The compelling argument for emerging managers

By Jon Finger, Tom Zahn and Abdul-Rahman Lediju, McGuireWoods

McGuireWoods recently held its Emerging Manager Conference at The Ritz-Carlton in Dallas, attracting over 725 emerging managers and limited partners with various investment strategies. This two-day event is the centerpiece of the McGuireWoods Emerging Manager Program. Below are some key takeaways:

Emerging managers: the place to be
Emerging managers offer investors a compelling investment opportunity in today’s environment, outperforming many other private investment segments. The attractiveness of the mid-market and lower-mid-market, compared with larger private equity or public markets, as well as the alignment between emerging managers and limited partners were highlighted at the event. Attendees suggested that LP’s have flexibility to accommodate investing in successor funds as well as pre-fund / independent sponsor deals with emerging managers.  This dual mandate for LP’s requires a team with various competencies (e.g. GP-side; direct investing; allocating to established managers as well as emerging managers).

Great investor, great emerging manager?
Many emerging managers who were on Fund II and Fund III commented that being a great investor is not enough to have success and durability as a fund manager. Many of the fundamentals to being a fund manager – such as the ability to raise a sizable amount of capital from institutions, crafting a sophisticated business plan to support and encourage the strength and partnership of the team, and managing a larger group of people – are required for success, each of which extends beyond being a successful investor.

Don’t swim in a sea of sameness
Almost universally, LP’s are recommending emerging managers spend time developing a strategy to be differentiated. One method for standing out is to be a sector specialist. Other LP’s suggested having contrarian themes within fund investment mandates as opposed to following the herd. Regardless, an emerging manager should understand what they are good at, stay disciplined in the focus and not let fund size dictate strategy.

Endowments are increasingly active with emerging managers
Many endowments are revamping their portfolio, some with a bent to emerging managers. It was recommended to engage early with an endowment and be persistent and concise with the pitch. As part of approaching an endowment, make sure to really understand their portfolio and how an emerging manager may fit with the portfolio. An emerging manager should focus the pitch on its strategy and performance versus generic slides or information about the attractiveness of a market segment (i.e. private equity returns).

Be comfortable with rejection and ask for help
Appreciate the reality that so many investor meetings will end without a fund commitment, but if you are professional, embrace feedback and, in the right situations, ask for help, chances for success improve dramatically. The LP network communicates regularly with each other; an investor that turns down an emerging manager can still have a meaningful impact by directly or indirectly introducing an LP that commits to the fund. Placement agents, even without a formal engagement, can serve as an important litmus test for an emerging manager’s prospects and be a great source of valuable insights on the market and potential LP’s. It is important for emerging managers to understand the nuances of LP emerging manager programs as there remains incongruence among allocators when defining an “emerging manager program” – both in terms of an “emerging manager” definition and positioning relative to other investment activities.

Some emerging managers implement an independent sponsor approach to navigate uncertain fundraises
Many emerging managers either were independent sponsors or closed pre-fund deals before raising a committed fund. In light of the current fundraising environment, some emerging managers have decided to close deals as an independent sponsor, either as a short-term solution or instead of raising a new fund. Emerging managers often shift between operating as an independent sponsor and a committed fund manager; this phenomenon is expected to continue.   

Build it before you need it
For independent sponsors or anyone looking to raise their first fund, it is important to prepare the necessary framework as early as practical to ensure a successful fundraise. For independent sponsors, one strategy is to construct an LP base for pre-fund deals that could support an eventual committed fund. Similarly, having a CFO on the team or ready to join the team, as well as other necessary infrastructure in place, such as deal sourcing personnel or processes for an eventual committed fund, demonstrated to LPs commitment and preparation for life as a fund manager.

Consider implementing “super carry”
Within the fund construct, waterfalls have largely remained consistent while other material terms have been more open to variation. There is a perception that emerging managers sometime focus too heavily on “fringe” fund terms, which often undermine other negotiations. It was suggested by multiple LP’s that emerging managers would be well-served to propose a “super carry” structure with high multiple of invested capital hurdles instead of derailing negotiations on other issues.

Jon Finger, partner at McGuireWoods LLP, is co-chair of the firm’s private equity industry team and leader of the emerging manager program. Tom Zahn, partner at McGuireWoods LLP, is chair of the firm’s corporate & private equity department. Abdul-Rahman Lediju is an associate at McGuireWoods LLP.