Emerging Managers Have Trouble Emerging

Good idea. Bad timing. That appears to be the case with so-called “emerging manager” programs. Several large pension funds have created initiatives to invest in these small, first-time venture funds, but big losses in both private and public equity have visibly slowed commitments.

Although the programs are just beginning to take shape, it seems that only one public institution has made any significant commitments to emerging managers: the California Public Employees’ Retirement System (CalPERS). It has invested $55 million in four small, new funds. But even in that case, CalPERS has no immediate plans to make additional investments in emerging managers.

Other large investors say they want to invest in emerging funds, but there is little evidence that they are doing so. To wit, the first investment made by the Colorado Public Employees’ Retirement Association (CoPERA) from its emerging manager fund was a $15 million commitment to a 10-year-old buyout shop.

With the private and public markets showing no signs of a rebound soon, it’s anyone’s guess when we’ll see a real influx of capital from newly formed emerging manager programs. And yet, these programs seem to make perfect sense during a private equity downturn.

“We believe that smaller funds can exhibit many desirable characteristics, including focused strategies, hungry GPs and strong alignment interests,” says Kevin Kester, director of CoPERA’s alternative investment program. “Quite frankly, we believe a positive dynamic exists when a fund has great deal flow and less money, which in turn forces them to be highly selective in their evaluation process.”

Small private equity funds, those capitalized with $250 million or less, have traditionally fallen off the radar screen of large institutional investors. Pension funds like CalPERS, the nation’s largest public private equity investor, rarely commit less than $50 million to a single fund. Additionally, public funds often invest only in firms with a long track record or with established general partners.

But diversity is the new buzzword in private equity circles. Investors who have been burned by negative returns hope to get back in the black by putting money in emerging manager programs.

“For us, it’s about making sure we build a long-term program in which we can get into venture funds early so we can be at the table as they become successful,” says Henry Robin, a partner in Amsterdam’s NIB Capital. NIB, which manages a $15.5 billion private equity program for the Netherlands’ national pension funds, recently handed $100M to Grove Street Advisors to set up an emerging managers program. “To sustain a venture capital program as large as ours over a long period of time, it’s critical to commit early and identify top-tire managers as they emerge,” Robin says.

CalPERS, which manages $20 billion in alternative investments, created an emerging managers program last May. It dedicated $55 million to what it called “new and innovative” California private equity funds. CoPERA followed suit with its $250 million Targeted Opportunities Program (TOP) program in July. And next month (May), the California State Teachers’ Retirement System (CalSTRS) is set to announce the details of its own $100 million emerging managers program.

Private equity managers argue that smaller funds can guarantee the returns that larger funds can’t and that large LPs must fund the next generation of fund managers if they expect to successful in the long term.

“Many of the more established general partners have, or will have, succession management issues that may affect the future successes of those funds,” says Richard Rose, a member of CalSTRS’ alternative investment staff. “And, at many funds, there is an upcoming generation of senior investors who will seek to develop their own funds, as they outgrow their current roles at their existing general partnerships.”

CalSTRS has said it plans to diversify its $4.1 billion private equity program, and it plans to invest in new partnerships spun out of bellwether firms and younger firms raising their second funds.

It’s still working on the details of its emerging manager program. So far, it has said only that it will seek out a single investment manager, either a fund-of-funds manager or an investment gatekeeper, to get access to young partnerships.

CalPERS created its emerging manager program about a year ago as part of its $475 million Urban/Rural California Initiative (URCI). The URCI was established to drive growth, build businesses and create jobs throughout the state. CalPERS earmarked $55 million of URCI for “innovative new funds.” That money has already been invested in four funds:

* American River Venture Fund. The $75 million Sacramento-based venture fund plans to invest in technology startups throughout California’s Central Valley. It snagged a $10 million commitment from CalPERS, but it couldn’t find enough interest to meet its $75 million goal. It decided to leverage $20.6 million in institutional commitments into a $62 million SBIC-backed fund.

* California Embarcadero Fund. The $125 million Los Angeles-based fund is managed by Nogales Investors and targets opportunities stemming from a growing ethnic population throughout the state and their purchasing power. CalPERS has committed $25 million.

* Garage California Entrepreneurs’ Fund. The $10 million Palo Alto-based fund is managed by Garage Technology Ventures. It plans to invest in 20 to 40 early-stage technology companies. The fund was fully capitalized by CalPERS.

* Silicon Valley Community Ventures. The San Francisco-based fund hopes to close with $25 million in commitments later this year. Now known as Pacific Community Ventures, the firm plans to finance private companies in low-income cities in the Bay Area. CalPERS has put up $10 million.

Over in Denver, Colo., CoPERA put its $250 million program in place last July. Managed by Alignment Capital of Austin, Texas, the program plans to invest up to $50 million each year, committing $10 million to $15 million to funds all over the private equity spectrum: venture capital, leveraged buyouts and special situations funds. So far, the fund has invested just $25 million in two private equity funds-and neither are funds managed by new partnerships. One of the investments is the fourth fund to be raised by Jefferson Ventures, a Canadian firm that invests in early- to late-stage Canadian IT companies. The other is a $15 million commitment to Dallas-based SunTX Capital Partners, a 10-year-old middle market buyout shop raising its first institutional fund. SunTX has historically raised capital on an as-needed, deal-by-deal basis.

Although created with the best intentions, emerging manager programs have fallen victim to an overly cautious investment climate. “With some of the emerging funds, it’s about what risks you’re willing to accept in order to make the commitment,” NIB’s Robin says. “If we make eight to 12 investments, after a certain period of time, one-third will emerge as fairly clear winners. Another third will be undeterminable, while the remaining one-third will be under-performers. For a small amount of capital relative to the size of our program we can take that top third and later be supportive of them at a much greater amount in their next generation of funds.”

Even with the support from large institutions, emerging managers face an uphill battle. Until pension funds truly open their wallets to young firms, emerging managers will be exactly where they were before the emerging manager programs were created-nowhere.