LPs have continued to commit to managers through the pandemic, but much of their capital has landed in well-known names, largely through re-ups.
And even where LPs have been considering new strategies, their capital over the past 18 months has typically gone to existing GPs adding new products, as opposed to newer or emerging GPs. “There has been a definite bifurcation in the market,” says David Shäfer, Managing Director, Munich Private Equity Partners. “LPs have picked existing relationships in uncertain times.”
“There has been a flight to quality,” agrees Uwe Fleischhauer, Founding Partner and Managing Director of YIELCO Investments. “That means LPs have been sticking to established GPs and that has driven fund managers to extend their offerings beyond their core strategies in areas such as energy transition, impact and the mid-market.”
All this means that competition across the board has made it that much harder for newer managers to emerge over recent times. “Larger managers have become very good at coming up with strategies that are aligned with what they do, but at a smaller deal size,” says McKay. “They can use their scale and core skill set across multiple strategies and that can allow them to compete with and, in some cases, be better than smaller generalist managers.”
The considerable shortening of fundraising cycles over the past few years has only compounded this because it has made the LP commitment calendar busier than ever. “It has been a real challenge for many investors to keep up to speed with re-ups and faster fundraising timelines, along with less access to fund managers as a result of the pandemic,” says Dominic Abt, Executive Director, LGT Capital Partners.
So what does all this mean for newer and emerging managers? There have clearly been some significant first-time fundraisings over the past year or so, including: Trill Impact, a new firm founded by former EQT executive Jan Ståhlberg, which raised €900m for its inaugural fund; Avesi Partners, which reached an US$875m close on its maiden fund; and Seaside Equity Partners, which closed on US$160m. Yet many of these firms are managed by executives that many LPs already know well, and that has allowed them to circumvent the fact that they haven’t been able to travel to meet the GPs in person.
For many others, however, the pandemic has proved challenging. Very few LPs have committed to managers they have not met in person at some point. “The flight to familiarity we saw in 2020 is still playing out to some extent,” says an executive at a fund of funds manager. “Some firms put fundraising on pause as LPs figured out how to navigate virtual due diligence processes.”
Yet the move to more virtual due diligence processes over the longer term may well help emerging managers. “The greater efficiency of moving at least part of the due diligence process to virtual means that we can evaluate more opportunities today and meet, or have contact with, groups we couldn’t previously,” says the executive. “That means emerging managers may be more able to get a meeting with LPs, even if it’s not face to face at first.”
Marc der Kinderen, Managing Partner at 747 Capital agrees. “I love virtual due diligence because it allows us to filter opportunities down to, say, the top ten or 20 managers that you can then meet in person,” he says. “It’s very efficient for triage.”
However, this does mean that emerging managers will need to hone their message to suit a shorter, virtual format, while also offering regular updates. “If we’re doing more interim meetings virtually, we won’t be spending entire afternoons with teams,” says the fund of funds executive. “That means the pitch has to be really to the point. Emerging managers also need to provide frequent, transparent information, as this helps build trust and engagement with LPs as a basis for relationships until the point where you can meet and close the investment.”
“Emerging managers need to remember that fund commitments are illiquid, blind pool investments that are locked up,” adds Brian DeFee, Director, Top Tier Capital Partners. “Trust is ultimately what this boils down to. Fundraising will take longer and feel far less efficient than running a deal, but you need to build trust.”
As due diligence processes bed down and some travel resumes, emerging managers should also benefit from the increasing numbers of LPs that now actively seek out GP talent. “We see emerging managers as additive to our portfolio of established managers,” says Joana Castro, Principal at Unigestion. “They are hungry and offer strong alignment, attractive terms and returns, and we can tap into niche strategies that we are unlikely to find in established and typically larger funds.”
There are also some investors that specialise in funding smaller and emerging managers, such as 747 Capital. For der Kinderen, there are obvious advantages in backing newer talent. “One of the things we appreciate most about emerging managers is that they don’t have a legacy portfolio,” he says. “If you invest in Fund V, there will still even be assets in Fund I, which means attention has to be directed there. That’s far less the case when you’re investing in Fund I or II – you’re not backing managers with 25 or so portfolio companies to look after.”
Indeed, there are increasing numbers of LPs that want to actively support the development and growth of new managers. Some support deal-by-deal structures in the first instance or they might commit to short-duration funds to help emerging teams strengthen their track record. LPs can also support emerging managers in other ways. “Emerging managers often need assistance and resources,” says Sven Czermin, Director at Palladio Partners. “They are often just five to ten people who want to do investments; they may not be so good at fundraising or fund governance. We can help them with these aspects – we can be on the LPAC and support them to institutionalise their processes. We provide a small commitment and invest time and resources at an early stage so that we can grow together.”
It’s clear that large players are only going to get larger as they increase fund sizes and launch new strategies. Yet there is also increasingly a space in LP portfolios for emerging managers as investors seek greater diversification, more finely tuned exposures and the chance to build relationships from the ground up. And while virtual due diligence processes may have stalled some fundraising efforts over the past 18 months, they may well work to less well established managers’ advantage over the long-run.
We see emerging managers as additive to our portfolio of established managers
