First-Time Funds

First-Time Funds – private equity funds managed by a new management team for the first time – represent a significant and growing segment of the alternative investments market. In recent years we have witnessed a dual trend: on the one hand, first-time funds are flooding the market and account for more than a quarter of the new funds in fundraising; on the other, many investors tend to prefer established, proven managers, which makes it harder for new funds to reach a successful close. Historically, First-Time funds have delivered impressive performance, at times even outperforming established funds, with a higher median IRR in most vintage years. At the same time, raising a first fund involves significant challenges: sophisticated investors (LPs) demand high operational and regulatory standards from the outset, the due diligence process is long and rigorous, and economic concessions in favor of anchor investors are sometimes required.

Investor sentiment toward new managers: A Preqin survey of 2,598 institutional investors found that the general perception of First-Time funds is fairly positive, but divided. Approximately 33% of investors reported that they are open to investing in first-time funds in general, and another 16% said they would consider an investment depending on the specific opportunity. About 12% expressed willingness to invest only in the case of a Spin-out – that is, a fund established by a team leaving a well-known fund or financial institution – while 39% stated that they would not invest in first-time funds at all. This means that roughly 61% of investors are open in one way or another to new managers, although some require that the fund manager have a prior affiliation with an established firm. The result is a significant investor population willing to back Emerging Managers, but also a large core of more conservative investors who prefer to avoid the perceived risk of a fund without an independent track record.

One of the most striking findings in Preqin’s reports is that new private equity funds have consistently shown strong performance – at times even better than established funds. An analysis of fund vintage years (Vintage Years) from 2000 onward shows that in most years, the median net IRR of First-Time funds exceeded that of established follow-on funds. In particular, in the 2000–2003 and 2010–2012 vintages the gap was significant, reaching more than three percentage points in favor of first-time funds. For example, funds with a 2012 vintage achieved a median net return of 23.8%, compared with only 11.8% for non-first-time funds of the same vintage. A similar trend was observed in the early 2000s, reinforcing the argument for a certain structural advantage in favor of new managers early in their careers.

Distribution of performance rankings: It is not only the averages that favor first-time funds – a breakdown by quartile also shows a positive skew. According to Preqin, 31% of first-time funds rank in the top quartile (Top Quartile) of performance relative to peers in the same investment group, and a further 23% in the second quartile. This means that more than half (54%) of new funds made it into the top half of the industry’s performance tables. This figure is higher than would be expected if performance were entirely random, and suggests that First-Time Funds may frequently deliver excess value to investors. Of course, this finding comes with a methodological caveat (see below) – there may be survivorship bias in the data, since failed funds tend not to report or raise a successor fund – but even after accounting for this, the potential embedded in new managers should not be ignored.

Why might first-time funds generate excess returns?

Several explanations have been offered in the literature and by industry practitioners. First, a first-time fund is usually smaller in capital than follow-on funds, and can therefore focus on small and mid-sized deals in a less efficient and less competitive market. These niche markets may yield bargains and higher returns compared with the large investments that big funds are required to make in more efficient markets. Second, the motivation and hunger of a new management team are especially high – these managers are eager to prove themselves and are building an initial reputation, and therefore invest great effort in making their first investments succeed. In addition, prominent managers sometimes leave large firms to establish an independent fund; they bring with them expertise, relationships and experience, but in a smaller fund they are free to act flexibly and without the bureaucratic constraints of a large organization. Another factor is sector focus: many first-time funds concentrate on a specialist sector (Tech, Healthcare, Energy, etc.) in which the founding team has deep expertise, making it easier for them to identify promising investments and avoid mistakes in that field. Indeed, a prominent investment manager provided an example of this: she invested in a first-time healthcare fund in which one of the founders was a physician by profession – the team had an impressive sector Track Record that gave it an edge over generalist competitors.

Why invest in a new fund?

Institutional investors back First-Time funds for a variety of strategic reasons. First, the opportunity to gain exposure to a high-quality manager before they become a household name attracts many: being an early investor with a manager who may later run very large funds (Megafund) is an opportunity to enjoy strong returns in their early funds and also to establish a long-term relationship. Those who enter a first-time fund on favorable terms may benefit from continued access to Funds II and III of the same manager on preferential terms. In addition, there is a perception that a first-time fund is “smart money” – the manager invests the utmost of their energy and personal capital to succeed, unlike, perhaps, a sixth or seventh fund of an established manager, where a degree of complacency may have set in. Indeed, sophisticated investors note that they are “always looking for the next manager,” alongside supporting proven managers – and that they are prepared to step back from programs with established managers who lose their discipline or outperformance.

The importance of the Spinout and the manager’s background: Most sophisticated investors will not take a risk on a team with no experience at all. There is therefore a marked preference for managers emerging from existing institutions. A Spin-out – where a management team leaves an established fund, bank or insurance company and sets out independently – is perceived as a relatively safer investment, because the managers already have a proven Track Record from their previous activity. As noted, 12% of investors even stated that they would invest only in First-Time funds of Spinouts. An investment manager at Caspian Private Equity explained that in her view, “a new fund doesn’t necessarily mean inexperienced managers – many leave with extensive experience and have even been tested through a business cycle.” Investors examine: Has the team worked together before? Do they have a shared investment history? A fund of partners who previously operated as a team in a similar composition earns credit, since they have proven that they know how to work together. In addition, the managers’ individual investment history is examined: which deals did they lead? How did they perform during periods of crisis (for example, during the 2008 financial crisis)? Did they show sound judgment in the use of leverage, and did they have the sense to sell at the right time? Positive answers to these questions can set new managers apart from the many peers trying to raise capital.

Operational readiness and a professional organization: Institutions expect the manager of a new fund to arrive “ready out of the box” – with all the infrastructure, procedures and staff needed to manage a fund, almost like a mature fund. A manager who does not present a solid infrastructure – an office, finance staff, appropriate legal advisors – will struggle to impress investors. Moreover, advanced investors will not hesitate to go into detail: they will ask to meet the fund’s service providers (administrators, trustees, auditors) and verify that they meet the expected standards. All of this is done to reduce operational risk – investors want assurance that although the manager is new, the “school” and the infrastructure are already in place.

Considerations for investors when selecting new managers:

Given all of the above, how do institutional investors approach the selection of a First-Time fund in an informed way?

• Individual and team investment track record: This is probably the most important parameter. Investors will ask to see evidence of past success – whether profitable deals led by the manager in their previous role, or returns of a previous fund (for example, in the case of a Spinout who left another fund and can present part of that fund’s performance). There is no substitute for a quantitative Track Record review: DPI, TVPI and IRR of the deals/funds in which the manager played a significant role. However, a first-time fund usually has no such ready-made document, so the investor must try to extract performance from the manager’s work at another institution – a challenging task given the legal restrictions on attributing individual achievements. In addition to financial performance, past failures and the way the manager dealt with them will also be examined.
• Shared work experience and team composition: Investors prefer a team of partners who have worked together over a long period. When a management team comes “from the four corners of the earth” – each from a different background and with no shared history – there are concerns about the dynamics and coordination among them. By contrast, when a particular group has coalesced and worked together elsewhere, it is easier to place trust in them. Check that the team has already completed 2-3 successful investments together prior to the fund, and assess the fit between the founders. In addition, examine the team’s shared history: how many years they have worked together, how many deals they have done jointly, and whether anyone left the team during fundraising – a significant warning sign.
• Clear specialization and strategy: In a world saturated with funds, a new manager must present a distinctive story. An investor will ask: how is your fund different from dozens of others? Here, sector or geographic specialization can work in the fund’s favor. For example, a team with a background in green energy that establishes a fund in this field will be perceived as authentic and as having a relative advantage over generalist funds. A fund focused on a mid-sized/small market (for example, agricultural technologies in Southeast Asia) may also interest an LP seeking focused exposure. The investor will look for the manager to understand the competitive landscape in their field and be able to explain why their strategy is superior.
• Alignment of the team’s interests: One of the important parameters is to see that the managers have “Skin in the game” by investing their own personal capital in the fund. New managers often invest a relatively substantial percentage (sometimes 5%-10% of the fund) of their own money to demonstrate confidence and commitment to success. Investors also examine the incentive structure: the internal Carry split among the managers and the management fees requested (in a first-time fund, 2% or even less is customary, so as not to create an impression of “wealth without a test” among managers who have not yet proven themselves). Anchor investors, as mentioned above, will certainly demand benefits, but other investors will want to make sure this does not come at the expense of the manager’s motivation. LPs may also make their commitment conditional on additional Alignment mechanisms: for example, a Key-Person Clause (a provision allowing investments to be halted if one of the partners leaves), or a GP Clawback (an obligation to return profits if the fund’s subsequent performance is insufficient). All of these provide assurance that, should a problem arise, investors are protected.
• Fundraising ability and attracting anchor/additional investors: Admittedly this is a circular consideration (you need investors to attract investors), but an LP will not want to be the first and only one to place its trust. Investors will therefore always ask: who else is in with us? If a manager can point to Soft-Commitments or understandings already received from several LPs, it makes it easier for others to join. In particular, if there is an anchor investor willing to commit – that is a very positive sign. Institutional investors sometimes coordinate among themselves (within permitted limits) to gauge whether the fund will be able to reach a First Close. In some cases, an investor will be willing to go first only on condition that it is guaranteed preferred status or ongoing information on progress, so that it can withdraw if there is no momentum.

Although the accompanying reports present impressive data on First-Time Funds, they should be treated with methodological caution. The data may be based mainly on funds that reported voluntarily, while funds that failed or did not manage to reach a First Close are not represented in the sample. This may lead to Survivorship Bias, which causes performance to be overstated. It is also necessary to take into account the challenges of a crowded, highly competitive market, in which new funds must invest in infrastructure, risk management and branding, sometimes without adequate resources. Managers and investors are advised to cross-check the data and conduct critical analysis before forming investment decisions.

First-Time Funds are a vital component of the private equity ecosystem. They represent the next generation of managers who will ultimately lead the investment industry. For institutional investors, ignoring this segment entirely could mean missing an opportunity – some of today’s first-time funds will become tomorrow’s market leaders. History teaches that excess returns may well come from an early investment in a high-quality manager rather than from following established names alone. At the same time, an investment strategy in first-time funds must be calculated and cautious.

**Disclaimer:Nothing in this publication constitutes an offer to the public or an invitation to make any investment; it is a publication and presentation of general information only. The article and its contents rely on information, publications and data received from third parties, which were assumed to be accurate without the company having examined or verified their accuracy. The information presented in this publication does not constitute investment advice/marketing or a substitute for investment advice/marketing tailored personally and specifically to each individual, taking into account their data, needs, financial situation, circumstances and investment objectives.Sources:

Privcap LLC & Preqin Ltd. (2015). First-Time Funds: Veteran LPs Discuss Their Appetites for Emerging Private Equity Fund Managers. Privcap Report, Q4 2015.