The Rising Importance of Emerging Managers & Keys to Their Success
The definition of an emerging manager varies; it could include managers at an early stage of their life cycle, managers raising a first or second institutional fund, or managers whose businesses are minority- or female-owned. Because of the many hurdles to starting their own funds, emerging managers often start small and work their way up. Emerging managers are more motivated and nimble and less organizationally bureaucratic. Therefore, in general, emerging managers consistently outperform industry benchmarks.
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.
Even though some of the leading pension funds in the country have increased mandates for allocations to emerging managers in recent years, emerging managers are still hungry to get attention from the pension funds, institutional investors, and foundations whose allocation of funds allow emerging managers to grow and get recognition. Despite their proven success, these managers work with only a fraction of the assets in the United States.
The key to an emerging manager’s success is the ability to raise capital. Many managers are good at running their investment strategies but don’t have the experience of running a business. It’s hard work, but the manager should be focused on building relationships by talking to influencers without the pressure of day-to-day operations. Emerging managers should choose their service providers carefully, viewing them as an extension of their team. Experienced finance providers should be adept at addressing ever-changing tax, audit, and compliance issues. Considerations for successful capital raise may include:
- 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
The emerging manager must have a clear, easy-to-understand pitch deck that highlights the people behind the operation and strategy and their résumés. The deck typically should provide the following information:
- How the portfolio will be built
- Investment criteria and due diligence
- Risk management strategy and process
- The fund’s unique differentiators
- Expected assets under management (AUM)
- Effect on returns and risk as AUM grows
- Supporting infrastructure and service providers
Part of an emerging manager’s plan should be shaped by tax implications. The main objective for any fund manager is naturally to enhance the investor’s return on investment. But without any proper tax planning, it is almost impossible to achieve this objective. An efficient tax structure should therefore seek to decrease tax leakages, reduce tax reporting requirements, and mitigate risk at the investor and fund manager level. To accomplish this, emerging fund managers and their tax partners should work closely from the formation of the funds.
The viability of a tax-efficient structure should include the following:
- Avoiding double taxation – Partnership structure
- Avoiding an immediate taxable income event
- Long-term capital gains versus ordinary income
- Fund manager’s compensation (carried interest)
- Avoiding nondeductible items
- Avoiding withholding and other taxes on foreign investment
- Reducing state tax exposure
- No tax on distribution of assets
- Unrelated business taxable income consideration for tax-exempt investors
- U.S. tax considerations for foreign investors
The goal of the above listed tax considerations, as explained above, is simple—reduce taxes on investors’ earnings and compensation of fund managers. Accordingly, it is imperative that specific tax implications related to the structure of the general partner, management company, and fund are considered at formation.
Some upfront time spent on these points can ultimately improve the tax effectiveness and efficiency of the fund structure and ultimately increase the investors’ returns. Emerging managers and their tax partners should be in sync to avoid any misunderstanding that could pose real liability for the emerging managers in the formation of the fund and in the future.
Emerging managers can shape our economy and continue to provide investors with diversity and the ability to gain alpha.