Should emerging managers be expected to grant big fee breaks?

Already saddled with financial constraints, some upstart firms are pushing back against generous concessions to investors.

Basis Investment Group, a New York-based manager, had help from an unexpected ally last year while raising its first commingled fund.

Chicago Teachers’ Pension Fund chief investment officer Angela Miller-May credits Blackstone for her decision to back Basis’s debut fundraise with $30 million. BIG Real Estate I, a mid-market US debt fund, paired well with the pension’s investment in the mega manager’s debt platform, she told PERE.

“Blackstone Real Estate Debt was a very safe investment and we wanted to start our real estate debt portfolio with something that was safe and provided expected returns of 8 to 9 percent,” Miller-May said. “For Basis Investment Group, we expected returns closer to 11 to 13 percent due to the high demand and dealflow in the middle market space. They complemented each other by having different market exposures and by having different risk/reward profiles.”

Unaware of CTPF’s other debt investments, Basis bolstered its pitch with a 10-year track record of joint ventures and separate accounts as well as a seed portfolio of eight investments indicative of its strategy. But the pension’s prior debt investment with Blackstone ultimately helped Basis seal the deal.

However, many first-time fund managers must rely on steep concessions to secure investor commitments. Some groups that support emerging managers encourage institutions to consider the capital restraints new firms face before demanding fee breaks.

“To work with an emerging manager, an investor must consider what it takes for the manager to grow and come up with a structure that allows them to pay their team, keep talent and ultimately prosper,” Peter Braffman, managing director of Chicago-based investment firm GCM Grosvenor, told PERE. “That’s the tradeoff.”

Raising a commingled fund for the first time is an arduous task, even for experienced managers. Basis chief executive Tammy Jones, a 24-year industry veteran, contacted 152 prospective investors just to secure 16 commitments for BIG Real Estate I, which closed on $410 million last month.

Industry sources tell PERE that such a low success rate is standard for emerging managers. Many investors will summarily reject all first-time fundraisers. But other institutions, such as the Teachers’ Retirement System of Texas – with its $5.7 billion emerging manager program – seek upstart funds, with commitments often contingent on fee discounts, general partner equity and/or governance positions. Miller-May, who typically asks for a discounted fee of between 1.5 percent and 1.75 percent on committed capital, said these arrangements offset the risks presented by an unproven manager.

“As an investor, you always want to get paid for the risk that you are taking, and no matter what, there is always going to be some level of risk,” she said. “Emerging managers sometimes bring with them portable track records … and if it’s a new venture or manager, we want to make sure we are compensated for any additional risk.”

As more investors demand lower fees and other favorable terms from managers across the board, emerging firms face the greatest pressure to grant discounts. An early commitment from a prominent investor, such as CTPF, can give a fund legitimacy. However, many of these young firms are not well positioned to forgo income.

Braffman helps upstart firms get off the ground through joint ventures and advises investors on establishing emerging manager programs. He advises new managers to be prepared to invest approximately $6 million of their own money during their firm’s first decade.

“And forget about making a return on your investment in that time period; you should not expect to get that money back for about 12 years…and that’s if everything goes well,” Braffman said. “The fund model is a very difficult model in the early years.”

Roughly 1,000 managers have brought debut funds to the market since 2010, according to GCM Grosvenor proprietary research, with typically around 100 new entrants annually. Since then, only about 30 percent of those firms have succeeded in raising capital. Most successful startups, like Basis – which GCM Grosvenor backed through a $55 million joint venture – have track records that demonstrate a pipeline of deals and provide vital revenue streams.

While a first-time manager can withstand a certain amount of financial strain, too much will hamper the firm in the long run and prevent it from retaining talent. Jones conveyed this risk to investors that pushed for excessive discounts and found many were willing to negotiate on fees.

“The old adage is if you don’t ask you don’t get, so people will ask, but I was really happily surprised that when I held my ground most investors understood,” Jones said. “It is an issue, but it’s evolving, and I think folks are starting to get it. It makes sense to get fee discounts from larger managers who can afford to give them.”