You’d think that one of the least likely consequences of the global economic crisis would be an increase in allocations to emerging managers.
Indeed, as institutional investors reconsider and diversify their allocations, conventional wisdom suggests that they would have reduced their exposure to lesser-known managers. In fact, many pension funds and other institutional investors are actually increasing their allocations to emerging managers because of their superior performance, particularly in down markets. Although emerging managers still raise a very small percentage of total investment dollars, they are becoming increasingly popular with large institutional investors.
Emerging managers, often defined as those with a high percentage of employee ownership, a track record of less than five years, and less than $2 billion to $3 billion under management, are increasingly being recognized for providing higher investment returns than some of the larger, more established firms. Comptrollers’ offices and investment officers who have worked with emerging managers affirm that investing with them provides an opportunity to broaden manager diversification while achieving competitive returns. Contributing to investor satisfaction are the smaller staffs, lower overhead costs, and lower management fees that are often characteristic of emerging managers. In addition, emerging managers tend to be nimble, adjusting quickly to changing market conditions and trends. Moreover, emerging managers frequently contribute a larger percentage of their own capital to the funds they manage, which results in a greater alignment of interests between the manager and its investors.
Several public and private pension funds and asset management firms in recent years have developed programs specifically to target minority and women-owned and other emerging managers that have a track record of superior returns. The California Public Employees’ Retirement System, New York City Employees’ Retirement System and Maryland State Retirement and Pension System, for example, are some of the plans that have developed and implemented innovative emerging manager initiatives.
A number of other pension plans have mandates to allocate small stakes to emerging managers, and some investment firms have established funds that make direct equity investments in and invest primarily or exclusively with emerging managers. In addition, pension plans are engaging emerging managers of managers, such as Progress Investment Management Company and Leading Edge Investment Advisors, to build their emerging manager programs. Several funds-of-funds managers, investment firms, insurance companies and others also are generating opportunities for managers that, although accomplished, are largely undiscovered, underutilized or undercapitalized. Emerging manager incubators also provide capital and technical assistance to advance the development of promising firms. Programs that provide back-office support, marketing training, and assistance with product development, compliance and investor relations have been instrumental in creating best-of-breed managers. Similar initiatives are in place for emerging broker-dealers.
To populate emerging manager programs, investment talent is sometimes identified through databases that are repositories for a comprehensive body of information on emerging firms. Altura Capital Group, together with a team of large institutional investors, has developed an information and research platform to provide subscribers unprecedented access to a wide array of information regarding emerging managers. CalPERS, the Office of the Comptroller of the City of New York, California State Teachers’ Retirement System and the Illinois State Board of Investments were among the founding subscribers to that database. The increased focus on emerging managers is a trend that existed before the economic crisis, and appears to be continuing into 2010. But will regulatory reforms proposed by Congress, state legislatures and regulators reduce the number of emerging managers that are able to compete effectively in the marketplace, notwithstanding these innovative programs and initiatives?
Because action is pending on a number of measures proposed by Congress and the Securities and Exchange Commission, it is difficult to know which regulatory reforms will be enacted and whether any of those regulatory changes will adversely affect positive trends for emerging managers.
For example, the Private Fund Investment Advisers Registration Act of 2009, which was approved by the House Financial Services Committee in October 2009, is one such proposal that could make life more difficult for emerging managers. If passed in its present form, the legislation would require domestic advisers to private funds with more than $150 million of assets under management to register with the SEC and comply with the substantive provisions of the Investment Advisers Act of 1940. Advisers would be responsible for establishing and maintaining compliance policies and procedures and a code of ethics, maintaining prescribed records, filing mandated reports and undergoing SEC examinations. Although advisers to venture capital funds would be exempt from registration, they would be required to comply with recordkeeping and reporting requirements. Currently, as a general rule, advisers to private funds are exempt from the mandates contemplated by the 1940 Act. Compliance would require a significant investment of time, money and human capital, which may have the effect of widening the competitive advantage of larger, more established fund managers that have the infrastructure in place to comply with the proposed requirements.
Rules intended to eliminate pay-to-play practices with government officials also may create competitive disadvantages for emerging managers. Those rules, among other things, would prohibit advisers from paying or agreeing to pay finders, placement agents and other third-parties to solicit government entities for advisory services. The SEC also has proposed such a ban, although it has been reported that in final rulemaking an exception may be made for broker-dealers that are registered with the SEC and that act as legitimate placement agents, if the Financial Industry Regulatory Authority develops and implements rules that would prohibit pay-to-play practices. A few states, such as New York and New Mexico, have passed legislation banning future investments with money managers that pay third-party placement agents to market their funds. Other jurisdictions that have not banned the use of placement agents have regulated their use in a variety of other ways.
Instituting a complete ban on third-party placement agents may not affect all emerging managers equally. Managers that have already established relationships with pension funds or otherwise have access to institutional investors may be successful in attracting investors without placement agents. Moreover, some managers may be able to form affiliated broker-dealers in order to take advantage of provisions such as those in the proposed SEC rule and the law in New Mexico that permit certain persons affiliated with an adviser to solicit a government entity on its behalf. However, a ban on third-party placement agents may create a significant disadvantage for emerging managers that have not cultivated relationships with pension plans, other institutional investors or firms willing to assist with introductions to government entities and other well-heeled investors. In addition, for many emerging managers, forming an affiliated broker-dealer may not be a viable alternative. Attracting investors may become increasingly difficult for those managers, absent measures designed to provide wider access to institutional investors.
Opportunities Outweigh Challenges
Several important initiatives are working to broaden opportunities for emerging managers. By providing capital, infrastructure and other resources, those initiatives help to position emerging managers to excel in the marketplace and navigate regulatory challenges more effectively. Institutional investors have begun to assess more closely the strength of managers’ regulatory and legal compliance programs, as a part of the overall manager evaluation process. Emerging managers that are successful in (i) increasing their transparency by providing meaningful disclosure to investors and prospective investors, (ii) documenting, adopting and implementing compliance policies and procedures that are business-specific and reasonably designed to prevent, detect and correct violations of applicable laws, (iii) adopting a code of ethics and allocation and other policies that address conflicts of interest, (iv) developing appropriate governance standards, accounting, recordkeeping, reporting and valuation policies, and custody arrangements will meet many of the standards required by institutional investors. By taking proactive steps to implement strong legal and regulatory compliance programs, emerging managers with superior investment performance may further increase their opportunities to manage the assets of institutional investors. Those opportunities may outweigh the challenges that may arise in connection with regulatory or legislative changes or efforts to implement best practices.
Kimberly Mann is a partner at Pillsbury Winthrop Shaw Pittman whose practice is concentrated in the area of corporate and securities law, and the leader of Firm’s Private Equity Practice Team.