PE emerging managers brace for headwinds in 2023

Private Equity
January 13, 2023
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The year ahead could be challenging for emerging managers in private equity, but LPs won’t abandon them altogether.

LPs are becoming increasingly selective about the managers they invest with, as market conditions make capital deployment more difficult. For emerging managers, who typically don’t have a proven track record of outperformance or preexisting relationships with LPs, this environment could mean lighter inflows of capital in the year ahead.

In 2023, LPs are expected to be more careful about their allocations and only deploy capital with GPs they know and trust, according to Silicon Valley Bank’s Global Fund Banking Outlook Report Q4 2022.

“If you’re an emerging manager these days, the market is a lot less favorable than it was a year ago,” said Jesse Hurley, SVB’s head of global fund banking. SVB defines an emerging manager as a firm that has less than $200 million in AUM.

This marks a shift from only a few months ago, when 83% of LP respondents to an SVB survey said they were open to or actively seeking new manager relationships; a mere 16% said they were looking to invest exclusively with established managers.

The trend is, in part, a product of today’s difficult fundraising environment. While fund formation remained elevated in the third quarter of 2022, most of it occurred with the world’s largest players: In 2022, the top 35 funds took in 75% of all LP capital raised by US PE funds; last year, the largest funds took in only 40%, according to PitchBook’s Q3 2022 US PE Middle Market report.

Today’s fundraising environment is particularly difficult for emerging managers who don’t have industry connections or established records of outperformance. According to PitchBook analysts, middle-market fundraising among first-time or emerging managers fell from 22 first-time fund closures in 2021 to only 13 as of Q3 2022.

What’s more, LPs continue to face the impacts of the denominator effect, limiting their ability to deploy capital until valuations rebalance.

While LPs are prioritizing their allocations to existing managers, investors won’t abandon emerging managers in 2023. On Wednesday, Calpers, the largest defined-benefit public pension in the US, announced a $1 billion commitment to diverse emerging private equity managers, a step forward in the pension’s larger initiative to help develop startup investors and connect emerging managers with allocators.

Emerging managers are an important part of investors’ portfolios that add diversification in deal size and industry specialization, which contributes to outsized returns. They outperformed private and public markets on a 10-year asset class risk-adjusted performance basis, according to Hamilton Lane data provided to PitchBook News. Emerging buyout firms and emerging VC/growth firms generated annualized total returns of 15.1% and 15.8%, respectively, outperforming all private markets (14.1%) and the MSCI World Index (9.5%).

“[LPs] understand that selecting new groups is core to how you build a long-term outperforming portfolio,” said Katie Moore, managing director on the fund investment team at Hamilton Lane.

While commitments to smaller managers might be strained in the short term, LPs remain committed to private equity as a core asset class in their portfolios. In 2021, private equity generated a return of 54%, outperforming the public stock markets by 12%, according to alternative investment adviser and manager Cliffwater’s annual long-term private equity performance report.

Moving into 2022, preliminary data shows a descent toward a drawdown in the asset class, according to PitchBook’s 2022 Global Fund Performance report. But until private equity firms stop outperforming the public markets, Chris Smyth, E’s Americas PE leader, said he doesn’t foresee a “fundamental shift” in how LPs allocate to various managers.

“LPs want to have a diversified footprint within the asset class,” Smyth said. “I think as the data plays out over time, we’re going to continue to see LPs invest in the lower-end funds because the market they’re going after is very different than what the mega funds are going after.”

Still, LPs aim to allocate to managers with solid past performance when capital is scarce, Hurtley said, adding, “If you’re retrenching and you are constrained in terms of the amount of dollars you have to deploy, you go with the [manager] that is the safe option, the safe bet,” Hurley said.