Making Sense of Investing in Emerging Managers & Understanding Their Challenges

Thoughtware Article Published: Oct 23, 2019
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Emerging managers are money managers starting a new fund. These managers often have a wealth of talent, are mission driven and may be breaking away from a large institution. Although they’re starting up and may be small, they’re commonly known for being eager, nimble and innovative.

Many of these managers have gained considerable experience managing large accounts at big financial institutions, but many times they tire of the limitations and bureaucracy of large institutional structures. By their nature, large institutions must operate under prestructured operational complexity due to a stringent regulatory environment. This can create challenges for operating nimbly when market inefficiencies or innovative ideas are identified.

According to Preqin, emerging managers that have been trading for less than three years had average returns of 12.2 percent, whereas the hedge fund industry was averaging returns of 7.7 percent. Conventional wisdom is that emerging managers often outperform larger funds because they begin with managing their own money and have skin in the game. Emerging managers are commonly known to be operationally flexible, acutely aware of changing market conditions and better able to adapt quickly.

These managers usually have a high degree of operational ownership, beginning from the general partner, portfolio managers and employees. The young managers are under significant pressure to generate alphas while hedging against negative market conditions. They operate like true hedge funds as opposed to long-only strategists, a trait that helps investors perceive value when paying their manager fees.

Key to an emerging manager’s success is the ability to raise capital. Many emerging managers are good at running their strategies but don’t have the experience, time or patience for running a business. Fundraising has become more difficult since the 2008 financial crisis. Emerging managers often start with their own money, sometimes supplemented by family and friends. But to really grow, they need to fundraise—a task that wasn’t typically part of their duties at a larger platform.

In capital raising, fund managers need to follow a blueprint or framework that will work. Here are some pointers to keep in mind that may help improve success:

  1. Highlight prior experience
  2. Reach out to prior clients
  3. Find a seed or founding investor
  4. Have a thoughtful marketing strategy
  5. Build an operational infrastructure
  6. Have a clear pitch book
  7. Have a good strategy for targeting investors
  8. Have an innovative fee structure
  9. Present a track record

Building and presenting the manager’s résumé is extremely important because it helps create trust with potential investors. Managers should outline prior experience, which institutions they’ve worked for, the strategy they’ve managed and their differentiating factors. The résumé, which can be part of the pitch book, should clearly and succinctly outline how they’ve generated alphas and managed risk. Investors will want to know how much money was managed, which class of investors was catered, how the manager’s strategy hedged against market downturns and the corresponding performance track record. The résumé should illustrate how the manager’s institutional expertise translates to the emerging fund experience for the investor.

Don’t forget the manager’s previous clients may follow the manager to the emerging fund. It’s hard work, but the manager should be focused on building relationships by talking to influencers without the pressure of generating capital. The process will help the manager target seed capitalists or founding investors. It also can help managers find other target investors such as financial institutions, high-net-worth individuals and family offices. More experienced managers also may seek out foreign money. As managers meet with these potential investors, they should make notes of their individual likes and processes, including goals, allocation history, decision makers, risk/return profile, allocation time and the amount of potential capital allocation. These data points will help match the manager’s profile to the investor profile. In addition, they can help the manager adjust the business and investment strategy to match the potential investor’s needs and outlook.

A manager should build an operational infrastructure, including client relationships, trading platforms, compliance and middle- and back-office functions. The manager must select its third-party service providers and in-house functions, such as the marketing and client relationship management, prime broker(s), banker and administrator. Another key resource is the audit and tax service providers, which should meet the needs of the fund today and as it grows. During early stages of fund formation, the general partner and the key portfolio managers should be key parts of the capital hunting and investor relationship-building exercise.

Some of the steps outlined above may help the emerging manager build stronger client relationships and trust, which is the building block for capital generation. The manager shouldn’t push its strategy onto the client. Instead, the manager should try to walk through the strategy and business with the potential investor as an idea—one that can incorporate the investor’s needs and feedback. The manager should integrate the investor’s outlook and requirements into its offerings using the homework it has done to understand the client’s goals and needs. As conversations with the investor progress, the manager should get to know other decision makers or influencers the investor relies on. Many times these influencers’ approval can be key to winning an allocation.

The emerging manager must have a clear, easy-to-understand pitching deck that highlights the following:

  • People behind the operation and strategy and their résumés
  • How the portfolio will be built
  • Investment criteria and due diligence
  • Risk management strategy and process
  • Strategy or fund’s track record
  • The fund’s unique differentiators
  • Expected assets under management (AUM)
  • Effect on returns and risk as AUM grows
  • Supporting infrastructure and service providers
  • Fee structure and its effect on returns

A good pitching deck shouldn’t be long and cumbersome. Remember, it’s more of an art than a science. Make sure your pitching deck is tailorable so you can address each investor’s specific concerns. This is the manager’s opportunity to drive home the message to the investor within the limited time the team has. Consider tailoring the pitching deck based on the investor’s profile.

It’s important to picturize the performance track record in a meaningful way that tells a complete story. Don’t be afraid to share downturns and upsides. Explain the assumptions, risk containment triggers and their impact during challenging times. The longer the duration of performance history, the more effective it will be. Show returns, both gross and net of fees. This will show the hard work that was put into earning the fees. Talk through the portfolio selection, investment and divestment process. Expected risk in the portfolio, and how it will be monitored and measured, is very important to many investors. The manager’s presentation should keep an investor’s expectations and needs in mind.

Fee discussions should never be the leading topic during investor conversations, but they’re an important part of the discussion. Some emerging fund managers offer significantly reduced fees, while others have more creative structures. One shouldn’t cut fees to a point where it’s difficult to survive and meet overhead costs. During initial periods, a manager may have only management fee income to meet its expenses. The stronger the case the manager makes, the better fee negotiations will proceed. Here are some innovative fee ideas used by some emerging managers:

  • Outline the expected standard fees
  • Show how the manager fees scale up as AUM increases
  • Make a case for the management fee with expenses that are incurred
  • Categorize expenses the fund will pay and those the manager will pay
  • Increase the period for measurement for performance fees (two or three years versus annually)
  • Use private equity-type hurdle rates for performance—over multiple years or the life of the fund with clawbacks
  • Include a sunset clause to limit the extent of clawbacks—hedge funds are different from private equities
  • Limit the side letter fee arrangements

A seed investor is an initial investor who brings in initial capital and is offered equity in the investment manager or general partner. They’re able to negotiate significant initial discounts to the fee as a favor for the provided capital and its lockup. However, emerging managers should ensure that seed investor participation sunset clauses are in place so as additional capital flows in, the seed investor’s fee discounts and equity participation are phased out.

Founding investors are investors who don’t typically take interest in the investment manager or general partner but are able to get significant initial discounts on fees. Again, the manager should ensure appropriate sunset clauses are used to manage or keep intact manager’s long-term interest in the business.

Emerging managers are often the source for innovation in the investment industry and dynamic capital markets. Even some of the most established institutional investors recognize that emerging managers are vital for developing and retaining talent in the industry. Some of the leading pension funds in the country have set mandates to asset allocation for emerging managers. Using emerging managers can give allocators additional scale and diversity, as well as access to innovative alphas. This also may enable allocators to obtain exposure to diversified industry strategies that are undiscovered by institutional investors.

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