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How LPs Can Encourage Differentiation for Emerging Managers in a Crowded Market

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In our recent webinar we discussed how emerging funds can become "institutional ready" such that they can attract the attention of national endowments and banks. One important piece of advice for funds in today’s market is: you can’t follow the usual path and channels to funding. Firms such as SVB Capital have always offered a strong support business for emerging managers, says Jessica Baron, COO. She noted that it's always been a difficult place to be and they try to support those that are unorthodox. It is a crowded space today and it is a difficult market with no track record.

Former Senior Portfolio Manager at CalPERS for over 11 years, Joncarlo Mark, commented that the path to "institutional readiness" is strong portfolio analytics. He says the difference between today and 20 years ago is vast. There are now all different types of investors: foreign, growth of asset manage firms, fund of funds, even LPs doing everything (co-investing, lending, etc). This sophistication has led to conflicts in the LP universe. What it means: it is important to have good governance and transparency from the start. Funds should set up their limited partner advisory committee (the “LPAC”) and reporting protocols. This offers the opportunity for inputs to the LPAC discussion. Important issues today worth noting:

  • Conflicts of interest may arise given all the levels of investment today.
  • An active dialogue between LPs and General Partners (GPs) is critical.
  • Transparent conversations and thorough reporting from the beginning.

Every ten years or so we have a crisis, so the need to have protocols and active communications and trust with LPs is a requirement, although Joncarlo notes it is never a straight line. He offers there may be a slow turn of events and continual tacks to get there.

Diversity is a way to set your firm apart. How does it impact quality and deal flows?

Not all emerging managers are in the same category. Our experts noted that there has never been a better time for a minority or female-owned business seeking investment or growth than right now. Any male dominated funds where there isn’t a woman on the team may want to take an introspective look at how to diversify. This doesn't mean the firms would discriminate against a particular fund, but right now they want to see that diversity more than ever before. Furthermore, SVB Capital’s Jessica Baron said that having a diverse group of GPs has been proven to enable positive returns.

Wells Fargo’s Head of Fund Investing Division, Tim Rafalovich, reflected that five years ago, socially responsible questions would not have been top of mind, like they are today -- it would have been uncommon to hear: “Tell me about the women and minorities on your board or team, tell me about your impact on the environment, etc”. This is not to say that these are primary decision drivers but these factors help drive decisions, particularly with family offices that weigh the impact they are having on society, not just returns. In fact,  recently, VC firm Act One Ventures, announced a grassroots initiative to approach diversity from the cap table with a new Diversity Rider, which requires the lead investor to commit to diversity from the beginning of the funding process. The goal in mind is to increase diversity representation in venture capital deals, even when firms invest in non-diverse teams. As a data analytics company, Aumni is committed to tracking the diversity rider in its deal database with the goal of empowering its customers and stakeholders with diversity metrics across the venture and startup community. More details, including how firms, partners and diverse check writers can sign up are available here.

Ashley Drake, Partner at HighCamp Compliance, echoed that LPs are really focused on questions about diversity of management and workforce. They have seen LPs asking GPs for data points on titles and even pay gaps within the firm.

Environmental, Social, and Corporate Governance (ESG) and transparency gain attention.

Today more than ever investors are looking for ancillary benefits, not just the expected returns on capital. ESG refers to the central factors in measuring the sustainability and societal impact of an investment in a company or business. Firms are looking to see that funds are also good stewards of capital. When evaluating funds they will often look for what other benefits the company provides. For example, does the company positively impact a geographic location? What societal impacts are there? Is there diversity in company, or quality jobs? Our panelists stressed that we have to be aware of this phenomenon as an industry because there will be more scrutiny of VC and Private Equity (PE) firms in the future. Governance is important -- even at the LP to portfolio level.

Overall, regulation and the political landscape will only become more of a topic going forward in the investment community, especially for VCs and PE firms. We can expect an increase in scrutiny and a move towards standardized reporting and transparency.

On the regulatory front, Ashley noted that when it comes to Security and Exchange Commission (SEC) registrations, her firm has noticed a few factors. They are seeing a lot of LP driven requests to register with the SEC. This provides LPs with a comfort level, infuses compliance into the culture of the firm and drives a desire for transparency. She has seen pressure from the LP community for increased transparency. We could see more SEC registrations in the pandemic to give them more investment optionality to fall under a VC exemption.

Know your blind spots and start early.

The unanimous opinion of the experts here was that fund managers should begin the process of establishing a healthy practice for corporate governance and compliance early. Doing so puts less strain on the relationship between GPs and LPs, as it puts the GPs on the offense instead of defense to be upfront from the beginning about disclosing that they have thought of all the basic areas of compliance, which is especially important for emerging managers. Their advice:

  • Sit down and map out the due diligence process from the beginning before you reach the $150M revenue mark. It is easier to set up the proper governance policies now.  This also offers the benefit of getting comfortable with the process at the outset.
  • Crafting transparency policies early is critical. If the firm knows what's coming and what questions will be asked, they can lay the framework early. Doing so puts the dialogue between the LP and the GP in a better position to be funded.
  • Utilize the management you have now instead of hiring compliance leadership right away. A CFO or legal counsel can often handle this area and there are other strong outside resources and specialists to help without making a hire immediately.
  • Technology is very useful to get some of these things accomplished now without investing heavily in infrastructure and new hires. Firms can more easily share information and reporting guidelines, as tech allows digital interaction and reporting, without the traditional manual entry of data.

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