First-time Funds in Emerging Markets
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Why Do First-time Funds Matter?
First-time funds, defined here as an asset manager’s first private equity (PE) vehicle, have historically accounted for a significant share of fundraising activity in emerging markets (EM). Between 2008 and the first quarter of 2015, 286 first-time funds reached final closes on an aggregate US$45 billion, accounting for 30% of the number of funds with final closes and 15% of total capital raised during this time period. But their prominence in overall EM PE fundraising is not the only reason why first-time funds matter to the asset class.
For limited partners (LPs), the benefit of supporting first-time funds is tangible from an industry development perspective; new fund managers not only encourage a more diverse marketplace, they also address financing gaps in many underserved markets. Of all funds that held a final close in 2014 at or under US$100 million—the smallest segment of the private equity market—53% were first-time funds. What’s more, in some EM PE markets with fewer active players, firsttime funds account for a significant share of the number of funds raised. This is most clearly illustrated in Sub-Saharan Africa, which boasts the highest percentage of first-time funds reaching a final close, at 78% of all funds in 2014.
Yet despite their contribution to the industry, EMPEA has anecdotally witnessed an increasing number of emerging managers that are unable to raise capital. Investing in first-time funds, as LPs interviewed for this brief noted, compounds the risk of investing in EM PE with the uncertainty associated with a first-time manager. Haydee Celaya, Cofounder and Chief Investment Officer at Avanz Capital, an investment firm that specializes in PE across emerging and frontier markets, reflects: “Some of the underlying concerns that LPs have about investing in a first-time manager are around the team itself: Can the partners live off the management fee? Is the carried interest sufficient to keep the investment team employed and interested? Are they going to survive or are they going to start losing people? The commitment of a first-time group is always a big question.” In the following section, a close look at recent fundraising trends helps to shed light on the state of the market for first-time fund managers.
The State of the Market for First-time Funds
Since 2010, the number of first-time funds reaching a final close has steadily declined. In 2014, only 28 first-time EM PE funds reached a final close (see Exhibit 1), the lowest number on record since EMPEA began tracking fundraising statistics in 2006. While this should be contextualized within the overall decline in the number of EM PE funds closed, fund managers raising their first, second or third vehicle have been harder hit than fund managers raising their fourth fund or later, both in terms of number of funds and total capital raised. Since 2011, total capital raised by EM-dedicated first-time funds has declined on an annual basis, hitting an all-time low of US$2.8 billion in 2014 (see Exhibit 2), while second- or third-time funds have declined annually since 2012, both by the number of funds reaching a final close and by total capital raised.
So why are emerging managers raising less capital across fewer funds? Is the fundraising environment simply more challenging? While later sections of this brief implicate a confluence of factors on the fund manager side—including increasingly competitive geographies, a shift towards smaller VC vehicles in the overall composition of first-time funds and significant variance in performance—one broad factor likely contributing to this decline is LPs’ growing appetites for larger and more experienced fund managers.
Development finance institutions (DFIs), rather than commercial LPs, are the largest supporters of first-time EM PE funds, likely for the reasons previously highlighted by Avanz Capital’s Haydee Celaya—there are many unknowns with a first-time team. Hiran Embuldeniya, Managing Partner at Sri Lanka-focused private equity firm Ironwood Capital Partners, witnessed institutional investors’ preference for more experienced fund managers first-hand when raising the firm’s debut fund in 2014: “We spoke with a host of funds of funds and other commercial institutional investors, and the feedback we received almost uniformly was that committing to a first-time fund manager in a new market like Sri Lanka is difficult, so let’s talk again when you’re on to fund two.” What is notable here, however, is that according to EMPEA’s statistics, many LPs appear not only to be looking past first-time funds, but also past second-and third-time funds.
EMPEA’s data reveal that more experienced fund managers (those on their fourth fund or later) are accounting for an increasing proportion of EM PE fundraising—perhaps expected in light of the recent decline in first-, second- and third-time funds. In 2014, fourth funds or later in a series reached final closes aggregating to US$39 billion, almost double the amount raised by fourth series funds or later in 2013. Moreover, 58 such funds closed in 2014, up from 42 in 2013.
The known universe of EM PE funds currently in the market also reflects LPs’ preferences for more experienced managers. Of all the funds currently raising capital, an estimated 42% are fourth-time funds or later and 29% are first-time funds (see Exhibit 3). Not only are fewer first-time funds than later-series funds looking to raise capital, but—at least by slight margins—those that do, by some measures, tend to take longer and raise less capital than their more experienced counterparts. In one illustration of this, of all funds launched in 2011, 2012 and 2013, 23% of first-time funds have yet to hold a close, in comparison to 19% of funds that are fourth or later in a series (see Exhibit 4). Similarly, 56% of first-time funds launched in 2011, 2012 and 2013 have reached a final close, compared to 64% of funds that are fourth or later in a series.
Given these disparities, it is perhaps not surprising that fourth-time or later series funds are more prolific in number, and also raise more capital than first-, second- or third-time funds. This reflects not only a preference for firms with experience and significant track records, but also likely a preference for larger investment vehicles. First-, second- and third-time funds are not necessarily decreasing in number only because LPs may prefer more experienced managers with well-known, demonstrable track records, but likely due to a combination of LP preferences for both more experienced managers and for funds large enough to absorb increasing commitment sizes.