5 Reasons Why We’re Excited About Emerging Managers
by Samir Kaji, Allocate CEO & Co-Founder
Without question, 2023 has been a challenging fundraising environment for funds of all types. However, the emerging manager (typically defined as firms on Fund 1, 2, or 3) segment of the broader venture capital market has felt the most pain. In times of market uncertainty, LP capital tends to flow to proven fund managers, and commitments for new managers often dry up.
According to Pitchbook/NVCA, emerging managers have raised just $11.4 billion across 170 funds through Q3 2023, representing a 63% decline in total capital raised and a 66% decline in the number of funds raised compared to 2022.
At Allocate, we believe that emerging managers are a valuable sleeve for limited partners building venture portfolios. Since our inception in 2021, we are proud to have partnered with 24 emerging managers on our platform. What are some reasons to pay attention to emerging managers?
The best established managers of today were the emerging managers of yesterday.
Every name-brand venture capital firm today started as an emerging manager at some point. Andreessen Horowitz was an emerging manager in 2009. Upfront Ventures was an emerging manager when it was first founded as GRP Partners in 1996. Kleiner Perkins and Sequoia were emerging managers in 1972.
The venture capital manager landscape is ever-evolving; from 2007 to 2021, the number of active venture firms in the US alone nearly tripled from 987 to 2,889, according to the NVCA. Some of today’s most well-known venture firms did not exist 15 years ago, and some of the best-performing venture funds of the next 15 years might not even exist today.It is imperative to identify these managers early in their lifecycle, often when raising their first or second fund or even before they formally launch. For the best-performing emerging managers, securing early allocation is critical; by the time it is evident that a strong breakout firm has “emerged,” it is often difficult to gain allocation given that managers typically give first priority to existing limited partners.
Emerging managers have a demonstrated ability to generate outlier performance.
Some of the best-returning venture funds of all time were emerging and first-time venture funds. For example (based on publicly available information), Lowercase Fund I (Uber and Twitter) returned 250x+, K9 Ventures Fund I (Twilio and Lyft) returned 50x+, and Initialized Capital Fund I returned 50x+ (Coinbase, Instacart).
Data Source: Kauffman Fellows - A New Platform for Emerging Managers There are a number of reasons why this may be the case, notably:
Fund sizes: Emerging Managers in venture capital typically raise smaller funds, and a single outlier company can have a disproportionate impact on fund returns. Let’s take Fund A, a $50 million fund. The fund gets 10% ownership at the seed stage and reserves half of its fund for follow-on. Let’s assume dilution of 50% through exit, so 5% terminal ownership. A single $1 billion unicorn company with 5% ownership at exit would return the whole $50 million fund. One $5 billion unicorn would return the whole fund five times over.
GP-Thesis Fit: In the early days, it’s more likely the fund manager has the strongest GP-Thesis Fit, as Allocate CEO Samir Kaji previously pointed out. In other words, the manager will most likely lean into their strengths and have a singular focus.
Emerging managers tend to have strong GP/LP alignment.
Recent data from Carta shows the dispersion in management fees by fund size. According to Pitchbook, the average fund size for an emerging manager in 2023 is $41.7 million, so if we use smaller funds as a proxy for emerging managers, they tend to have a friendlier fee structure.
Source: Carta Emerging managers also tend to offer substantial co-investment opportunities to their LPs, as they often don’t have the reserves or follow-on capital to take their entire pro rata in breakout companies. Co-investment opportunities are typically offered at a reduced fee/reduced carry (sometimes zero fee/zero carry) basis, allowing LPs to decrease their aggregate fee burden while gaining additional exposure to promising portfolio companies within emerging manager portfolios.
Additionally, emerging managers with smaller funds rely on carried interest as their primary source of wealth creation, and their economic incentives are focused on performance.
An emerging fund manager charging 2% on a $50 million fund will only generate $1 million in management fees. After organizational expenses (rent, operating costs, staff), this may leave the GP with a small salary when accounting for the fact the GP is usually also personally investing in their fund (GP commitments are often 1-5% of the fund).
Emerging managers can offer LPs pure pre-seed or seed-stage exposure.
Investing at the earliest stage of a company’s lifecycle allows the possibility to generate outlier returns where the power law in VC is most prominent. Many VC firms today have multiple strategies including opportunity funds and geography or sector/thematic-specific funds. These firms often require LPs to invest across their entire platform, which offers the benefit of diversification but reduces the LP’s overall exposure to pure early-stage investments.
When it comes to emerging managers, most operate just one strategy, which typically is investing at the earliest stages of company formation. For LPs looking for pure early-stage exposure, emerging managers can be an attractive option for capturing that exposure.
Emerging managers are diverse.
At Allocate, we believe diversity can drive outperformance. According to a McKinsey study, racially diverse firms financially outperform their peers by 35%, and firms with meaningful gender diversification financially outperform their peers by 25%. However, diversity within emerging managers goes far beyond just racial and gender diversity. Emerging venture firms tend to consist of individuals with different backgrounds, skill sets, and socioeconomic statuses. Emerging GPs often don’t come from traditional venture backgrounds - for example, some come from operating backgrounds or have previously worked in a niche industry that has given them deep domain expertise in a particular investment area. We firmly believe diversity of thought and experience contributes to a more robust decision-making process which can lead to better outcomes.
According to Fairview Capital, nearly 90% of all minority or women-led firms in the market in 2022 were emerging managers and 57% of these firms were first-time funds. And according to this Women in VC report, in 2020 over 90% of all women-led funds were emerging managers.
Despite the fundraising headwinds emerging managers are facing this year, Allocate remains steadfast in our belief that emerging managers represent a key area of opportunity for investors. Of course, manager selection matters considerably, as the dispersion of returns amongst emerging managers has historically been very wide. However, with strong and consistent manager selection, emerging managers can be a meaningful source of alpha within any investor’s portfolio.
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