Emerging Managers: Setting the Stage for Success
Private equity investing requires a substantial commitment of resources in the form of personnel and organizational infrastructure. We believe it takes all the complexity of stock picking and adds illiquidity, deal dynamics, unique legal structures and opaque information; it is no wonder many think it too difficult to get involved. It is essential to have a defined and repeatable process of sourcing, diligence, execution and negotiation in order to navigate a market that grows more competitive each year.
The number of private equity-owned companies has doubled in the past ten years and private market assets under management (AUM) have grown by $4 trillion or roughly 170%.1 To put that growth in perspective, global public markets’ AUM has doubled over the same time frame while the number of public companies in the US has remained flat.
We think there are a number of factors that have instigated the shift to private assets. These include, but are not limited to, increasing regulatory costs and scrutiny of public companies and a low yield environment incenting asset allocators such as pensions and sovereign wealth funds to shift their portfolios to higher-returning asset classes.
With more capital pursuing private opportunities, it is reasonable for investors to ask, “How do I outperform in this increasingly competitive market?” Though future performance cannot be guaranteed, we believe a focus on smaller and younger funds, which typically target smaller deals for which there is less competition is one way to compete.
The private equity fee structure provides a strong incentive to grow assets under management. Private equity funds collect a management fee based upon the size of the fund and they also earn a percentage share of profits generated (known as “carried interest”). In both cases, the fastest way for a manager to increase revenue is to raise larger funds. This dynamic can make it challenging to moderate growth for even the most disciplined general partner.
As fund sizes grow, managers will typically pursue larger transactions. In our view, this shift increases the complexity and competition of each transaction. While some managers have strategies that can be successful with a larger fund, most leave the size range in which they were first successful to pursue larger funds and more fees.
Enter Emerging Managers
Emerging managers are those that are raising their first few funds (funds I, II or III) and are typically less than $1 billion in AUM. These managers are often most incentivized to outperform because they have staked significant personal capital and their professional reputations in order to launch their business. Furthermore, the smaller fund size means wealth creation for the general partner is more heavily dependent on the sharing of profits and not the annual management fee.
Research from Cambridge Associates (a private markets consulting firm) suggests that although the range of outcomes for smaller funds is greater, the potential magnitude of increased gains significantly outweighs the magnitude of the potential increase in losses. That is, there is a greater likelihood of outperformance for smaller emerging managers.
Oxford has over twenty years of experience investing in private equity and has the resources and infrastructure to both identify and transact with emerging managers. Over time, Oxford has developed the network to help identify funds before they get too large to outperform, the experience to underwrite more complex opportunities and the processes to work quickly, all of which we think are essential to invest in emerging managers.
The Oxford team seeks a diversified portfolio of emerging managers. Through this strategy, our hope is that Oxford clients have the ability to capture outperformance in an increasingly competitive environment.
The above commentary represents the opinions of the author as of 7.23.21 and are subject to change at any time due to market or economic conditions or other factors. The information above is for educational and illustrative purposes only and does not constitute investment, tax or legal advice.