We recently announced the launch of our private equity fund at Impact Engine. In launching our fund, I stepped into the role of being a new fund manager for the first time. I thought I was prepared given that I’ve spent most of my career investing in emerging managers, but I was still surprised at how challenging it was to raise a first-time fund.
Yet, there are so many good reasons for investors to prioritize first-time funds:
Performance advantage. Many studies have shown that first-time funds outperform across most vintages. For example, Preqin’s analysis showed a consistent outperformance in IRR that was over 3% in several vintage years. Manager selection does matter, however, as the spread between the top quartile and bottom quartile performance can be more significant for first-time funds which highlights the need for rigorous due diligence and portfolio diversification.
Stronger alignment of incentives. With smaller fund sizes and no prior funds paying management or incentive fees, first-time fund managers need to produce returns to get paid beyond a minimal salary from the management fee. In my experience, emerging managers often sacrifice significant compensation with their prior firms in order to start their own. This drive to succeed makes managers very focused in their early years.
Co-investment opportunities. Smaller funds often have additional allocation capacity in deals which they tend to prioritize for their investors. This provides allocators a pipeline of high quality investments with minimal required effort in sourcing, diligence and management, often with low or no fee.
Increasing diversity and equity in finance. Only 5.2% of PE firms are women-owned and 3.9% are minority-owned. Diversity of thought comes from diversity of life experiences, and it leads to a performance advantage. The wealth generation potential for managing a fund also brings the opportunity to close the wealth inequality gap in our society by investing in first-time fund managers.
Desire to support entrepreneurs in the financial industry in order to make it better. When starting a new fund, it’s common for even experienced investment professionals to rethink their strategy, process, and objectives. This can lead to significant improvements, much like startups disrupt industries, forcing competitors to step up. As new fund managers increasingly incorporate impact and ESG into their investment decisions and see those strategies drive attractive returns, they can influence the entire industry, thus creating a multiplier effect with far greater impact than the investment an allocator makes into one fund.
The fulfillment of creating value with capital vs just allocating capital. This is a personal preference, but I enjoy the work of helping a new fund get launched more than investing where there is minimal to no value creation on my part beyond financial capital provided. The opportunity to help create something from nothing and build lasting relationships is valuable.
All of these reasons, plus the need for impact capital in the middle market, led to the creation of our private equity strategy, through which we invest in emerging private equity impact funds as well as direct growth equity financing rounds. Why aren’t others doing this? There are real hurdles in the current system:
Few institutional investors will invest in new funds. Sophisticated endowments know the advantages of new funds, but there are fewer of these investors than you think. Single family offices are the most frequent investors in first-time funds. However, they can be difficult to access without a personal network, which highlights another barrier to entry that is keeping out diverse talent. Fund of funds are also common investors in new funds, but are facing their own fundraising hurdles as more investors prefer to invest directly.
Fund size minimums are difficult to achieve. While some pensions have emerging manager programs, the frustrating part is that they often have minimum size hurdles that can’t be cleared by a new fund. Institutional investors that allocate large dollar amounts often cannot invest in small funds due to concentration limits. The minimum fund size they will consider can range from $100 million to $1 billion. While new managers optimistically expect these investors to just write a smaller check for their smaller fund, that rarely happens as they prefer to maintain concentrated portfolios. This may lead managers to consider raising their target fund size, which presents a conundrum in that now there is more capital to raise but from a limited pool of investors that will consider a new fund.
Atypical track records are difficult for investors to process. Many new funds are launched by professionals with years of experience leading deals and managing teams. This does not mean they have an audited track record or one that can precisely measure a net IRR. The reason for that is often because their prior employers withhold rights to their track record to try to keep their most talented professionals from leaving. Unfortunately most investors need an explicit track record and are unwilling or incapable of doing due diligence to analyze a team’s actual track record of managing money to develop their own opinion of the team’s skill and judgement.
Lack of startup capital limits options to start showing results. Investors want to invest in a fund where there is some knowledge about the companies in the portfolio, but fund managers need the capital to make investments.
Questioning whether an emerging manager has the hustle, network, budget and stamina to overcome all of these hurdles: the meta challenge! Oftentimes this questioning isn’t direct but on the minds of risk-averse investors.
Most of these hurdles faced by new fund managers stem from allocators acting as risk managers, regardless of whether they are foundations, pensions or family office investment teams. It is a loss for society, as so much capital and power is tied up in capital markets that, if allocated strategically, could help create a more equitable and resilient society -- all while generating strong financial results.
Leading allocators and advisors who really want to capture the advantages listed at the beginning of this article can and will develop the flexibility to help their clients diligence, diversify and de-risk new fund investments. For example, the Surdna Foundation has invested in several new impact funds, including ours, with a hope that their investment may help these fund managers raise capital from investors with less expertise in first-time funds. My partner, Jessica Droste Yagan, is currently working with her financial advisor to develop an emerging manager diligence strategy to complement their typical, more traditional approach, to enable more opportunities to invest in new impactful and diverse fund managers. Our team welcomes conversations and collaborations with investors and advisors interested in this space.
While allocators and advisors are adjusting, here’s my advice to new fund managers, based on my own experience:
Put effort into finding a large anchor or group of small anchors that are strategically aligned -- perhaps a family office that is focused on your particular sector or geography and thus values your expertise -- and secure those commitments early before speaking to investors less focused on your market or further away from your personal network.
Consider partnering with an existing firm that is strategically aligned with you. Launching a new fund on an established platform can make your fund more eligible to institutional investors otherwise uninterested in emerging managers. However, consider all partnerships prudently and structure them thoughtfully to ensure that your core objectives, values and incentives are aligned to create long term mutual success.
Take the long view in considering your fund size. Target only what is appropriate for your market opportunity and set a realistic fundraising goal. Don’t worry about being a large fund from the start. There are many funds that started small, but generated strong returns to come back with much larger successor funds. Where you start is not where you will end!
Assemble a reference list of former employers, peers, and CEOs to make the diligence process easier for those willing to roll up their sleeves to do it. Make sure these contacts can speak specifically about your historical investments, including the role you played, the quality of your analysis and decision to invest, how you responded to opportunities and challenges during the life of the investment, and the ultimate financial outcome. In aggregate, the references should cover all investments you led, not just cherry-picked success stories.
Provide a transparent and thorough pipeline to help address investors’ concerns about the ability to execute on the investment strategy. Being able to warehouse a deal that then transfers to the fund at the first close is an even better solution, but again that is not an option for emerging managers that don’t have existing access to capital. Another approach to consider is operating as an independent sponsor to prove your pipeline and ability to execute, which also contributes to assembling a track record.
In terms of showing grit and ability to persist against these hurdles, I recommend being transparent about what it takes to launch your fund, address potential investors’ concerns upfront, and explain how you are managing them. Building a trusted relationship with investors that lasts over multiple funds begins in those first meetings. Trusting potential investors with your vision and plan will lead to investors trusting you.
Backing a new fund does not mean backing a new investor. And investing in a fund managed by a firm with a long track record does not mean their track record will repeat itself. We all know this, yet the traps of behavioral bias, check-the-box due diligence, and perceived safety in following the herd bring well-intentioned investors to make this mistake repeatedly. These barriers further perpetuate the lack of diversity in thought and experience in our industry that ultimately leads to more capital going to the same old ideas.
Where most investors see risk, we see an incredible talent pool of experienced private equity professionals with all the tools necessary to succeed. We welcome you to join us in this view and help us diversify the strategies and demographics of the private equity industry.
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