Private assets

Private equity: the surprising outperformance of emerging managers

October 03, 2024 - 5 min read

Nitin Gupta

Managing Partner – Flexstone Partners

Highlights

LPs often gravitate towards large funds from established private equity partnerships and eschew first-time funds due to their return variability and hence need for more upfront diligence. However, in doing so, they risk missing the outperformance that can occurs in Funds 1, 2 and 3 of a GP’s lifecycle.
Manager selection is key, but emerging managers outperform, firstly because they have more “skin in the game” as they are putting in meaningful GP commitment in their early funds. Secondly, given the smaller early fund size, these GPs are more driven by generating a strong return on investment upon sale of the investment rather than relying on annual management fees generated by larger funds. And thirdly, smaller companies have more value-creation and growth levers to pull versus larger more established companies.
LP due diligence should focus on emerging managers’ track record, consistency with prior investment strategy/sector focus, and ability to source and execute deals on their own, without the brand and infrastructure of their previous firm.

In the asset management world, “new” does not always have positive connotations. Consultants and fund allocators are particularly cautious about recommending brand new products and newly formed firms.

This caution is understandable. However, there are times where such caution can be misplaced.

The case for emerging managers

Allocations to private equity tend to be both significant and illiquid, so investors’ due diligence in the asset class is necessarily considerable. Funds 8, 9 and 10 are generally preferred to Funds 1, 2 and 3, and track records should be as long as possible and consistently positive.

In short, Limited Partners (LPs) gravitate towards large funds from established private equity managers and generally eschew first-time funds. There is logic here: there is more disparity in performance between early funds than later ones, where firms are more established and have recognisable brand names.

However, this can lead to foregoing the outperformance that can occur in Funds 1, 2 and 3 of a GP’s lifecycle. “Based on our analysis of 25 to 30 years of industry data, emerging private equity managers tend to outperform more established managers,” says Nitin Gupta, Managing Partner and co-CIO in charge of the US Investment team at Flexstone Partners, an affiliate of Natixis Investment Managers.

“Rather than avoiding emerging managers, we look for opportunities to capture additional alpha from them,” Gupta adds.

Flexstone Partners defines “emerging managers” as those with funds of less than $750m and which are raising funds for the first, second or third time. Flexstone Partners’ analysis has indicated that fund sizes of $750m and below are most additive to portfolios.

First time’s a charm

Flexstone Partners’ emerging managers program typically looks for first-time funds, but not first-time teams. These managers have typically worked together in a larger private equity firm before setting up independently.

“We want to alleviate the team risk,” says Gupta. Similarly, it is important that the emerging team is executing similar deals in similar sectors as at their previous firms. The size of the deals may well be smaller, however, given that the emerging manager will probably have raised less capital in their new endeavour than their previous firm.

Emerging managers outperform, Flexstone Partners believes, because the managers have more “skin in the game”. First- and second-time managers often have a sizeable amount of their own capital in the fund, which aligns them closely with the LPs.

Also, they run smaller funds and cannot rely on their cut of large fees stemming from the volume of assets managed. Their compensation is therefore more correlated to the performance/ultimate sale of investee companies.

Gupta says: “These managers typically find under the radar opportunities, rather than relying on broader auction processes, make sizeable operational improvements given these companies tend to be less sophisticated due to their smaller size, which leads to meaningful increase in EBITDA during the investment hold period. This in turn leads to higher return on investment upon exit from both growth of the company and possible multiple expansion.”

In addition, there is considerable pressure on emerging managers to succeed in their first and second funds. “Clearly they will find it harder to raise Funds 2 and 3 if Funds 1 and 2 are not successful,” Gupta adds.

Mitigating the risks of emerging GPs

The key to investing in emerging managers and to managing the different kinds of risks inherent with early funds is deep due diligence and manager selection.

“We often know teams that are launching a new fund from our global private equity business, which allocates to funds across mid and later life cycles,” Gupta says. So Flexstone Partners has strong insights into the prior track record, knows if the strategy is in the GP’s sweet spot and is consistent with deals at their previous firm.

These insights substantially mitigate the “newness risk” of firms. Due diligence also focuses on emerging managers’ ability to source and execute deals on their own, without the brand and infrastructure of their previous firm. Gupta says: “Do they have the requisite networks and can they replicate the returns they generated before? If they have focused on a specific sector we want to see them do deals in that same sector.”

When it comes to its own investment team, Flexstone Partners makes no distinction between its emerging managers program and its other strategies given that most emerging GPs are known from existing relationships, “There are a lot of synergies and embedded knowledge so it makes sense to have the same team managing the relationships whether they are in our emerging managers program or in other programs,” says Gupta.

Dedicated emerging managers program is bearing fruit

Flexstone Partners’ standalone emerging managers program was formally launched in 2019 after investing in emerging managers on an ad-hoc basis for years.

Gupta says: “We had been investing with emerging managers as part of our private equity offering for a long time. One of our clients was impressed that the outperformance from these managers was persistent and agreed with us that it would be additive to their broader private equity strategy.”

The dedicated emerging managers program has invested in over 35 funds, and has made over 55 co-investments.

The strategy has met expectations to date, with annualized returns in the double digits since inception more than five years ago[1] . In addition, Gupta notes: “Since we started, all the emerging managers in the program that have launched subsequent funds have gone on to successfully raise them.”

¹ Since 2019 for the dedicated US emerging managers program.

Past performance is not necessarily indicative of future results. Actual performance may vary.

Flexstone Partners

An affiliate of Natixis Investment Managers

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