It’s a hard time to be an emerging manager. Private equity emerging managers closed just 15 funds in 2023 with a total $12.7 billion in committed capital, according to data from PitchBook. The headline number looks a little better for emerging hedge funds.
According to data from HFR, 146 new funds launched in the first quarter of 2024, the highest quarterly launch figure since 2022. However, hedge funds are easier to open and close and 106 hedge funds liquidated in the first quarter – making things a bit of a wash. Startup costs to launch new funds are higher than they ever have been and the pool of potential investors is smaller.
Still, data on emerging managers shows that across almost all alternative asset classes new and smaller funds tend to outperform. Some of these funds are testing unique strategies. But many, as a function of their size, are simply able to take advantage of opportunities at the small end of the market that have greater upside potential. Those gains can add up – especially during higher volatility market cycles.. Lower middle-market private equity transactions too can have a better return profile – these deals typically have little to no leverage, making them easier to complete even when debt markets are tight and they often capture a high growth period in the lifecycle of a portfolio company.
These trends have likely contributed to putting a number of high-profile launches and new allocations on the books for this year. Jain Global, a new $5.3 billion multi-strat hedge fund launched officially on July 1, following a period of intense fundraising and hiring. In June, Arrowpoint Investment Partners, a new Asian hedge fund said it secured an investment from the Canada Pension Plan Investment Board after being seeded by Blackstone. Also in June, the Los Angeles City Employees’ Retirement System also committed $20 million to Builders VC, an emerging venture capital firm, which is in market with a fund targeting $400 million in assets, according to LACERS board documents.
Questions remain, however, about whether the value emerging managers bring to portfolios will be able to overcome industry trends like the emergence of mega funds across all alternative asset classes. According to data from Goldman Sachs, multi-manager hedge fund pod shops grew AUM by 175% from 2017 to 2023, while the rest of the hedge fund universe grew 13% over the same timeframe, for example.
“Resources are still an issue with every LP. It can be easier to maintain a relationship with a handful of mega funds, whereas managing a portfolio of smaller funds is more resource intensive,” says Mina Pacheco Nazemi, head of the diversified alternative equity team at Barings.
But, some institutional investors argue that allocators have a fiduciary duty to include them as part of a diversified portfolio.
Raising Awareness
A relatively small handful of institutional investors have formalized emerging manager programs. These programs have fallen out of fashion in recent years as strategies have shifted and capital has gone into multi-billion-dollar multistrategy firms and mega funds ready to offer allocators a little bit of everything on a single menu. Now, there are some signs that the trend could be shifting.
Institutional investors have started to raise questions about the performance of the big shops wondering aloud whether or not their returns will beat the cash rate or whether multiple compression at the high end of the private equity market will dampen the return prospects of some vintages.
At the end of last year, all of the pension funds in the New York City retirement system announced plans to expand their emerging manager programs. The funds said the expansion came after internal analysis showed that since 2015, their emerging manager programs outperformed their benchmarks net of fees in all asset classes. The NYC Comptroller’s Bureau of Asset Management anticipates that by 2029, 20% of the systems’ investments will be with emerging managers.
Other allocators have also had several emerging manager events this year designed to raise awareness of high-performing emerging firms including investment consultant Meketa, the Teachers Retirement System of Texas, the New York State Common Retirement Fund, and most recently the New Jersey Division of Investment.
New Jersey’s emerging manager program is relatively new – it was launched in 2021. New Jersey Division of Investment Director and Chief Investment Officer Shoaib Khan says that after an internal review, it was clear the pension system would be leaving money on the table if it opted to leave emerging managers out of its target allocation.
“Our objective is to find the best risk-adjusted returns,” he explains. “When we looked at the larger universe of investment opportunities, we discovered that by investing with emerging managers we could make good on our objective to provide the best risk-adjusted returns in part because emerging managers often outperform.”
Khan plans to include emerging managers throughout the portfolio. “We started with private equity and we’re slowly expanding that out to other private markets asset classes,” he says. “We also have program partners at Barings who are doing a lot of the due diligence for us. For example, they are working with us on the private equity sleeve. We’re also working with GCM Grosvenor on our real estate sleeve. Our next sleeve will be private credit and we’re still doing the review work there to see what our best options are going to be.”
Structural Challenges
Even with positive performance data and advocacy at the institutional level, a number of structural challenges remain for emerging managers. Startup costs are high. It is no surprise that the most successful hedge fund launches in recent memory are large multi-billion dollar affairs like Jain Global or ExodusPoint. These managers are positioning themselves to qualify for institutional capital at the outset – but doing this requires a good pedigree and a vast list of institutional contacts.
Emerging managers in private equity, venture, private credit, and real estate can close maiden funds on less and usually do. But to get up and running in any asset class often requires overcoming questions of career risk from allocators.
“Many of our peers invest in emerging managers, but broadly there is a lack of LP capital in this space, and it does have a negative impact on the success of emerging managers as a whole,” says Mike Silva, an associate investment manager and investment officer at CalPERS, who directs the emerging manager program across all asset classes. “There’s a narrative out there that emerging managers pose an additional risk and that could be one reason LPs hold back on committing to the space.”
In the last two reported fiscal years, CalPERS has invested $2 billion with emerging managers and committed an additional billion through programmatic ventures with TPG Next and GCM Elevate. Silva adds that CalPERS also has an emerging managers program in real estate although it currently has no dry powder. Silva says that the review process is significant, he and his team are looking at hundreds of managers per year.
“In the current marketplace, I see a lot of competitive emerging managers, but I don’t think there is enough capital available to support all of them,” he says.
Pacheco Nazemi adds that consultants play a role as well. “There aren’t a lot of consultants that do work on emerging managers,” she explains. “It is rare to see material commitments from consultants in the emerging manager space. They are often deploying sizable commitments across their client base and therefore their aggregated commitment size makes investing in emerging managers prohibitive.”
For allocators that are interested in emerging managers then, it may require building an internal team that can start work on reviewing and comparing managers. Khan says the N.J. division being in control of their review process has helped overcome questions about risk.
“I do recognize that our peers might feel like they are stepping out on a limb investing in emerging managers. But we feel like at the end of the day we have done our homework and we are comfortable with our options and the potential risks,” he says. “As an investor, unless we are investing only in risk-free assets, we are assuming some risks in our portfolios. In fact, I would argue that we are brought in to assume risk within a portfolio. However, these are calculated risks after much diligence and risk which can be monitored and managed. Investing with emerging managers is no different.”
Pacheco Nazemi adds that emerging managers can help differentiate allocations in the alternatives portfolio from core passive allocations in important ways. “When we think about emerging managers, I always say ‘You won’t be fired for hiring IBM, but you really should be fired if you didn’t buy Google. From a portfolio construction standpoint, there is only so much allocation that the mega firms should consume and LPs need to have a diversified portfolio. High exposure to the larger end of the private market translates to a higher correlation to the public markets which defeats the purpose of investing in the private markets.”
Building Long-Term Relationships
Sources say, apart from performance emerging managers can be a place where allocators can create long-term relationships with a clear alignment of interest. Many portfolios have years and years of re-commitments to large funds that were originally made when these firms were smaller, based on relationships that no longer exist as a function of retirements and fund size. Emerging managers can offer a chance for a reset.
“When we consider emerging managers, we’re looking to see if they have an appealing strategy and that there is a portfolio fit,” explains Silva. “Team and talent are also critical. We’re looking at how they make decisions, how long has the team been together, and whether the strategy is scalable, repeatable. We want to understand their organization and also how their interests align with ours.”
Pacheco Nazemi points out that for medium and small-sized investment portfolios, emerging managers can offer a higher touch relationship than the allocators are likely to get coming in as a small investor in a mega fund. “As a small allocator, one could ask how material a $20-$25 million allocation would be to a multi-billion dollar fund. That $25 million is going to be more meaningful in a mid-size or small fund.”
Khan says the time horizon that allocators work with can be helpful as well. “I do think there is value added in getting to know a manager early on and building that relationship. If we can grow our investment with them as they grow, that’s an ideal scenario.”
Allocators could end up with access to better investment opportunities as well. “I think it’s incumbent upon us as CIOs to make sure that we have explored all of the available investment options and to make determinations about what should be in a portfolio,” Khan says. “Emerging managers are looking at opportunities the larger funds aren’t. So we made a path to capture those opportunities.”
Tags: Arrowpoint Investment Partners, Barings, Builders VC, California Public Employees’ Retirement System, Canada Pension Plan Investment Board, ExodusPoint, Jain Global, Los Angeles City Employees’ Retirement System, Mike Silva, Mina Pacheco Nazemi, New Jersey Division of Investment, Shoaib Khan, Teachers Retirement System of Texas