As seen in the Chicago Business Journal

Citrin Cooperman conducted its inaugural Emerging Managers Survey and issued The Path Ahead for Emerging Managers in Private Equity and Venture Capital report. It provides valuable insights into the challenges and opportunities faced by emerging managers.

Citrin Cooperman polled 97 professionals for the most significant areas impacting emerging managers including capital-raising, investor fees and terms, significant themes around environmental, social and governance (ESG) issues, cybersecurity and overall industry outlook.

The path for an emerging manager to launch a successful fund requires strong fundraising supported by an experienced operational team. Fundraising is always difficult and is even more challenging in the current economic environment as many allocators either favor larger institutions or prefer to reinvest with established managers. It now costs more to run a fund due to increased compliance, information technology, legal and administrative costs. Emerging managers must be adept at identifying and tapping into more diverse fee and investment term structuring.

Two of the key levers emerging managers use to attract investors are varying fees and terms of investments. The majority of private equity (PE) and venture capital (VC) investors are restricted from owning a significant percentage of a fund’s total capital or commitments. Moreover, institutional investors and state pension funds have been reducing the number of managers with whom they invest in recent years. This explains why 55% of respondents have an anchor or seed investor in their flagship funds.

The report reveals that in the PE and VC sectors, management fees typically stand at 2% or more, while performance fees reach 20% or higher for a significant portion of funds. Additionally, 53% of the respondents’ funds employ a claw back arrangement, 45% use a hurdle rate and 13% rely on a high watermark to manage returns. Due to the importance of having a seed investor, 31% of the respondents provided these seed investors with more favorable terms compared to other limited partners (LPs). Furthermore, 59% of participants believe LPs will increasingly pressure emerging managers to discount their fees and/or offer accommodations on investment terms through the end of 2024.

The trend towards giving up economics to seed and other investors has grown significantly, with newer managers willing to concede these terms to expedite their fundraising efforts. This shift reflects a broader change in the industry, where securing initial capital often requires more flexible arrangements. LP advisory committee (LPAC) participation and contractual co-investment rights are among the most common accommodations provided by fund managers, with 74% and 40% of respondents, respectively, offering these benefits.

Less frequently, fund managers extend investors discounted management and performance fees, preferred returns and ownership stakes in the general partnership (GP) or management company. Emerging managers are more inclined to offer such accommodations to secure capital while they build their track record and brand. As managers launch future funds, it is anticipated that their track record will improve their negotiating power and allow them to limit the accommodations and discounted fees they must extend.

The report also highlights several industry specialists who emphasize the importance of emerging managers’ strategic decision-making when offering accommodations, particularly in maintaining long-term viability. The balancing act between securing necessary capital and preserving the investment manager’s future profitability is crucial, as managers must consider the implications of deviating from industry standards.

One industry specialist cautioned that while these alternatives can be beneficial, the terms of investor participation must be carefully structured to avoid disrupting the manager’s operations and future fundraising efforts. The decision to offer accommodations should be grounded in a clear business rationale, ensuring that such moves support the fund’s long-term success without compromising its financial stability.

The report demonstrates the current landscape for PE and VC emerging managers will remain challenging, at least through the end of 2024. However, there is optimism that allocators will invest with emerging managers due to their potential to generate outsized returns in the long term. Until that occurs, emerging managers must position themselves in a competitive market by utilizing innovative fees and terms to build a strong investor capital base.

To learn more about the path ahead for emerging managers, contact Timothy Schnall at tschnall@citrincooperman.com.