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Editor’s Letter: LPs want exposure to first-time funds, and performance shows they should

One issue that has haunted emerging managers trying to persuade LPs to open their wallets is: How well do these early funds perform and are they worth the risk?

Preqin has an answer: It reviewed a sample set spanning 13 vintage years from 2000 to 2012, and it found that 2004 was the only year in which non-first-time funds outperformed first-time funds.

The 2012 median net internal rate of return hovered around 24 percent for first-time funds and around 11 to 12 percent for non-first-time funds, the private equity data provider said in a recent report.

This should be good news for LPs looking for an alternative to the more established firms that don’t necessarily need their capital. And many LPs are looking for that alternative: 51 percent of more than 400 institutional investors surveyed in June 2016 will invest, or consider investing, in a first-time private capital fund this year. That is a 12-percentage-point increase from 2013, Preqin said.

As well, 11 percent of LP respondents said they would invest in spinout firms, up from 6 percent in 2013, Preqin said.

“Developing relationships with first-time or spinoff managers may be a pragmatic strategy for less experienced LPs looking to build out their portfolios and foster new GP relationships,” the study said.

“For larger or more established LPs, committing to first-time fund managers can supplement their core portfolio funds with more niche strategies, potentially enhancing portfolio alpha through smaller funds, or establishing long-term relationships with up-and-coming investment talent,” the study said.

First-time funds come in different forms — generally a first-time fund is not going to be run by a team of completely inexperienced managers. It may be a spinout from a larger shop, or it may be an experienced PE veteran teaming up with a partner.

First-time funds, lumped into the larger category of emerging managers, which generally include Funds I, II or III and are sometimes run by women or minorities, have been a hot ticket for a few years. Though in an uncertain environment, some LPs pull back from committing to first-timers or emerging managers in favor of sticking with established names. This has been the more recent state of play around first-time fundraising in the wobbly markets.

Last year, for example, commitments to first-time funds dropped after a few years of strong fundraising. A total of 153 first-time PE funds closed last year, with aggregate capital of $16.7 billion, according to Preqin. That is the lowest number of first-time funds closed since before 2005, the first year Preqin started tracking first-timers.

That slowdown followed an overall reduction in PE fundraising, which last year totaled $303.1 billion across 740 funds. That was down from $333.9 billion across 915 funds in 2014.

Sources say LPs will refocus away from first-timers in uncertain environments, especially when strong-performing managers come back to market. Last year, several managers came back earlier than expected, or introduced new products, taking advantage of the strong fundraising environment.

“We’ve seen a bit of pullback on embracing risk as it relates to a number of different topics, like China, first-time funds and commodities funds,” Alan Pardee, managing partner and co-founder of Mercury Capital Advisors, told Buyouts in a past interview. “First-time funds are harder today than they were in 2014 or 2013.”

All indications point, however, to continued LP interest in at least taking a look at new offerings and establishing relationships with first-time managers, if not going so far as to commit. This is a good sign for young managers, and the industry as a whole, as it’ll be the young unknowns who will help drive the industry forward.

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