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The Appeal of Emerging Managers (EM)

As we have discussed in previous newsletters, it is reasonable to assert that the lower end of the Private Equity market (Lower-Mid Market or LMM) is the most attractive. SMEs make up about 60% of the economy, yet less than 15% of the Private Equity market provides capital to these types of companies. This creates a market inefficiency, resulting in a clear imbalance between supply and demand.

Figure 1: Disparity between supply and demand in the Lower-Mid Market1.

The main consequence of this disparity is that there is less competition from GPs (General Partners) in the lower end of the market, while at the same time, there is more supply of quality companies available to be acquired, making it easier for GPs to acquire these companies at lower multiples than in higher segments of the market where the supply and demand relationship is tighter. As is evident, the less that is paid for an asset, the lower the risk assumed in the transaction, and the greater the expected return.

If we analyze the profile of managers focused on the LMM, we observe that it is the segment with the highest proportion of Emerging Managers (EM), understanding Emerging Managers or emerging funds as GPs who are launching their first or second fund. The reasons for this EM concentration in the LMM are diverse, but it is important to highlight the difficulty these GPs experience in raising capital, as discussed in the fourth newsletter. Since the most important determining factor for investors (Limited Partners or LPs) in choosing a manager is the GP’s historical performance, EMs often struggle to attract LP capital given their lack of established track record.

Figure 2: Most important factors for LPs when analyzing a new manager2.


Interestingly, despite attracting fewer investors, EMs have been observed to deliver highly attractive returns. There are multiple factors that explain this success. As newer managers, EMs tend to raise smaller funds and, consequently, typically invest in LMM companies. This allows EMs to take advantage of the favorable market dynamics and buy portfolio companies at attractive prices. Therefore, this focus on the lower end of the market significantly reduces the risk of EM funds.

There are three main investment dynamics that support this hypothesis. First, as we have previously analyzed, the LMM is a segment where companies can be acquired at lower multiples than the market average, meaning high-quality companies can be purchased for lower prices and, therefore, lower risk. Additionally, the LMM is a segment where it is relatively easy to achieve multiple arbitrage, i.e., sell a portfolio company at a higher exit multiple than the entry multiple. Since the company will grow during the 4-5 years that the team is managing it, companies may position themselves in a higher market segment where there are more GPs eager to buy it. Given increased demand in this higher end of the market, the multiples paid for this company are likely to be higher and value can be harvested in the price differential. Finally, transactions in the lower end of the market typically apply less leverage than in higher segments since banks do not offer extensive financing to medium-sized companies. With lower debt multiples, investors can expect lower risk associated with their investments.

The first two dynamics mentioned above both drive returns and reduce implied risk. Leverage, however, is typically perceived as a value creation lever, especially in higher market segments where multiple arbitrage is more difficult. Therefore, it could be said that the returns generated by leverage in the higher ends of the market are achieved in the LMM through multiple arbitrage, generating a more attractive risk-return profile for investments in the LMM.

Figure 3: Entry multiple and leverage by market segment.3.

These factors are not the most important predictors of success for EMs, however. The most important explanatory factor for strong returns is the skin-in-the-game these GPs have in their funds. Though novice managers may not have large sums to invest given their limited career experience, these GPs have more than money at risk. Founding Partners of an EM may have risked their career with a more established firm to build their own firm. The difficulty these GPs may experience in fundraising leads them not only to invest a large part of their personal wealth, but also to turn to closest friends, family and other contacts for capital investment. The skin-in-the-game that many founding teams have in their fund’s success can have a powerful effect to enhance GP motivation and commitment the project. Furthermore, since EMs do not have legacy portfolios(old funds in operation that can distract them from current investment activity), these GPs can dedicate all their firm resources to seeking the best opportunities and creating value for their portfolio assets in the current fund.

In conclusion, if the characteristics of the Private Equity market are taken as a reference, it seems reasonable to think that those known as Emerging Managers generally generate more alpha than more experienced managers. Not only do they operate mainly in the most attractive segment from a risk-return perspective, but their personal situation can generate greater motivation for success. Therefore, these EMs are able to find better opportunities and generate more value both for their assets and for their LPs, positioning many EMs in the top quartile of the market.

We cannot ignore the reality that many low-performance EMs are not analyzed in market studies given survivor bias and their unwillingness to report poor results. Therefore, it should be kept in mind that, although EMs seem more likely to generate alpha than other GPs, the thesis cannot be understood as a rule. For this reason, it is crucial that LPs develop a sophisticated GP selection process when investing with Emerging Managers.

Notes:

  1. Preqin Investor Interviews (2015): A Partial and Fragile Recovery; European Commission y European Mid-Market Private Equity Report: A Partial and Fragile Recovery; European Commission and European Mid-Market Private Equity Report:
    Delivering the goods; EVCA y PEREP Analytics; Pitchbook Global PE Deal Multiples Report 2017 IV; Datastream.
  2. Percentage of respondents. Depth of investment history refers to the number of investments the team has made together and the results obtained. Source: Preqin Investor Interviews (2014).
  3. EV / EBITDA: Qualitas Insight & LDC Quarterly Lending Review, market composed of 13.874 transactions in Qualitas Insight database from 1989-2022; Net Debt / EBITDA: Qualitas Insight & LDC Quarterly Lending Review, market composed of 9.657 transactions in Qualitas Insight database from 1989-2022.