Public and private pension plans, endowments, hedge funds and other institutional investors are investing trillions of dollars annually with alternative asset managers. Many of these fund managers are well-established with a long history of top-quartile performance, but as these managers have increasingly become over-subscribed while favoring “big ticket” investors, many smaller investors have been left on the sidelines. This demand has opened the door to first time funds, which generally feature seasoned teams breaking off from funds that are too large and inflexible to employ unique strategies and where incentives are not aligned between the funds’ top executives and their rising stars. These first time fund managers are successfully marketing flexibility on investment types (e.g. opportunistic strategies and longer hold times with liquidity through open ended fund structures) and reduced infrastructure and other expenses that are ordinarily paid by their funds.
It would be wrong to imply that the process is simple, but with enough preparation, dedication and a seasoned team of industry advisors in place, you can hit the market with a product that includes fund mechanics and an operational, administrative and reporting framework that fits within the investment parameters of many institutional limited partners eager to allocate capital to this asset class. We’ve outlined below several key areas that institutional investors and their advisors carefully scrutinize during their due diligence process before making an investment decision.
As reported in Emerging Manager Monthly, institutional investors ranked team composition as more important than investment strategy or even individual track record when evaluating emerging managers. Institutional investors expect a cohesive team of qualified professionals with a synergistic blend of backgrounds and expertise, as well as solid institutional-quality industry relationships, with many limited partners additionally seeking a team with some members having actual operating experience. Emerging managers must weigh the benefits of building institutional-quality investment and operations teams against the potential costs. Many smaller funds have outsourced certain functions, such as CFO, accounting, sector and regulatory diligence, valuations, or other back-office support functions to one of the many professional services providers in the space. Furthermore, fund managers should ensure that track record details in marketing materials comport with portability requirements of their current firm and under securities laws and that they maintain records adequately supporting any reported performance figures.
A thoughtful and differentiated strategy featuring a tailored investment focus based on strategy, stage, and/or geography in the context of current market conditions and management team expertise can distinguish an emerging manager from its competitors. Marketing documents should clearly articulate the due diligence, investment, post-investment value-add and realization process and demonstrate a pipeline of proprietary deal flow. Managers should also consider what level of diversification and investment restrictions to incorporate into their fund agreements, and to consider whether the target fund size reflects an appropriate amount of capital to deploy toward the proposed investment activities.
Emerging managers should consider prospective investors’ target fund size, geographical location and tax status (i.e. taxable or tax-exempt), and whether such investors are subject to the Employee Retirement Income Security Act of 1974 (“ERISA”) or are individual retirement account (“IRA”) investors. Such information will determine the overall structure and complexity of the fund, as well as the various legal, securities and regulatory compliance measures that the fund manager will need to work with legal counsel to identify and address (including, with respect to ERISA plans and IRA investors, the U.S. Department of Labor’s fiduciary rule that went into effect on June 9, 2017).
Furthermore, fund managers should consider whether to secure a credible anchor investor that will commit a significant amount of capital, which may help attract other investors. Anchor investors will often seek preferential economics (e.g. reduced management fees and carried interest or GP or manager participation), but fund managers should be leery of granting anchor investors either too much control over the general partner’s or management company’s operations or waiving too large a portion of the general partner’s carried interest (which may create a misalignment of interest amongst the investment team), either of which may discourage other limited partners from investing.
In recent years, and in particular since the Institutional Limited Partner Association’s release of the private equity principles in 2011, institutional investors are increasingly working with fewer fund managers and drilling down into the terms of their fund’s governing documents. At a high level, investors seek an appropriate fund structure to fundamentally align the general partner’s interests with those of the fund’s limited partners. Moreover, managers are encouraged to cater their fund agreements from inception to appeal to institutional investors such as pension plans and public entities by including many of the statutory or other institutional-friendly terms that they require (e.g. regarding public disclosure and reporting requirements, affiliate transfers, sovereign immunity, relevant ERISA and tax provisions, etc.). As an example, California public pension plans are subject to a recently enacted statute (Cal. Gov’t Code § 7514.7) that requires increased fee transparency reporting from investment managers.
Emerging managers benefit greatly from meeting before going to market with investment consultants (firms that help institutional investors make their investment decisions), investment advisors, and placement agents that work with emerging managers to gain market insight and make industry connections. Emerging managers will also greatly benefit from engaging fund formation counsel early on to avoid costly mistakes and to produce investor-friendly marketing materials and fund documents that reduce the barriers to entry, anticipate tax structuring concerns, and navigate regulatory issues in the U.S. and abroad.