‘Desktop diligence’ is hurting new GPs

There is a simple truth about working in private markets: success often depends on who you know. But building new business relationships has become harder than ever during the coronavirus pandemic, when investors began working from home and due diligence shifted almost entirely to being conducted from behind computer screens.

For established asset managers, this has brought a business boon, as investors have weathered economic turmoil by turning to long-time partners to commit new capital. New managers, however, are having a harder time winning investors’ trust. These firms, many of which are diverse- or women-owned, are discovering that the rapport built through eye contact and a firm handshake is difficult to replace with pixels and a headset.

“We were in the final stages of selecting our placement agent, and then covid happened,” says Ken Bryant, a co-founder of Sidereal Capital Group, a New York-based private equity firm raising its first fund to invest in lower mid-market manufacturing companies. “Placement agents weren’t saying it would be difficult. They said it would be impossible, that this is a relationship business.”

Arturo Sneider, who founded the 25-year-old Los Angeles real estate developer Primestor, tells a similar story. “It’s incredibly hard to get anybody to pay attention to a new fund right now,” he explains.

After launching Primestor’s first fundraise late last year, to invest in the revitalization of growing Latino and Black communities throughout the US, Sneider says he and his partners “don’t know if the fundraise is going to be successful or not.”

“Placement agents weren’t saying it would be difficult. They said it would be impossible, that this is a relationships business”

Ken Bryant
Sidereal Capital Group

For decades, institutional investors in the US have created programs specifically to direct capital to new managers in the hopes of finding a strategy that outperforms benchmarks, securing management fee discounts or discovering the next firm that has a knack for seeing things others do not.

Whatever their reasons, investing with new and diverse managers typically pays off, according to data from GCM Grosvenor, an asset manager which runs a fund placement business. In 2019, Grosvenor found that diverse PE funds outperformed industry benchmarks in more than three-quarters of the vintage years tracked between 1994 and 2018.

Now, during the age of desktop due diligence, as those same investors hunker down with the firms they already know, the new faces of private markets fear they are being overlooked and forgotten at a time when they need capital the most.

A ‘light touch’ for re-ups

Fundraising this year has continued mostly unabated across three asset classes: private equity, real estate and infrastructure. In private equity and infrastructure, commitments through the first half of 2020 outpaced the same period last year, according to data collected by sister title Infrastructure Investor. Meanwhile, real estate is down only 16 percent.

Fully remote due diligence has forced private markets to answer an unusual question: does an investor have to meet a new manager in person before signing a multimillion-dollar check?

The answer so far, around six months into the pandemic, seems more ‘yes’ than ‘no’. Of the $369.2 billion of private equity, real estate and infrastructure commitments that closed in H1 of 2020, less than 3 percent was committed to firms raising either their first- or second-time funds, according to Infrastructure Investor data. Only 16 percent of 486 investment vehicles that held final close in the same period are managed by new firms, the data show.

The story could not be more different for the industry titans.

The largest PE fund that has closed in 2020, Ardian Secondary Fund VIII, hauled in $14 billion ($19 billion including co-investments) by June. During the height of pandemic lockdowns, in April, Blackstone closed its sixth Europe-focused real estate fund. In the same month, Macquarie launched its fifth North America-focused infrastructure vehicle, and four months later, the firm had $4 billion committed.

According to Jonathan Glick, who runs the real estate-focused fund placement agent Incubation Capital Partners, which focuses on working with new managers, securing commitments this year is like “taking a 500-question exam that you need to get a 99 percent on just to potentially make the cut.”

“For re-ups,” Glick says, “all the manager needs to do is pass.”

Brian Collett, the chief investment officer of the $8.2 billion Missouri Local Government Employees Retirement System, confirms this. He says that MOLAGERS has been unsure about committing to new relationships without meeting face-to-face, but for new funds being raised by familiar partners, only “light touch” due diligence is needed.

“If they’ve been doing what we wanted, given our expectations, and we still have allocation in that space, we don’t re-underwrite them,” Collett explains. “It’s a ‘yes’ or a ‘no’.”

Ross Alexander, who manages the infrastructure portfolio at the $65.3 billion Alaska Permanent Fund Corporation, also says leaning on existing relationships has been an “efficient use of capital”.

“If things are going in the right direction and managers are meeting our objectives, we’re happy to make re-ups,” Alexander explains. “Existing relationships have always dominated our portfolio, but even more so now. It’s near impossible to really get to know a new manager and feel comfortable over a video call.”

‘Risk off, pencils down’

Glick says investors went “risk off, pencils down” during the deep economic volatility of March and April. “New managers have largely been put on hold right now, unless the strategy is so unique or it’s a strategy people want,” he explains, citing the industrial space and data centers as currently attracting broad investor interest.

For Primestor, the LA-based real estate developer, a unique strategy that was “starting to get some traction” when the $250 million fundraise launched in the third quarter of 2019 “can’t get any follow-ups” today, according to Sneider, the company’s founder.

Sneider, who immigrated from Mexico to the US when he was 18, has positioned Primestor into a company that is taking advantage of changing demographics in favor of minorities, while also making socially conscious investments.

In 1992, starting with a single commercial property that was converted into three separate units, Primestor’s strategy has been to boost impoverished Latino and Black areas across the southwest US through community-involved real estate development. The company acquires, renovates and leases upscale commercial properties and attracts high-profile companies, such as Nike or Verizon, to set up shop.

The most important requirement of tenants: hiring must be local. “We have perfected the model of connecting with the community and enrolling them in the process of participating in the transformation of their own neighborhoods, and then sticking with it,” Sneider says.

“When you see the work we’ve done in person and can go through a community to see the past, the present and the future, it changes the perspective of what your dollars can do,” he explains. “When you don’t get that experience, it makes [fundraising] much harder.”

Pre-pandemic, Sneider says people were flying to Los Angeles from as far away as Europe to tour the firm’s developments. But since covid, with not a single investor commitment secured, the effort is essentially on hold for now.

The “significant choke point” for new managers securing fund commitments may be risk-averse investor consultants, says Carmen Ortiz-McGhee, executive vice-president of the National Association of Investment Companies, an organization advocating for diverse- and women-owned managers.

“It’s easier for [consultants] to recommend managers they know and have had success with, rather than do the work to identify and get to know new managers with which they do not have a relationship or may not be comfortable,” she says, adding that the lack of diversity in finance may also be at play.

“I don’t think anyone who launches their own firm has an easy, beautifully paved road to success,” Ortiz-McGhee explains. “But relationships are everything in this business, and [relationships] become even more important when talking about under-represented and marginalized groups that don’t grow up naturally in networks that provide access.”

Diverse-owned firms have historically played a small, but growing, role in the PE industry. These firms account for less than 4 percent of all US private equity firms, according to a report published last year by Bella Research Group and Harvard Business School. Diverse-owned firms account for 30 percent of the field when zeroing in on new managers specifically, according to data from the fund-of-funds group GCM Grosvenor.

“The people we represent have checked all of the boxes: they’ve gone to the best schools, have found success in the business, and were motivated to launch their own firms,” Ortiz-McGhee says. “But the moment that they make that transition, they face challenges over and above what their non-diverse counterparts face.”

New thinking needed

Investing during unprecedented times, such as a pandemic, can actually allow for a new manager to stand out or “cut through the clutter,” as Derek Jones of GCM Grosvenor puts it.

Jones, a private markets managing director and member of the diversity, equity and inclusion committee at Grosvenor, an asset manager that helps connect new firms with institutional capital, says that new and diverse firms must “have a strategy that is differentiated and fairly specific” to show how they can add value.

Jones’ colleague, Jason Howard, who also manages private markets investments, adds that, given the diverse backgrounds of these firms, they often bring different “insights and perspectives” to the table to what has been tried in the market before.

“New and diverse managers have created very unique investment strategies that are differentiated from others in the marketplace,” Howard explains. “These managers are typically focused on investment performance versus asset gathering. There’s no second or third fund if the first doesn’t work.”

Amid these uncertain times, a new way of approaching the investment landscape could be well needed, according to Angela Miller-May, chief investment officer of Chicago Teachers’ Pension Fund, an $11 billion investor. “Maybe we need some of that,” she says, adding that “as a long-term investor, it’s not like we can stop meeting managers just because of covid.”

“We need managers that are innovative and don’t have the pre-existing thought of comparing today to how the market did in 2008,” Miller-May explains. New managers today should make sure they have a diversified track record and the right strategies for the post-pandemic market environment to pitch to investors, she says.

That’s what it took for Sidereal, the New York-based new private equity manager, to secure a $10 million commitment from CTPF, the first in the firm’s inaugural fundraise. Bryant, one of the co-founders, says that even with this one fundraising success, the firm still lacks a marquee anchor commitment.

“Looking at our pitch book and hearing our strategy over a Zoom call is great,” he explains, adding that Sidereal’s founders, which launched the firm in 2012, have built a lengthy track record of one-off deals to show potential investors. “But until they sit across from us and have a beer or a sandwich, it’s tough to build a level of comfort.”

For now, Bryant says Sidereal, like investors, is also shifting focus away from building new relationships and is instead seeking investor commitments from relationships from earlier in his and his partners’ careers.

Vanessa Gabela, a principal at the Miami-based private equity manager WM Partners, says that turning to investors that committed to the firm’s first fund five years ago has been “fruitful” in pulling off its second fundraise this year.

“We have had several LPs make commitments that were relationships we developed when raising Fund I,” Gabela explains. “Making sure we stay in front of them with updates and developments, and with results and achievements is what has made those relationships stronger and built our credibility.”

‘Ready to re-engage’

As 2020 draws to a close, investors are becoming more comfortable with the new normal of due diligence during a pandemic.

Kirk Sims, head of the emerging manager program at the $158 billion Teachers’ Retirement System of Texas, says that, after a shutdown of all commitments from March until around May, his staff picked up on the pipeline of firms they were already reviewing.

“Earlier this year, it was very difficult, because a lot of organizations were just dealing with the market environment,” Sims explains. “That’s changed in the last month or so. That constraint is lifting and the worry isn’t as great now. People are starting to say, ‘I’m ready to re-engage in conversations.’”

Still, for new firms, he adds: “You’re going to have to work harder right now to get the process started because of the lack of face-to-face meetings.”

For Chavon Sutton, director of diversity, inclusion and emerging manager strategy at the Office of the NYC Comptroller’s Bureau of Asset Management, her “desire to pull someone up” throughout her career did not falter this year. As of June, investments with small and diverse firms totaled over $18 billion, she says. The program grew another $1.7 billion in 2020 with the establishment of four early-stage manager initiatives across private markets.

“The performance of new and diverse managers is a reason to include them,” she says. “They are strong performers, they are additive to our portfolios, so we have to do more of that work. It’s our fiduciary duty to do so.”