A New Platform For Emerging Managers
Previously, we examined the unmet needs of micro-VC and emerging managers, and the opportunities this may bring for an enterprising, emerging manager-focused LP.This time we delve deeper and explore four areas:
- What exactly is the opportunity presented by emerging managers in venture?
- A platform to focus on emerging managers could capitalize on this opportunity, but what does this look like?
- Has a platform model worked elsewhere?
- Recast Capital: the platform for investing in emerging and diverse managers.
As highlighted in the previous article, as businesses have become easier to start, there has been an explosive demand for early-stage capital, which in turn has driven investor specialization across sub-stages, sectors, and geographies. As a result, a new venture sub-category called micro-VC emerged, which are specialty venture capital firms with $25-$100M in assets under management (AUM). According to PitchBook only 100 micro-VC firms were active in 2012, and as of October 2019 over 900 micro-VC had been launched resulting in ~9x growth in just 7 years. The underpinning insight was that the “generalist” approach by legacy VC created an opportunity for bespoke firms that could better support founders at the early-stage in their respective markets and that this would lead to improved outcomes. The definition of emerging managers in this document includes Micro-VC managers, and any other manager who’s raised less than three funds. What exactly is the opportunity presented by emerging managers in venture?Some Facts Supporting a +$20Bn, Overlooked Opportunity According to PitchBook, since 2017 the venture capital industry has raised ~$271Bn in committed capital. And on average, funds of <$100M represented about 5-10% of total capital committed in any given year. Specifically, PitchBook tracks $25.6Bn raised by 870 micro-VC managers from 2012 through 1Q 2020, and more than half of that was raised in the last 3 years.
As of the date of this article, we identified 358 emerging and micro-VC managers actively raising a new fund, which in aggregate represent about $6-8Bn in capital demand. Assuming a fund investment cycle of 3 years, going forward one could expect a +$20Bn investment opportunity in the emerging manager and micro-VC subclass. Of course, only a portion of these managers will succeed given the skewed nature of returns in venture capital. Understanding how to identify, assess, and support the high-potential managers is therefore a challenge and a unique opportunity.Additionally, investing in emerging managers can serve as a pathway to enable more diversity in venture, which is much needed in our industry. According to the NVCA, in 2018, women, Black and Hispanics represent only 14%, 3% and 3% respectively of investment partners or equivalent on US venture investment teams, drastically misaligned with their proportions of the US population. This means that most established venture firms are operating with predominantly homogenous teams, which has been shown to yield poorer outcomes; these homogenous team constructions are potentially impacting their deal flow and decision-making capabilities, which ultimately contribute to sub-standard returns. Women and racial minorities make up a growing proportion of emerging managers (one study found that 16% of micro-VCs included at least one female investment partner and well over 50% of firms included at least one minority), and the explosion of emerging managers in the market today provides an opportunity to not only capture an interesting business opportunity but also impact the diversity profile of venture.Why This Opportunity Exists While many traditional limited partners (LPs) understand and appreciate that thoughtful allocation to venture capital can lead to alpha, many will allocate capital only to brand-name VC firms (where they can, as many of the top names are now access-constrained) and stay away from emerging firms given the (often-overestimated) risk. While this may be perceived as the optimal strategy, there’s plenty of data supporting that such an approach may not be as profitable anymore. There are many specialist emerging managers that not only have unparalleled expertise in their respective markets and industries, but are often the first choice for top entrepreneurs. Respected LPs like the Kauffman Foundation and consultants like Cambridge Associates have reported that emerging managers and smaller funds tend to outperform larger scale, established funds.
A simple math exercise supports such an argument: assume a $1Bn fund looking to return 3x invested capital, and that on average the fund owns 10-20% of the companies it invested in. Without factoring dilution, the fund manager needs to realize exits worth $15-30Bn in aggregate. This is possible, but rare, which is maybe why larger funds tend to underperform. Conversely, a $50M fund looking to return 3x, which on average owns 5-10% of its companies would need to realize $1.5-3Bn in exits. Still a very hard task, but an order of magnitude less than the $1Bn fund play. This isn’t a general rule as there are large funds that outperform and small ones that underperform, but if LPs carefully examined their portfolios they’ll probably find there’s truth in it.As a result, we believe a thoughtful venture portfolio includes exposure to emerging managers for outsized returns. Despite all of the analysis and data, the emerging manager group is largely disregarded by many LPs; why? In addition to the high-risk bias on emerging managers (and the often understated risk of established managers) there are several, practical constraints:
- Policy - many LPs have rules that prohibit directly investing in managers without an institutional track record of 7-10+ years, and by definition an emerging manager won’t have it.
- Check size - for many LPs, it’s inefficient to make commitments into small funds given the overall size of their portfolios and the amount of capital they need to put to work, so emerging managers won’t meet their minimum check size requirements (can’t absorb checks that big).
- Gatekeepers - LPs are bombarded with pitch decks and many rely on consultants for parsing through investment ideas. The emerging manager landscape is highly fragmented and given the smaller fund sizes, consultants are not incentivized to spend much time in this space.
- Signal in the noise - given the large pool of emerging managers, and that not all great emerging manager opportunities fit traditional pattern-matching and underwriting processes, it can be difficult for even experienced, institutional LPs and consultants to find the signal in the noise.
- Work load (to do it right) - it’s a big lift to source, underwrite, and provide ongoing support to emerging managers (as identified in the previous article).
A platform to focus on emerging managers could capitalize on this opportunity, but what does this look like?The Value Proposition for Emerging ManagersWe studied the strategies and portfolios of the 358 micro-VC and emerging managers that are actively raising, and interviewed over 45 of them to better understand their pains (emerging managers, please submit this form to be included in our ongoing analysis). While the needs vary across fund stages, we consistently heard that emerging managers value a committed LP who can truly provide more than just capital. Critical areas of support and guidance needed include:
- Investor relations and reporting
- Fund accounting, tax, and audit
- Cash-flow management
- Portfolio construction and risk management
- Liquidity management
- Investor community development
The Value Proposition for Limited Partners (Who would invest in this strategy)We also solicited feedback from multiple, strategic LPs and we consistently heard that a platform focused on emerging managers would be useful to:
- Provide an investment entity that can absorb larger check sizes from LPs and diversify their investment into a series of emerging managers.
- The platform’s support services for the emerging managers further de-risk the exposure for the LPs.
- Given exposure to various high-potential emerging managers from the pooled fund, the LP can more efficiently identify those managers that they may want to take a core position in their portfolio and go “over the top” to invest directly with the platform’s support; every subsequent FoF raised keeps this flywheel going for the LPs.
- Gain access to an outsourced research team to provide ongoing market insights and intelligence.
- Gain access to unique co-investment and secondary opportunities from the underlying emerging managers.
- Identify and invest in diverse managers more effectively.
Has a platform model worked elsewhere?To be clear, investing in emerging and diverse teams with a platform approach is a mature and proven concept in alternative investments like PE buy-out, growth equity, hedge-funds, private credit, and real estate. And there are several, large-scale players that stake emerging managers and provide supporting services. As an example, GCM Grosvenor has allocated +$16.8Bn to emerging and diverse managers since 1989, across PE, hedge funds, and real estate strategies. Other groups like Dyal Capital manage $21.7Bn and invest in GP stakes, offering a “business services platform” to the GP they work with: “The BSP focuses on two aspects of business development: vertical (asset raising) and horizontal (enterprise value creation). The BSP consistently engages with senior management, business development and back office personnel, working to drive the firm forward while leaving the firm’s core competency—investing—untouched.” While these approaches are tailored to the asset classes they focus on, there are many parallels that can be drawn for emerging managers in VC.Recast Capital: the institutional-grade platform for investing in emerging and diverse managers.Emerging managers are screaming for an LP that understands their pains, and can help them build a successful firm by providing more than just capital. While some fund-of-funds and LPs have successfully invested in this space, their approach is insufficient for what now is a +$20Bn sub-asset class composed by ~900 managers, and growing +20% CAGR. This opportunity didn’t exist before, and the manager pool is now large enough to be able to execute with calculated risk. We believe there is an unclaimed opportunity to build the defacto platform for emerging managers and micro-VC.A group of Kauffman Fellows joined forces to launch Recast Capital - the platform to support and invest in emerging managers in venture.Recast’s goal is to become the high-signal “wire service” for the broader LP and GP base - akin to what TechStars and Y-Combinator did as accelerators, and First Round Capital did for seed stage rounds. Recast is led by Sara Zulkosky (class 23) and Courtney McCrea (class 3), who previously worked at Greenspring Associates and Weathergage Capital, respectively. In addition Esteban Reyes (class 23), an emerging early-stage, direct investor joined as an Emerging Manager in Residence. The diverse team brings extensive institutional investment experience, a deep understanding of the challenges of being an emerging manager and the solutions to address them, and credibility in the emerging manager and LP communities. They also share a deep passion for supporting diverse teams and believe in their power to increase returns. “Emerging managers, particularly those with diverse partnerships, represent both an underserved market and overlooked business opportunity. By providing them with institutional-grade support and innovative capital, we can accelerate emerging managers' success and provide our LPs the magnitude of returns that were originally intended by the asset class”, said Sara Zulkosky.
While Recast may not be able to invest in all great emerging managers, they do want to enable as many as possible to be successful. To further support the emerging manager ecosystem and build the number of investable opportunities in the space, Recast Capital has established an Enablement Program to support the GPs of venture firms that have recently been or have yet to be established. The Program provides up-and-coming emerging managers with the same support offered by their investment platform but via a structured curriculum, led by a network of seasoned venture professionals, Limited Partners and trusted service providers. The content provided via pre-recorded videos, live and interactive webinars, and in-person events. The goal is to be as inclusive as possible; the Program is offered tuition-free to all participants and neither a warm introduction nor a referral is required to apply.If you’re an emerging manager interested in learning more about Recast, or a member of the community and want to get involved, please visit recastcapital.com and leave your contact information to continue the conversation.Next Questions:
- Which are effective frameworks for effectively assessing emerging managers and their portfolios?
- Are there opportunities in micro VC secondary transactions as an Emerging LP?