Up-and-Coming Managers Don’t Always Outperform

While many limited partners believe that “emerging” private equity managers outperform the more seasoned ones, the return data may tell a somewhat different story, according to a PitchBook report.

First, the outperformance level of emerging managers (defined by PitchBook as those raising Fund I, II, or III) over established funds (defined as those raising Fund IV or subsequent funds) is minimal — if it exists at all — across different fund stages. 

The median return of established funds is 13.2 percent, according to data that PitchBook shared with Institutional Investor. That compares to 11.2 percent for Fund I and II, and 12.7 percent for Fund III. 

Emerging manager funds also demonstrate higher volatility in outsized (more than 25 percent IRR) and poor (less than 5 percent IRR) returns. Fifteen percent of established funds have generated outsized returns, compared to 15.1 percent of first-time funds, 10.7 percent of second funds, and 17.1 percent of third funds. When it comes to poor returns, more than 27 percent of emerging managers across Fund I, II, and III have failed to make it to the 5 percent IRR benchmark, compared to only 19 percent among established managers. 

“This is kind of intuitive,” said Rebecca Springer, a private equity analyst at PitchBook. “There may be more room for error when you’re a brand-new team and haven’t run your own fund before.”

Secondly, the report found that smaller emerging manager funds don’t necessarily scale up faster. Theoretically, it would be easier to double a $1 million fund than to double a $1 billion fund, but emerging managers who raise smaller funds often want to “specialize in that smaller company investment bracket,” according to Springer.

Emerging managers often leave “larger firms because they [want] to be able to invest in those smaller companies again,” Springer said. “They think they can outperform by investing at the lower end of the market.”

Investors often choose new managers due to the perception that they’re more motivated to perform well in order to remain competitive in raising their subsequent funds, the report said. Some LPs are also interested in building relationships early with general partners so that they can receive favorable fee terms in the future.

About one-third of emerging managers fail to raise the subsequent fund at each stage, according to the report. As the emerging managers progress from Fund I, II, and III to become established fund managers, they polish their investment strategies and begin to generate more stable returns, Springer said. 

Emerging managers who are sector specialists are particularly sought after because they deliver higher returns than generalists, the report pointed out. Since the financial crisis, specialists have consistently beaten generalists by more than 5 percent in returns. 

“Our data shows that emerging managers are driving the overall specialization trend within PE, [because] many new managers leave larger generalist firms in part to pursue a more focused strategy,” the report said. “LPs also may prefer to invest with specialists to facilitate portfolio diversification.”