These are tough times for anyone trying to launch a private equity fund. Perversely, that likely makes it a great time to invest with first-time fund managers.
PE funds, every institutional investor’s favourite flavour of alternative asset in recent years, now face significant headwinds. Rising interest rates have insurers and pension plans – historically PE funds’ biggest backers – shifting their portfolios to fixed-income assets. A year-long drought in initial public offerings means PE managers are sending less cash back to their investors, known as limited partners, or LPs. Those investors, in turn, have less money to redeploy.
Despite this, there are an astounding number of established and startup PE funds out raising money. Preqin, a data service that tracks 39,544 managers around the world, said in a report published on Monday that 22 per cent of them are currently fundraising. They’re all pitching the same LPs.
When pension plans and other LPs commit money to alternative assets, they are usually giving it to established managers. Last year, Preqin’s research showed that 80 per cent of the total capital raised in the sector went to PE funds whose managers had launched funds at least three times before, compared with 59 per cent a decade earlier.
Rather than fight the tide, well-known fund managers such as Onex Corp. have hit the pause button on new offerings. Other well-known managers are now quietly closing funds that are far smaller than they anticipated they would be when they launched them into the booming private and public markets of 2020 and 2021.
For many first-time fund managers, winning commitments from LPs has become a slog. Marketing campaigns that were projected to take months are now stretching into years.
But investors who now turn down the opportunity to back first-time PE funds could come to regret the decision, judging by what played out during the previous two market downturns.
Preqin and Zurich-based asset manager Unigestion analyzed the performance of 731 first-time PE buyout funds launched from 2000 to 2020, and compared them with 3,300 funds from managers that had offered funds previously.
Over the 20 years, first-timers broadly tracked the wider market. But the study found “significant outperformance” from first-time funds launched at the end of the turn-of-the-century dot-com boom, and after the global financial crisis, which played out from 2008 to 2009.
In the aftermath of the tech wreck, first-time buyout funds returned 16.3 per cent in 2002 and 15.6 per cent in 2003, versus 12.3 per cent and 13 per cent for established managers, according to Unigestion.
After the financial crisis, first-timers returned 16.6 per cent in 2010 and 22 per cent in 2011, versus 13.1 per cent and 14.7 per cent among their established counterparts. In a report, the co-head of Unigestion’s emerging manager program, Kim Pochon, said, “Early indications suggest that the pattern will be repeated in the post-COVID-19 era.”
Investors “who gravitate to the perceived safety of both established brands and managers could be missing out by steering away from first-time managers,” Mr. Pochon added.
“First, new managers have focus and dedication,” he continued. “They are starting from fresh and can focus on scouting interesting deals, rather than dealing with issues in the portfolio. Second is alignment of interest. Their first fund is make or break. If they don’t make it, it’s hard for them to start another business.”
Private equity’s pioneers – among them Gerry Schwartz at Onex, and Henry Kravis, George Roberts and Jerome Kohlberg at KKR & Co. Inc. – made their fortunes on insights into how to finance businesses, and motivate their management.
The next generation of PE fund managers are building on those skills, typically with their own insights into how to deal with complex issues, such as climate change, the energy transition, artificial intelligence or new medical technology.
Although the entrepreneurs launching these funds face serious challenges as they try to raise money, they are the future. As Preqin head of research insights Cameron Joyce put it in the report: “First time funds will remain critical to the long-term health and vibrancy of the overall private capital market.”