Making Sense of Investing in Emerging Managers & Understanding Their ChallengesOct24

By Sal Shah, Partner, BKD CPAs & Advisors

Emerging managers are money managers starting a new fund. These managers typically have a wealth of talent, are mission driven and may be breaking away from a large institution. Although they’re starting up and may be small, they’re eager, nimble and innovative. 

Many of these managers have extensive experience managing large sums of money at big financial institutions, but they may be caught in the limits of a large institutional structure. Large institutions have to operate under prestructured operational complexity, bureaucracy and regulatory environments, which can inhibit them from taking advantage of market inefficiencies and exploring innovative ideas. 

According to Preqin, emerging managers that have been trading for less than three years had average returns of 12.2 percent, whereas the hedge fund industry was averaging returns of 7.7 percent. Emerging managers outperform larger funds because they begin with managing their own money and have skin in the game. They’re operationally flexible, more aware of changing market conditions and can adapt quickly. They have a high degree of operational ownership, beginning with the general partner, portfolio managers and employees. The young managers are under significant pressure to generate alphas while hedging against negative market conditions. They operate like true hedge funds and aren’t just long-only strategists, which are not looked at favorably these days due to perceived high manager fees. 

A key to an emerging manager’s success is the ability to raise capital. Many emerging managers are good at executing their strategies but don’t have the experience, time or patience to run a business. Fundraising has become more difficult since the 2008 financial crisis, and these managers often start with their own money, or money of family and friends. They have little to no investment track record. They don’t know how to present themselves in front of potential investors, or they end up spending a lot of time with allocators who are less likely to provide them with capital. 

In capital raising, fund managers need to follow a blueprint or framework that will work. Here are some pointers to keep in mind:

1. Highlight prior experience

2. Reach out to prior clients

3. Find a seed or founding investor

4. Prepare a thoughtful marketing strategy

5. Build an operational infrastructure

6. Have a clear pitch book

7. Plan a good strategy for targeting investors

8. Develop an innovative fee structure

9. Present a track record

Prior experience and clients, seed investor, marketing strategy

Building and presenting the manager’s résumé is extremely important, as it helps create trust with potential investors. Managers should outline prior experience, which institutions they’ve worked for, the strategy they’ve managed and their differentiating factors. The résumé, which can be part of the pitch book, should clearly and succinctly outline how they’ve generated alphas and managed risk. Investors will want to know how much money was managed, which class of investors was catered, how the manager’s strategy hedged against market downturns and the corresponding performance track record. The résumé should illustrate how the manager’s institutional expertise translates to the emerging fund experience for the investor. 

Don’t forget that a manager’s previous clients may follow the manager to the emerging fund. It’s hard work, but the manager should be talking to people and developing relationships without the pressure of generating capital. This is vital to the relationship-building process and can help the manager target seed capital or founding investors. It also can help managers find other target investors such as financial institutions, high-net-worth individuals and family offices. More experienced managers also may look for foreign money. As managers meet with these investors, they should make notes of the individual investor’s needs and process, including goals, allocation history, decision makers, risk/return profile, allocation time and the amount of potential capital allocation. These data points will help match the manager’s profile to the investor profile. In addition, they can help the manager adjust the business and investment strategy to match the potential investor’s needs and outlook.

Operational infrastructure

A manager should build an operational infrastructure, including client relationships, trading platforms, compliance and middle- and back-office functions. The manager must select its third-party service providers and in-house functions, such as the marketing and client relationship managers, prime broker(s), banker, administrator and audit and tax service providers, which would meet the minimum infrastructure requirements and be scalable as it grows. During the early stages of fund formation, the general partner and the key portfolio managers should be a part of the capital hunting and investor relationship-building exercise. 

Some of the steps outlined above may help the emerging manager build stronger client relationships and trust, which is the building block for capital generation. The manager shouldn’t push its strategy onto the client. Instead, the manager should try to walk through the strategy and business with the potential investor as an idea—one that can incorporate the investor’s needs and feedback. The manager should integrate the investor’s outlook and requirements into its offerings using the homework it has done to understand the client’s goals and needs. As conversations with the investor progress, the manager should get to know other decision makers or influencers the investor relies on. Many times these influencers’ approval can be key to winning an allocation.

Pitch book and targeting strategy

The emerging manager must have a clear, easy-to-understand pitching deck that highlights the following:

• People behind the operation and strategy and their résumés

• How the portfolio will be built

• Investment criteria and due diligence

• Risk management strategy and process

• Strategy or fund’s track record

• Fund’s unique differentiators

• Expected assets under management (AUM)

• Effect on returns and risk as AUM grows

• Supporting infrastructure and service providers

• Fee structure and its effect on returns

A good pitching deck shouldn’t be long and cumbersome. Remember, it’s more of an art than a science. Its appeal can vary from investor to investor. This is the manager’s opportunity to drive home the message to the investor with the limited time the team has. Consider tailoring the pitching deck based on the investor’s profile. 

Fee structure and track record

It’s important to picturize the performance track record in a meaningful way that tells a complete story. Don’t be afraid to present downturns and upsides. Explain the assumptions, risk containment triggers and their impact during challenging times. The longer the duration of performance history, the more effective it will be. Show returns, both gross and net of fees. This will show the hard work that was put into earning the fees. Talk through the portfolio selection, investment and divestment process. Risk in the portfolio, as well as the monitoring and measuring process, is very important to many investors. The manager’s presentation should keep an investor’s expectations and needs in mind. 

Fee discussion should never be the leading topic during an investor conversation, but it becomes an important part of the discussion. Some fund managers offer significantly reduced fees, and others are more creative. A manager shouldn’t want to cut fees to a point where it’s difficult to survive and meet overhead costs. During the initial period, a manager may have only management fee income to meet the expenses. The stronger the case the manager draws, the better the resulting fee negotiations. Here are some innovative fee discussion ideas:

• Outline the expected standard fees

• Show how the manager fees scale up as AUM increases

• Make a case for the management fee with expenses that are incurred

• Categorize expenses the fund will pay and others the manager will pay

• Increase the period for measuring performance fees (two or three years versus annually)

• Use private equity-type hurdle rates for performance—over multiple years or the life of the fund with clawbacks

• Include a sunset clause to limit the extent of clawbacks—hedge funds are different from private equities

• Limit the side letter fee arrangements

A seed investor is an investor who brings in initial capital and is offered equity in the investment manager or general partner. Seed investors are able to negotiate significant initial discounts to the fee as a favor for the provided capital and its lockup. However, the emerging manager should ensure that seeder participation sunset clauses are in place so the follow-on and additional capital flows in the fee seeder discounts and equity participation are phased out. 

Founding investors don’t typically take interest in the investment manager or general partner but can get significant initial discounts to the fees. Again, the manager should ensure appropriate sunset clauses are used to manage or keep intact the manager’s long-term interest in the business. 

Benefits of emerging managers

Emerging managers are the source of innovation for the investment industry and dynamic capital markets. They must be encouraged to further develop and retain talent in the industry. Some of the leading pension funds in the country have set mandates to asset allocation for emerging managers. By investing with emerging managers, allocators can gain the scale and diversity, have access to innovative alphas and obtain exposure to diversified industries and undiscovered strategies. 

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If you have any questions, please reach out to Sal at kshah@bkd.com or another BKD trusted advisor. BKD CPAs & Advisors is a top-tier CPA and advisory firm dedicated to helping people and businesses realize their goals. Our more than 2,650 dedicated professionals offer accounting, tax and consulting solutions to clients in all 50 states and internationally.

This article is for general information purposes only and is not to be considered as legal advice. This information was written by qualified, experienced BKD professionals, but applying this information to your particular situation requires careful consideration of your specific facts and circumstances. Consult your BKD advisor or legal counsel before acting on any matter covered in this update.  Article reprinted with permission from BKD CPAs & Advisors, bkd.com. All rights reserved.