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Editor’s Letter: Emerging managers: the canary in the coal mine?

There has been a ton of spinout activity over the past few years, more than some industry veterans have seen since the halcyon days of the market peak.

At that time, sources told me, every investment professional with an inkling of talent was at least considering making a moving and starting his or her own shop. The prospect of engaging full-time in your preferred strategy, and snagging some of that 2 and 20 economic share was just too tempting, as it is now.

That’s the problem with an environment like today, or back in 2007, with so much money floating around, and institutional investors desperate to put capital to work in strategies that may actually produce meaningful returns. Investors risk becoming less careful than they might be when markets are struggling. It’s a setup for a great fall a few years down the line.

“Emerging managers are the canary in the coal mine,” a source told me.

I asked what that meant. The last time the market supported this level of activity around formation of new firms was the market peak in 2007, before the whole edifice collapsed, the source said.

The strength of the private equity fundraising market motivates investment professionals to leave the relative safety of their more established organizations and start their own ventures. Once markets correct, this type of activity dries up as execs choose security over risk.

(There’s a larger conversation there about whether security really exists anywhere, large organization or no, but we’ll save that for later.)

Data backs up the idea that first-time fundraising activity has picked up. Preqin shows that in 2007, generally considered the year of the market peak, 291 first-time funds globally raised $43.3 billion, followed by $41.9 billion raised by 299 first-timers in 2008. That dropped to a low of $19.2 raised across 235 first-time funds in 2010, and has been steadily climbing since.

Curiously, the peak year for first-time fundraising was 2011, when 267 first-time funds raised $45.2 billion. Last year saw $30.4 billion raised across 260 funds, and so far this year, 170 first-time funds raised $30.2 billion.

The average size of first-time funds has dropped since the $202 million recorded in 2011. Last year, the average first-time fund size was $144 million, and this year that jumped to $196 million.

But who actually makes it through the great test of private equity fundraising? This really is a rite of passage, a challenge that is supposed to weed out the unworthy, leaving only the strongest contenders still standing.

The shops we’re seeing have success spinning out and raising first-time funds are those that have established track records, either at their prior shops or by investing deal-by-deal for a few years. Many of these first-time firms had relationships with investors that helped fund their first few deals as independent managers. Some even found anchor investors to back their first fund.

It’s really all about having a name, and having a track record you’re proud of. If LPs know who you are (for all the right reasons), you’re already well-positioned to bring them on board.

Private Equity Editor Chris Witkowsky reflects at home. Photo by Wendy Witkowsky