Investing In Emerging Managers

Limited partner interest in “emerging managers” has grown impressively over the past decade. Many pension plans have programs targeting emerging managers or have made substantial efforts to increase their exposure to funds run by emerging managers in their venture capital/private equity portfolios. The definition of an emerging usually varies slightly for everyone, but in general, it usually refers to:

• Firms raising their first, second or third fund from a broad base of institutional investors.
• The firm may be a spin out of one or more members of an existing venture firm.
• It may also be the spin out of a group that was previously captive, i.e. they were the venture capital arm of a corporate parent.
• It could also be the coming together of investors from multiple venture firms or corporations.
• Many pension plans have mandates for emerging mangers which include a women/minority component, or a component targeting underserved markets.

In a time where funds are hard enough to raise for established venture firms with good track records, how can emerging managers compete? Why would anyone invest in them? First, here are some drawbacks associated with emerging managers:

• They often have no track record of investments or their track record is not substantial enough to qualify them. Basically, they’re unproven.
• Inexperience managing a venture firm. – an investor may have been great at working within an established firm with a developed structure, but when running their own firm, it’s a different dynamic and they are sure to run into situations not encountered within a larger organization.
• Team risk. Emerging managers often have difficulty in building out their team. An individual may be a great investor, but to have a successful venture firm it takes an entire team. There is risk around having emerging managers build not only a competent team, but a team that can work well together.

That said, emerging managers do feature characteristics which make them attractive, and in some cases even more attractive than established firms:

• They have comparable, or in some cases even deeper, domain expertise in the given sectors their strategy targets and often have relationship networks just as good as larger firms may, which means their access to deal flow is just as good too.
• They have the desire to build their firm’s brand and respect which lends to emerging managers being more hard-working.
• Being a smaller organization, they are more nimble when it comes to adapting to changes in the market.
• Without the influence of a larger organization, they can thoughtfully build a team that works best for the strategies they will be pursuing.
• Having a smaller LP base, emerging managers usually value their investors more and are able to give more attention to their needs.
• Investors are often able to get better economics in the form of a lower management fee and/or carry with emerging managers (although the argument can be made that emerging mangers need more fee income so they can build the proper infrastructure).

Manager selection is extremely important when investing in emerging managers. Understanding team dynamics, having a sense of their infrastructure, and the principals’ ability to run a firm are all factors that have heightened importance when evaluating emerging mangers. If the right group with the right backgrounds is coming together pursuing the right strategy the results could be impressive. Take for example Spark Capital, the firm was formed by Todd Dagres, formerly of Battery Ventures, and Santo Politi formerly of Charles River Ventures to pursue investments at the intersection of media and information technology. They’ve been early investors in great companies such as Twitter, Boxee, and Tumblr. A larger more established group may not have taken the risk to invest solely in such a narrow focus, but Spark’s nimbleness allowed it to identify and pursue companies in this exploding space. Investors would be foolish not to at least give emerging managers a fair shake when considering investments in venture funds, but they must be extremely prudent in their evaluation of managers because for every Spark, there is a firm that doesn’t make it.