Institutional investors with allocations to private equity are becoming more interested in finding emerging managers to handle parts of their investment programs. (Callan defines an emerging manager as a firm raising its first, second, or third institutional fund, with a fund size between $50 million and $1 billion.) As a result, we are seeing more private equity emerging managers begin to offer products to meet this demand.

In this blog post I wanted to lay out some recommendations for emerging managers that seek to receive institutional allocations for private equity investments, and how they can best position their firms to achieve this goal.

Starting an investment management firm is difficult, but the recipe for success is straightforward. Running a business requires a different skill set than sourcing deals, so a founder’s ability to create a cohesive team and a sustainable platform is critical. Teams with managerial/operational experience that previously worked together tend to develop faster, we find. Typically, these firms are better at institutionalizing the firm’s back office and creating written policies and procedures (e.g., valuation, ESG, code of ethics, compliance). Failure to develop professional infrastructure can lead to a dysfunctional back office and a significant distraction for a new management team.

A well-designed strategic growth plan for the firm, including details on future hiring, can help build credibility. Prospective investors must be confident that the management team can create an institutional, scalable platform before considering an investment.

Finally, it is imperative that the manager has the ability to raise capital. Fundraising starts with developing a marketing strategy and related materials that clearly and concisely articulate the firm’s investment strategy. Some new managers do not take the time to develop that strategy. And too many that get the chance to win new business fail to practice their marketing presentation before pitching prospective limited partners (LPs) and fumble their way through the presentation, failing to connect with the LP.

In evaluating investment managers for our clients (emerging or otherwise), we pay attention to a handful of critical areas. We primarily assess qualitative factors when working with a new private equity firm. We spend significant time getting to know the team, seeking those with the requisite operational and investment banking skills, supported by a successful and verifiable track record. Depending on the asset class, new teams typically have 5-10 years of institutional asset management experience executing a strategy similar to the one they intend to deploy with the new firm.

We also typically run a quantitative attribution analysis of the team’s track record, verifying cash flows and performance. In reviewing a team’s track record, we place significant emphasis on analyzing the individuals who sourced the transactions, as the ability to generate deal flow is critical for the team’s success.

Additionally, the distribution of ownership and sharing of economics are essential factors in our review. If economics are concentrated within the senior team, this can lead to staff turnover among the middle and junior investment professionals. Appropriate economic incentives for investment and operations professionals reduce the risk of losing talented staff and can help to create a sustainable culture.

Tips for Aspiring Private Equity Emerging Managers

For emerging managers seeking to target areas of opportunity, the focus of our institutional investor clients is on buyout and early-stage venture capital (VC) strategies. The recent sell-off in late-stage VC and growth equity has made some clients apprehensive about those strategies. Additionally, some successful small- and middle-market private equity firms have increased the size of their funds and are investing in larger transactions. Thus, they are leaving the market segment where the firm had been successful. When firms move into larger markets, it can leave a void at the lower end of the market, which a new entrant can fill. Emerging managers in small and middle markets that possess the above attributes are appealing.

In advising clients that want to start an emerging manager program, we believe that the process begins by clearly defining “emerging” and establishing the program’s goals. Institutions define emerging managers differently based on their goals. The most common goal for an emerging manager program is developing a “farm team” of top-performing managers, as building a relationship with a new firm early in its life cycle can be beneficial. Funds of successful managers are usually oversubscribed, and when finalizing allocations to LPs, managers tend to favor organizations that previously supported them. Also, some public defined benefit (DB) plans place a special emphasis on identifying emerging managers that have diverse ownership. Other goals might include funding managers within their home state or focusing on underserved markets or community development.

Support from senior management is also critical for a successful emerging manager program. The senior team must commit the necessary financial and personnel resources to the program.

It can be challenging for an emerging manager to get noticed in today’s market due to the large number of firms raising capital. It can be equally challenging for a new firm to distinguish itself from another emerging manager. New managers must work to establish credibility with consultants and prospective LPs. Many large DB plans and consultants have established emerging manager programs that enable new managers to interact directly with their investment teams, such as Callan Connects, which is a program to engage diverse and emerging managers.