Emerging Manager

What is an emerging manager?

An emerging manager is a fund manager early in its institutional life, generally raising a first, second or third fund with a small asset base and a short track record. There is no single agreed test, and each allocator writes its own, so the label describes where a manager sits in an LP's program, not a legal status.

Where the definition actually comes from

Because the term is a convention rather than a legal category, the working definitions come from allocators and from research. Cambridge Associates, analyzing US venture returns, grouped new and emerging managers as funds I through IV, and reported that for the last 10 years of its study period, 40 to 70 percent of total gains were claimed by new and emerging managers. That is the empirical case for the category: it is not a diversity gesture, it is where a large share of the value was created.

The same research explains why. An average of 61 firms account for value creation in the top 100 investments in venture capital per year, and after 1999, investments ranked 11 through 100 accounted for an average of 60 percent of the total gains generated by the top 100 investments per investment year, exceeding the contribution of the top 10. Value is spread across a wide and shifting set of firms rather than concentrated in a fixed roster, which is the structural reason an LP program needs new managers entering it every year.

When an allocator runs a dedicated program, that program's own policy sets eligibility, and the variables to read for are fund number, a fund size ceiling, a firm-wide assets under management cap, and whether the team has invested together before. Those thresholds are not standardized across allocators, so a manager can be an emerging manager for one pension plan and too large for another on the same fundraise.

The regulatory shape of a small manager

Three rules define the operating envelope most emerging managers live in.

The private fund adviser exemption under Rule 203(m)-1 covers an adviser managing private fund assets of less than $150 million, which is where most Fund I and Fund II managers sit, and it means filing as an exempt reporting adviser rather than registering. The venture capital fund adviser exemption under Rule 203(l)-1 is the alternative with no size ceiling, available if each fund represents to investors that it pursues a venture capital strategy, holds no more than 20 percent of aggregate capital contributions and uncalled committed capital in non-qualifying investments, and does not incur leverage above 15 percent of that same base other than for a non-renewable term of no longer than 120 calendar days.

The third rule is the one that decides how a first-time GP may present a track record. Under the Advisers Act marketing rule, any presentation of gross performance must also present net performance with at least equal prominence and in a format designed to facilitate comparison, and results must be shown for one-, five- and ten-year periods ending no less recently than the most recent calendar year-end. Predecessor performance from a prior firm may be advertised only where the same personnel managed the accounts, the accounts are substantially similar, all similar accounts are included unless excluding them would not materially increase returns, and the advertisement discloses that the results came from another entity.

That is the real answer to the chicken-and-egg complaint about track records. A departing principal usually can show attributed prior deals, but only as net figures, over prescribed periods, with the whole comparable set included rather than the three that worked.

Worked example

The figures below are hypothetical and chosen so the arithmetic can be checked.

A principal leaves an established firm and raises a $25 million Fund I with a 2.5 percent management fee over a ten-year term.

Step one, the budget. The fee is 2.5 percent of $25 million, which is $625,000 a year. Over ten years that is $6.25 million, or 25 percent of the fund. Investable capital is $25 million less $6.25 million, which is $18.75 million. The $625,000 also has to cover salary, an analyst, audit, admin, legal, travel and software, which is why solo managers at this size rarely hire before Fund II.

Step two, portfolio construction. Twenty initial checks of $600,000 use $12 million, leaving $6.75 million of reserves, which is a little over half a follow-on for each initial position.

Step three, ownership. A $600,000 check at an $8 million post-money valuation buys 7.5 percent.

Step four, what a fund-returner requires. If that 7.5 percent dilutes to 4 percent by exit, returning the whole $25 million fund from one position requires an exit value of $25 million divided by 0.04, which is $625 million. That single calculation is the heart of the emerging manager pitch and the heart of LP skepticism: at this fund size one $625 million outcome returns the fund, and the manager has 20 shots at finding one.

Step five, the LP's arithmetic. A pension plan with a $40 million minimum check cannot participate at all, because $40 million into a $25 million fund is impossible and even a $10 million commitment would be 40 percent of the fund. That is why the Fund I investor base is typically funds of funds with small-check mandates, family offices, and individuals, and why an anchor LP taking 20 percent, or $5 million here, has enormous leverage on terms.

Where the label shows up in practice

In LP documents, emerging manager appears in three places: an allocation policy or program mandate defining eligibility, a side letter with the anchor investor covering fee breaks, advisory committee seats, co-investment rights and sometimes a share of the management company, and diligence questionnaires asking for attribution of prior deals, the team's history of investing together, and succession and key person arrangements for a one- or two-person firm.

The diligence emphasis is different from an established fund. An LP underwriting Fund X is underwriting performance persistence. An LP underwriting Fund I is underwriting attribution, access and operational survival: did this person actually source and lead these deals, will good founders take their call without the old firm's name on it, and does the management company have the cash and the back office to run a ten-year vehicle.

Common mistakes

• Overclaiming a prior track record. The marketing rule's predecessor performance conditions, including the requirement to include all similar accounts, make cherry-picked attribution a compliance problem rather than a rhetorical one.
• Sizing the fund to the strategy without checking fees. At $25 million, fees consume a quarter of the vehicle across its life, which shapes check size, reserves and the number of positions.
• Ignoring reserve math. A portfolio with no follow-on capacity gets diluted out of exactly the companies that worked.
• Promising deployment speed to LPs and concentration discipline to founders. Those two promises collide in year two.
• Treating the first close as proof of the fund. Emerging manager fundraises commonly stall between first and final close, and the deployment pace set early is judged against the final fund size.

Related terms

A solo GP is the most common form an emerging manager takes today, and a micro VC fund is the size band most Fund I vehicles fall into. An anchor LP is the investor who makes the first close possible and prices that risk in terms. The GP commit is the personal capital the manager puts in, which is the hardest term for a first-time manager without prior carry. An emerging manager program is the allocator-side vehicle built to make small commitments to exactly these funds.

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