Embracing the Potential of Emerging Fund Managers

The "new kids on the block" help balancing Risk and Reward in Venture Capital Portfolios and might surprise you with exceptional performance.

This is the first article in a series of posts discussing the topic of investments in young venture funds, raised and run by emerging fund managers.

Building a strong venture capital portfolio requires a careful balance between established managers and emerging managers. While established managers offer stability and proven track records, it is the emerging managers who bring the potential for extreme outlier performance and the opportunity to participate in the future landscape of Venture Capital.

In this article, we delve into the significance of incorporating emerging managers into a portfolio, despite the inherent challenges. By understanding the potential payoffs and adopting a diligent approach to identifying the right emerging managers, limited partners (LPs) can unlock exceptional returns and establish a pipeline of future industry leaders.

Any industry has its incumbents and new entrants and Venture Capital (VC) is no exception. As a relatively new sector however, most of the VC firms active today have been “emerging” in the last 15 to 20 years. Emerging managers can stem from a large variety of origins, from the inside of the industry, i.e. GPs creating a split-off fund, or often from adjacent territories like tech-founders turned investors, operators from successful startups or professionals active in the wider startup context, e.g. incubators or accelerators.

The LP-GP relationship is one based on values like trust and consistency. Where Limited Partners typically expect some form of track record to support these values, emerging managers have to overcome the lack of history inherent to their condition as newcomers. In particular institutional investors usually require some proof of experience and a history of consistent returns. More often, consequently, budding fund managers raise their first fund from high net worth individuals and family offices or foundations in their own network, where a trusted relationship already exists and softens the lack of track record.

Emerging managers, however, have a lot to offer that investors might not be able to find in more mature funds.

The parallel with the role and characteristics of start-ups as industry newcomers is helpful to understand how new fund managers are driven by an exceptionally high and intrinsic motivation to succeed, and pack a set of advantageous characteristics not available to mature funds.

New fund managers need to impress if they want a life beyond (or even before) “Fund I”. No emerging manager wants be considered emerging longer than necessary. Therefore, they will be extremely focussed on return maximisation rather than playing it safe. Across the board, their performance might be more volatile than that of longer standing funds, but their potential for outsized rewards is also much higher. It is a risk-reward game after all.

At the same time, emerging funds are structurally very simple, even rudimentary businesses, with all the advantages coming along with it: they are very nimble and agile and know how to operate with extremely limited resources.

This reduced complexity makes them more likely to show a laser sharp focus in their investment activity and proportionally less time spent on administrative overhead. They know how to do more with less, and can make your management fees go a long way.

This agility also reflects in their investments. Most emerging funds are small and target pre-seed to seed stages with smaller ticket sizes allowing for faster fund deployment. As a positive side-effect, many emerging funds welcome co-investments alongside the fund’s involvement in a venture, allowing you as an LP, to gain increased exposure to an asset, but with lower fees.

This agility also provides very early access to ventures dedicated to potentially disruptive new technology or exploring innovative new customer needs in yet inexistent markets. As an investor, besides the high potential for outstanding returns, this also allows you to take a front seat and help drive groundbreaking innovation.

Many emerging funds also target new emerging markets niches, often because of the fund managers familiarity with the domain, or his own previous involvement with the industry as an entrepreneur or researcher. This is also where diversity plays an important role, when emerging managers use their privileged access to yet underserved populations or geographies, or their specific knowledge of unsolved problems and customer needs.

As a LP, you might also value this very personal link between emerging fund manager and investment thesis, even fund “purpose”, when it reflects your own values and helps you fulfil your investment goals or impact objectives.

Finally, these emerging managers might not be emerging for long, and those who will give you outlier performance will probably soon be amongst the most coveted funds. The most sought after funds have severe access constraints, and by getting a seat at the table early, you will certainly benefit from the privileges reserved for early supporters. As you position yourself to benefit from the growth and success of these managers in the future, you build a strong pipeline of established fund managers for your portfolio.

Balancing Risk and Reward

Incorporating emerging managers into a venture capital portfolio brings the potential for extraordinary performance and the opportunity to establish connections with future industry leaders. Despite the challenges and the inherent risk associated with emerging managers, the payoffs can be significant. By striking a balance between established managers and emerging talent, LPs can capture the benefits of outlier performance, build a pipeline of established managers, and create a diversified portfolio that embraces the potential for groundbreaking innovation and exceptional returns.

While it is true that investing in emerging managers comes with increased risk, it is essential to recognize that a diversified venture capital portfolio should encompass a mix of risk profiles. The potential payoffs of exceptional returns and the opportunity to shape the future of venture capital justify the effort required to identify the right emerging managers and build a well-rounded portfolio. By carefully managing the risk exposure through diversification and conducting thorough due diligence, LPs can mitigate potential downsides.

In our next article, we are going to look at quantitative insights on Emerging Manager’s performance and their contribution to the VC industry at large.

Note: The content provided in this article is for informational purposes only and does not constitute financial or investment advice.