Disadvantages of Private Equity Emerging Managers

Private equity emerging managers face many disadvantages on the road to success.  This article discusses seven of them.

Before addressing the disadvantages of private equity emerging managers, here’s a brief review from last week of the advantages emerging managers have (further discussion is available here).

1. Private equity emerging managers have the ability to make potentially high-yielding investments in under-served sectors typically ignored by the more established investor.
2. Emerging managers offer much needed diversification from the less risk-loving nature of established managers.
3. Emerging managers in the private equity sphere generally have a stronger connection with local entrepreneurial talent (niche areas of entrepreneurial activity).
4. Private equity emerging managers have the ability to adopt focused governance rights.
5. Emerging managers have the capacity for the investor and the emerging manager to align term interest, and build stronger, more mutually beneficial relationships (loyalty).
6. Private equity emerging managers have the freedom to be more nimble and adaptable, meaning emerging managers bring new ideas, fresh talent, and a desire to exploit market inefficiencies.
7. Emerging managers have the potential to produce better returns.
8. Emerging managers in the private equity realm posses the opportunity to align social goals with potential investors, something becoming increasingly important in the competitive world of social investment.  Social goals may include economic development, environmental issues such as renewable energy, and Sharia law compliant investments.

With this background of the advantages of emerging managers in mind, what are the disadvantages of private equity emerging managers?  According to John Koeppel, here are seven.

1. First, a good portion of private equity emerging managers don’t have portable or verifiable track records or significant experience documenting their underwriting decisions, which generally favors successful established managers.  Overall, about 90 percent of new money flows to the established private equity managers.
2. Second, emerging managers sometimes require program structure/mentoring, meaning investors typically must have a greater desire to be involved in the investment process (generally a disadvantage).
3. Transitioning to the fiduciary mindset is viewed as the third disadvantage of emerging private equity managers.
4. Coming in fourth, emerging managers have less experience with market downturns due to their small size and lack of experience, and investors usually have a good deal of concern for the downside capture ratio.  To address the assumption that emerging managers will do worse during a downturn, emerging managers must make up for the differential by selling their ability to perform above average on the upside.
5. The fifth disadvantage of emerging managers is the their potential difficulty in maintaining discipline and focus on their stated strategies, especially during peak market cycles.  Emerging managers must address this backdrop concern in an usually subtle style (e.g. potential investors normally don’t express their concern directly, and it’s usually not good salesmanship to directly mention concerns such as this one).
6. Sixth, emerging managers must be prepared for the disadvantage of getting a fund together.  Overall, the trend is for a lengthening of the time period for emerging managers to put a fund together, perhaps one or two years.
7. Lastly, emerging managers and general partners need to develop key relationships with crucial institutional investors, something established managers possess already.  The relationships must focus on shared due diligence, building a community of like-minded investors, and coordinating efforts.

Overall, these are seven disadvantages that private equity emerging managers face – in addition to the traditional disadvantages newcomers have in every other industry.

Tagged as: private equity