Hello Embracing Emergence Community!

Over the last months, I have seen more clarity form around the financial opportunity Emerging Funds can represent. In today’s volume, I want to not only bring more clarity to the risk and return profile of Emerging Funds but also highlight 12 factors of convergence between Limited Partners and Emerging Managers.

I spent time reflecting on the synergies between LPs and EMs while working with a single-family office for several years, where I developed a strategy specifically focused on Emerging Managers.

Here is a list of 12 reasons why I believe LPs should consider investing in Emerging Managers:

1. Attractive Risk / Return Profile

2. Fund-of-Fund Approach as Extra Sauce

3. Access

4. Alignment

5. Co-Investment Opportunities

6. Access to Top Talent

7. Insights

8. More Time to Build Trust

9. Time Efficiency

10. Access to Strategics

11. “Influence-to-Investment Ratio”

12. Impact

1. Attractive Risk / Return Profile

The Return Profile

For Limited Partners it is important to understand how the risk and return profile of Venture Capital investing has changed over the last years. Especially for family offices, which generally invest over generations, not cycles, it is crucial to constantly re-assess how returns are driven and where risk can most effectively be mitigated. The Venture Capital landscape has evolved into one of broad-based value creation across sectors, geographies, and investors.

This means that the best returns are no longer limited to a few established fund managers, who oftentimes can be difficult to access for the majority of LPs.

The below figure highlights this evolution and shows that top returns have consistently been generated by Emerging Managers (Funds 1-4):

From 2004 to 2016, the top-performing Venture fund was a new or developing fund (Fund 1-4), 9 out of 13 times. Out of the Top 10 funds over the observed vintage years, only 35 out of 130 were established funds.

James Heath, a VC allocator for a multi-family office, recently shared data supporting the general potential for the outperformance by Emerging Funds. This additionally leads to the general suggestion that it not more “risky” to invest in Emerging Managers than it is to invest in established funds.

The below graph represents 2,000 VC fund vintages between 1976 and 2020 from Pitchbook. The investment period of the observed funds is assumed to be three years.

Kyle Thorpe, GP at Pattern Ventures, recently published their report on 2,500 funds from 1980 onwards, which also supports the forming narrative of smaller funds having great potential to outperform.

To summarize their report: a portfolio of smaller funds (up to $50M in fund size) has the potential to outperform a portfolio of larger funds (funds above $150M in size) by 45-60%. This calculation excludes the top 5% performing large funds, suggesting the improbability for many LPs to access those.

Since I work in Treasury during the day, I am no stranger to analyzing performance correlation between two variants. And there is something important to note when it comes to investing in emerging funds: their stage exposure.

Returns in Venture are correlated to the stage of investment and the stage of reserve deployments. Due to the typical fund size of an emerging fund, Funds 1-3 generally invest at the early stages, which is a substantial factor in their return potential. Hence, understanding the stage exposure of the Emerging Manager is an aspect to reflect upon when grasping the return potential of Emerging Funds.

The Risk Profile

The various reports and data can illuminate that Emerging Funds are not more risky than established funds. As the data suggest, Emerging Managers actually have the potential to create a significantly higher upside for their LPs.

At the same time, I would like to encourage to keep in mind that there is a survivorship bias woven into the data we currently have on Emerging Funds. Many first funds, that have had to shut down, will not have been reported and therefore the data might not accurately represent reality, even though it can be indicative of what is true.

Also, the figure showing that Emerging Manager Funds have been the top performing fund 9 out of 13 times from 2004 to 2016 is encouraging, but looking at the best 10 funds of any given vintage year should not lead to any conclusions. It can show LPs the excellent potential to outperform any established fund with Emerging Funds but is not necessarily predictive of the outcome of the LP’s portfolio. The probability of finding those top-performing funds needs to be considered.

With that in mind, the risk profile of establishing a strategy around Emerging Funds is shaped by the access LPs have to the top-performing GPs. Many funds are popping up and finding the best Emerging Managers while also cultivating the right network of access can often take a long time and a significant amount of intentional pursuit. Having access does also not equate to the ability to pick winners.

Another risk is that the performance is simply difficult to predict based on a lack of track record in comparison to what LPs would be able to assess when investing in established funds. For VC Funds, previous top-quartile performers managed to keep top-quartile performance for their next time 45.1% of the time. This means that you almost have 2x better chances of hitting a top-quartile fund when investing in a fund with an established track record indicating top-quartile performance. Many Emerging Managers won’t be able to show this performance in their first fund, and depending on if their Fund 1 should be considered as a Fund 0, also not in Fund 2.

Conducting the appropriate due diligence on Emerging Managers often proves to be different than how LPs should diligence established Venture funds. I am planning on spending much time on mutual diligence between LPs and EMs in this newsletter.

To summarize: establishing a portfolio of Emerging Manager Funds brings substantial potential for upside and mitigated risk - risk that needs to be thoughtfully considered. I will dedicate an upcoming volume specifically to the return potential of Emerging Manager Funds, but this should highlight why investing in Emerging Managers proves to be extremely attractive for LPs.

2. Fund of Fund Approach as Extra “Sauce”

Generally speaking, a Fund-of-Fund (FoF) is an investment company that curates a portfolio of other investment funds. Over the last 4 years, according to Mountside Ventures, 85% of surveyed FoFs invested in Emerging Managers. 44% were lead investors.

A great way for LPs to access great Emerging Funds and get insights to best practices is through investing in Fund-of-Funds.

At the same time, LPs have the opportunity to build out their own portfolio of Funds and mimic the returns of FoFs, which can generate strong upside:

When analyzing fund performance for Fund-of-Funds investing in the US and Europe, the data makes clear that early vintages show strong financial returns across both the top quartile, median, and third quartile. Any vintages post-2016 also show reasonable upside but are still early in maturing their fund cycle and full return potential.

When I was working with a single-family office, we concluded that building out a portfolio of funds vs. investing directly in startups would be much more efficient, less risky, and most likely bear equal if not better upside.

The point I am making is that when LPs build out their own portfolio of funds, they have a good chance of outperforming funds that invest directly in startups. The additional benefits for LPs are strong diversification, mitigation of a lot of risks, and access to co-investment opportunities, learnings, etc.

To summarize: The Fund-of-Funds approach can be the secret sauce to generating strong financial returns, while at the same time mitigating risk in uncertain times.

3. Access

Yes, lack of access to top-tier GPs is one of the main risks to consider when reflecting upon investing in Emerging Managers.

At the same time, gaining the desired access to the best Emerging Managers is easier vs. getting access to the best startups. I’ve spent endless hours talking with founders, trying everything in the book and out of the box to get to the best startups out there. I even built a network of VC Associates to share deal flow with the top firms and their associates. It is not an easy task.

And here is the truth: the best founders can choose who they want on their cap table. And a family office (or other typical LPs) are often not the number one choice.

This is different with Emerging Managers. First, there is the obvious reason, that every Emerging Manager is fundraising and happy to talk to a potential LP. This substantially increases your probability of accessing the best funds. Secondly, if you’re an LP, you have the opportunity to actually add value to the GP. Your relationship can be aligned in a way that creates a mutual desire for both GP and LP to seek investment.

4. Alignment

Show me the incentive and I show you the outcome.

In almost all investments, the main incentive is of financial nature. And the alignment around the financial incentive between LPs and the fund matters!

The financial incentives for any Venture Fund lie in the Management Fees and the Carry Fees. BUT, the how these incentives are weighted between the fee types two are not equally distributed across all Venture Funds. Some funds are more incentivized around their Management Fees and some are more on their Carry.

Here is a paradox of Venture Capital: larger funds often take higher fees than smaller ones.

This can create misalignment for LPs, since some funds might be more focused on raising larger funds to monetize more on fees, vs. focusing on generating returns through their portfolio to monetize on Carry.

Emerging Managers often leave a lucrative career and salary behind to start their fund. Often they have to bridge a significant timeframe through their personal capital until they can actually pay themselves.

The management fees typically just serve as a way to cover expenses and salary for the Emerging Manager, but it is not the way to financial freedom. This is where the LP and GP find alignment: they both need to produce Venture returns in order to make money. Plus, if the Emerging Manager does not generate the appropriate returns, the likelihood of raising the next fund drops significantly.

To summarize: Emerging Managers have the type of skin in the game that aligns well with many LPs.

5. Co-Investment Opportunities

Co-investment opportunities represent another factor, which can make investing in Emerging Managers attractive for LPs.

Your typical Fund 1-3 most likely is in the $10-$50m, rarely up to $100m, ballpark. Depending on the portfolio construction strategy of the GP, follow-on capital for portfolio companies, who are indicating a pathway to success, is limited. In later rounds of portfolio companies, Emerging Managers can find themselves in the position of having run out of dry powder and are unable to execute their pro-rata. This is where LPs can step in and get access to a direct opportunity they most likely wouldn’t get themselves.

Also, Emerging Managers oftentimes will put together SPV opportunities through which LPs have the opportunity to participate in rounds of promising companies. LPs now not only have unique access to a direct investment but can also benefit from the conducted due diligence of the Emerging Manager.

Co-investment opportunities can give LPs the desired reps in conducting due diligence on startups, provide de-risked access to outlier companies, compound your return potential, and open a seat at the table with other investors you otherwise would never meet.

6. Access to Top Talent

When I was working with a single-family office I often enjoyed the privilege of exploring collaborations with other FOs. Many times family offices were looking for access to top talent bringing innovation to the industries where the FO had their domain expertise.

Investing in Emerging Managers with the mandate of introductions to talent, especially founders, can be a significant pathway to industry insights and learnings.

7. Insights

The opportunity to gain unique insights represents another factor for LPs when reflecting upon potentially investing in Emerging Managers. I speak with Emerging Managers daily and I mostly encounter Managers, who build their investment strategy around their unique domain of expertise (their zone of genius).

Whatever industries the Emerging Managers invest in, they usually have a lot of expertise and a unique network in this industry. A good relationship with an Emerging Manager can provide unique insights and learnings about an industry of interest for LPs.

8. More Time to Build Trust

The LP-GP relationship lasts longer than the average marriage…

One key factor many underestimate when it comes to LPs making investment decisions is trust.

The benefit for LPs to investing in Emerging Managers, in comparison to investing directly in startups, is the timeframe you have to build a trusted relationship with the GP and vice versa. If you have experience investing in startups, you know what it can to execute a deal and get a seat at the table. It’s all hands on deck, oftentimes turning deals around in the matter of a day. Many LPs cannot get comfortable with that pace, often because it is difficult to establish the needed trust in a very short amount of time.

When investing in Emerging Funds, LPs can utilize the longer timespan for diligence to get to know the Emerging Manager, listen to their stories, and establish the needed level of trust. However, if it’s a pass, send the GP a quick pass email and both can move on.

9. Time Efficiency

This is the least sexy reason, but it is true. The amount of time you have to spend to find and invest in the best startups vs. finding and investing in the best Emerging Managers is substantially different.

If you want exposure to Venture Capital that is time efficient, while at the same time offering top-quartile return potential and the potential to mitigate risk, investing in Emerging Funds, in my opinion, represents a good opportunity.

If you want to invest in the top founders building tomorrow’s Uber, while getting in the round early enough to make outlier returns, you have to meet the founder before they raise their round and then also compete with the established Venture Firms. It takes a long time and a lot of work to build that kind of network and reputation. And even if you get to the talent, you can’t take that access you’ve worked hard for to the bank.

Getting access to the best Emerging Managers still requires a lot of time, but it is, generally speaking, more time efficient, considering that most LPs juggle various investment strategies and jobs at the same time.

10. Access to Strategics

Experienced Emerging Managers will often have built out a network with companies, firms, and other family offices that can strategically align with the LP’s thematic investment strategy.

Hence, Emerging Managers can not only provide access to top talent, and their insights, but also to strategically aligned parties LPs can have access to.

11. “Influence-to-Investment Ratio”

What do I mean by “Influence-to-Investment Ratio”?

Influence-to-Investment Ratio = Check Size * Proximity

This ratio describes the amount of influence, voting rights, or what kind of seat at the table your check buys you. When investing in an Emerging Fund you have the opportunity to be proximate to the GP and the decisions of the fund.

If you compare the check you would have to write when investing in a top startup (if you could even get in) to get a board seat or some position of significant influence in the decision-making, it is often the case that the check that comes with influence is greater when investing in startups.

Emerging Funds are a great opportunity to get a seat at the table and to be in proximity to the GP, while writing reasonable check sizes.

At the same time, this ratio proposes that your influence is not only dependent upon the check size but also on the proximity the LP is fostering with the GP. Good LPs read updates and give feedback here and there, great LPs are hands-on and help.

12. Impact

For many LPs assessing the impact of a potential investment is a considerable factor in the decision-making process.

There are several different pathways to achieving the desired impact through investing in Emerging Managers. Not only is it in your hands to equip a diverse group of Managers with capital, but in general you are providing capital to the investors in the Venture ecosystem, who live and breathe the same air as the founders shaping our future.

Limited Partners have the responsibility to pick the funds they back wisely. The investors LPs back are those who decide what technological innovation should be funded or not funded.

Emerging Managers can often function as the first institutional capital a founder receives. They can turn the lights on for a startup or may advise some founders to never get going. However, it is the LPs’ capital that is backing the Emerging Managers who are catalyzing the growth of startups impacting the world’s future.

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Disclaimer: Opinions are my own. This is no investment advice.