We recently hosted about 175 of the most influential capital allocators in the venture industry for the first Emerging Manager Circle Summit. Despite the general fear of a recession looming, the optimism around the emerging manager landscape was pronounced.
And why wouldn’t it be? Cambridge Associates found that emerging managers accounted for 72 percent of the top returning firms between 2004 and 2016 despite representing a smaller share of the allocated capital. As established firms get bigger and bigger, this trend is likely to further benefit the emerging manager investment case as legacy firms fall victim to the Law of Large Numbers and generational transition issues.
LPs largely recognize that emerging managers tend to have more diverse profiles (which has shown correlation with higher returns) and often have better incentive alignment with LPs (they need to fight for survival, not just rest on fees). To further the optimism, in a recent survey of more than 50 institutional investors, 62 percent responded that the risk and return profile for emerging managers was as/more attractive than established firms.
That said, Axios recently published some dismal data on the reality of the emerging manager landscape. Thus far in 2022, 62 percent of the capital has gone to just 6 percent of funds, and in Q3 alone, 87 percent of the money was committed to just 66 funds. This fails to capture the countless emerging manager funds that are either trying to raise and are unable to close capital and/or too small to fall under the purview of this analysis. The reality is that the allocations are more (not less) skewed to established, larger firms. Respectfully, while there is a lot of optimistic talk about the future of emerging managers, we need to see a hell of a lot more action.
The harsh reality is that the LP-GP dynamic is incredibly slow to change for a host of structural reasons. Venture is a long-duration game and performance may not be fully realized until 10-12 years after a fund’s inception. In the course of that timeline, a firm may very well raise another five funds. In fact, the tenure of this return dynamic may indeed outlast those of the allocators.
The lack of real-time quantifiable data creates an uncertainty aversion to switching managers. “Return on time” is another complicating factor in this relationship. If an LP opts out of doing a subsequent fund for an existing manager and chooses to allocate that capital to an emerging manager, they need to manage two sets of relationships (not one). Given the uncertainty of performance and the additional work required, the general incentives align for LPs to continue backing their existing rosters of managers. While the returns of these funds may not be terribly persistent, their ability to raise certainly is.
For those saying, “It’s an efficient market, established firms have LPs willing to invest because of their returns,” unfortunately, that’s not really the case. A lot of these firms have returns below those that chose not to scale their AUM or are raising larger funds based on the success of funds that were far smaller. Matching prior returns with larger fund sizes will be incredibly difficult now that the bull run has ended. Despite this, the dynamics cited above result in an overwhelming incentive to back existing managers. This is why nearly every firm that can scale, will scale. The current system incentivizes managers to do so as it gets increasingly easier to raise at scale (not harder), and while it may result in deteriorating returns, the delayed response of LPs enables GPs to accumulate fees based on AUM that more than compensate for it.
As LP allocations concentrate behind a consolidated list of consensus managers, it pulls the venture industry decidedly away from the very aspects that make it so great. It makes firms favor fees over carry and growth stage pre-IPO investing over the early stages where founders need us the most. It leads to investors being taken off the field to run asset management firms, rather than working directly with founders to build great companies. Simply put, if your firm is successful and chooses not to scale, it’s because of one reason: You care more about your founders and your LPs than you do about the money.
Don’t get me wrong, being an LP is incredibly difficult. Identifying new managers before they are obvious is hard. A lot of the best performing managers of the last 20 years (firms like Union Square Ventures and IA Ventures) didn’t come out of the most premier VC hotbeds, making it difficult to spot them early.
Similarly, the sheer scale of the asset management industry requires LPs to put money to work, and most of the fund sizes that emerging managers can raise don’t align with what institutional LPs need to put to work. This is why emerging managers usually end up raising from connections they have to high-net-worth individuals and family offices. Unfortunately, these conditions inhibit diversity and meritocracy in our industry and stunt the entry of new firms with new perspectives.
How can we expect to broaden the scope and perspective of the venture industry when the only firms capable of launching are managed by folks who either worked at legacy firms or those inherently connected to wealth?
How are we creating opportunity for new perspectives in our industry when the existing LP-GP dynamic doesn’t allow it?
How can we bring down the barriers to fund emerging managers to create more competition, innovation and meritocracy in our asset class?
How can we make the venture industry better tomorrow than what it is today?
The answer to these questions is emerging managers. They provide the opportunity to carry us forward from the methods of the past to the best practices of tomorrow. To realign LPs, GPs and founders and re-establish the qualities that separate venture capital from other forms of asset management.
The last decade has represented one of the greatest bull runs in modern financial history, and the venture industry was amongst its greatest beneficiaries. Proceeds to both GPs and LPs generated during that run force us to a fork in the road. We’re seeing many of the greatest investors of this time retiring, making room for the next generation. While many of these legacy firms may have the same name, the investors deploying capital are not the same as the past and may indeed be less experienced (with less skin in the game) than emerging managers. LPs can either choose to back the next generation of these legacy firms or the next generation of managers betting on themselves to carry us forward.
While I know very little, I know the future of entrepreneurship will look very different from the past and I’m hopeful that the future of asset allocation in our industry will follow suit. The opportunity to create that future is in the hands of LPs willing to push the legacy constructs of the LP-GP dynamic and back the emerging managers capable of serving the needs of tomorrow’s founders, not just those of the past. I’m hopeful they seize it.
For those of you who are emerging managers, I encourage you to fill out this online form to apply to the Emerging Manager Circle, an online-offline community of over 400 emerging VC fund managers. For LPs looking to engage with Emerging Manager Circle, please email firstname.lastname@example.org. Read more about the circle here.
Rick Zullo is co-founder and general partner of New York’s Equal Ventures, which formed the Emerging Manager Circle. He can be reached at email@example.com.