When public markets experience volatility, experts say they invest in emerging managers

Branded growth funds may dominate the headlines, but an industry secret is that the best return profile of venture capital has historically been produced by newcomers and in the early stages of investing. Data from Cambridge Associates shows that new and developing companies are consistently among the top 10 best-performing companies in the asset class, accounting for 72% of the best-performing companies between 2004 and 2016.

The early stage is where you will find the most emerging managers, by virtue of the fact that funds with less than $ 150 million investing in pre-seed and seed companies are often early in their life cycle. Early funds are on the rise – most are under $ 25 million and backed by individuals and families willing to take the risk on a manager with a shorter track record. It’s a smart bet, because the top three funds are when a manager has more to prove and is working harder. They perform a different calculation than the funds in the next stage: they are optimizing for outsized returns to build their reputation, not for management fees.

They are also likely starting their own fund because they see an opportunity that they believe others are missing out on, which is what venture capital is all about.

Despite the better performance of consolidated funds, emerging funds are still underinvested. Data from NVCA and Pitchbook show that less than 40% of venture capital allocations over the past fifteen years have gone to emerging managers. For endowments, emerging funds may not be able to meet their sizing requirements, but for family offices and new fund-of-funds strategies, this opens up a great opportunity: better returns and Easier access (through innovative manager selection, lower minimum commitments and fundraisers that stay open longer than branded funds).

We are starting to see more and more LP strategies emerge to seize this opportunity, which certainly confirms the potential for return. Even the most established companies that have traditionally invested in “blue chip” funds have now collected dedicated vehicles for this year as a seed manager.

Higher return profiles

For venture capitalists who are strategic about portfolio construction, the path to outsized returns is, generally, to gain significant ownership in future unicorns at the lowest possible entry point. The challenge is: how do you predict the winners?

For LPs supporting these managers, the question is how to get exposure to as many winners as possible. According to a recent report from Verdis Investment Management, the seed asset class is driven by the law of power, which means that there are a small number of outliers (1–2%) that drive almost all returns. Volume is a key part of their strategy – by gaining exposure to over 1,000 seed investments in strategic networks and geographies, they can increase the likelihood of acquiring unicorns in their portfolio. Since it is difficult to invest directly in enough startups to make this strategy work, this means investing in several seed-stage managers who each have a portfolio of over 50 companies.

Jamie Rhode of Verdis Investment Management explains: “We decided to create our own seed fund of funds in 2017, committing to 20 seed funds, and now we have exposure to over 1,000 unique companies and 23 unicorns with a Series A and below entry point. in that portfolio. The results have exceeded our expectations and we have now increased the cadence of the funds we commit to. ”

This strategy has added benefits when public markets are subject to volatility. Although investing in the seed is risky (a startup in the seed phase has an estimated 2.5% chance of becoming a unicorn), the pre-seed and seed rounds are isolated from the turmoil of the next phase because the entry points of valuation are generally still interesting.

Jamie shared data from a regression they performed that validates what we early stage investors recognize on a daily basis – there is little or no correlation between current public market conditions and early stage venture capital returns as you are investing for an 8-10 year exit environment into the future.

While the power-law dynamics of seed investing mean that volume can be a hedge, the “spray and pray” strategy of gaining exposure to as many trades as possible is rightly criticized. Finding the best managers who will be able to repeat success and consistently access the best offers is key.

Evaluation managers

As I wrote earlier, many up-and-coming managers at some point found themselves grappling with the opportunity to start their own business or join an established company as a partner.

Once they have made the leap, emerging managers have the promise of high returns, but shorter track records. So how do you rate a great one?

Many of the best performing funds in the VC asset class are the smaller, early stage funds and many of these are managed by emerging managers, “according to Alex Edelson, founder and general partner of Slipstream, a limited partner in the stage funds. initial.

Alex says he seeks managers “whose investment strategy is tailored to their unique and enduring competitive advantage, who have been shown to add significant value to founders and whom founders and other investors love to work with.” It is also important for him to understand the right ownership goals for meaningful returns.

While there isn’t a one-size-fits-all background that means success for an emerging manager, he finds that former traders who can offer strong industry experience to founders tend to have an edge.

Winter Mead, who runs Coolwater Capital, the studio and accelerator for the launch and downsizing of emerging investment managers, agrees. He saw VCs from a wide variety of backgrounds, “including those in finance, marketing and PR who each offered key skills and strategic advice that helped founders and companies scale and reach the next level.”

Jamie takes the opposite position. He shared that “of the 38 initial funds we have invested in to date and which fit our general model, most are not former traders. This is typically due to the fact that their portfolio construction is not in line with the power law thesis that we believe in many shots on goal. Most former VC practitioners believe in a concentrated portfolio and board seats where they can help create the next outlier. “He wants his doctors to focus. collection outliers, no creating them – and definitely don’t try to bail out companies that aren’t profitable.

“It doesn’t matter how much you own if you aren’t into a winner,” he says.

Alpha without consent

Getting early access to startups doesn’t just mean favorable entry points, but being ahead of the market over broader trends, emerging sectors and new entrepreneur profiles. Jamie notes that emerging managers “can provide differentiated and diversified access to a pool of startups that more established brands may not have access to.”

Alpha without consent comes from identifying opportunities that are overlooked, often in geographic areas and underserved populations. Most of these opportunities are seeded by emerging managers, because even if established funds see these trades, they may not feel comfortable taking the risk.

Coolwater sees the inbound applications of over 1,000 aspiring managers each year and works closely with a selection of these teams through its Build program. Winter shared: “Over the past year we have worked closely with over 60 emerging curated managers. 60% are from non-traditional VC cities (outside of San Francisco, Los Angeles, New York and Boston) and over a third are international. Ambitious VCs are finding new opportunities to seek out the talent of founders and build innovation ecosystems in places that have historically been harder to reach. ”

For LPs investing in seed, supporting a group of similar managers who all have exposure to the same trades is not a sufficiently varied strategy to win. It is much more beneficial to create an index of managers who accept bets without consent with minimal overlap.

That said, there are some trends related to better returns: According to Jamie, geography (most of the winners are from California and New York) and networks (the value of the network a startup is in) can skew the odds. successfull.

During a recession, be aligned with the builders

If the great financial crisis of 2008 can be seen as an indicator of our current recession, we can expect a slowdown in funding in the later stages, but company formation and initial funding will continue unabated.

Indeed, one of the most significant trends of the 2008 crisis was the creation and financing of new companies at an increasing pace and from it revolutions in fintech and the sharing economy were born.

A retreat like the one we are experiencing now can actually have positive effects for seed investors – founders who want funding are forced to grow responsibly and focus on business fundamentals, such as their path to profitability. Less hype will make it easier to separate the winners from those who ultimately won’t survive. It may be counterintuitive, but the best times to build and invest are often when we feel most in trouble.


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