INTELLECTUAL PROPERTY: The importance of emerging managers

Programmes to foster the development of emerging real estate managers are sprouting up at a select group of US pension plans, underlining the importance of nurturing the industry’s next generation. PERE Magazine, February 2012 issue

According to industry research, 308 emerging managers – those that are raising their first, second or third fund and targeting total equity commitments of between $100 million and $500 million – have been in the market over the past 14 months. Of that number, about 12 percent have raised some capital for their funds – a success rate that generally is consistent with the broader US real estate fund market. However, less than a third of those managers have reached their targets, regardless of how modest they might be, and that is a cause for concern.

Pension plans and other institutional investors typically invest with emerging managers to capture their alpha potential and to access new talent and future manager capacity. Indeed, numerous studies have shown that small, employee-owned investment companies outperform their larger competitors. In fact, it almost has become a truism that the greater the assets under management, the less the likelihood of outperformance.
Despite the proven performance advantage of emerging firms, barriers to entry remain high. From a purely practical standpoint, it is impossible for many institutional investors to invest a meaningful amount with any one emerging firm. Risk policies often disallow pension plans from making an investment that would become more than a certain percentage of any one manager’s asset base. This limit usually ranges from 10 percent to 30 percent. Given that emerging managers often are ‘small’ in terms of assets under management (usually less than $2 billion to $3 billion, according to typical parameters), this certainly can present a challenge.

In addition, the investment industry, by its nature, is conservative and slow to change. Many investors still perceive bigger as better, and many still prefer household names to unknown start-ups run by entrepreneurs (many of whom, ironically, recently left those household names). Whether consciously or not, these investors would rather partake in predictable mediocrity than take a calculated risk on a small, unknown entity with the potential for spectacular returns.

Of course, established firms are not without their own risks, such as legacy investment issues and the unlikelihood of an existing team staying intact for the duration of a fund’s life. Some would argue that such factors make established firms equally as risky as emerging managers.

In addition, these emerging managers often are created by an exodus of talent from larger investment firms. In other word, they have the same talent and educational background as the people at larger firms, but they have opted to be their own boss and benefit more directly from their hard work. Should they be penalised just for not being part of a large financial services conglomerate or private equity behemoth?
Traditional consultant screens, such as minimum size and product track record, often reinforce these conservative biases against emerging firms, thereby excluding talented new firms with significant performance potential. This is true even when these emerging firms are led by experienced industry professionals with strong prior performance track records. As a result, few institutions invest with emerging managers at all, yet alone target them with a dedicated programme.

Indeed, according to research by Morgan Creek Capital Management, there are just 11 public US pension plans with emerging manger programmes for real estate. Among them are the Employees Retirement System and the Teacher Retirement System of Texas, whose efforts are featured on page 13, as well as institutional heavy hitters like the California Public Employees’ Retirement System, the New York State Common Retirement Fund and the Massachusetts Pension Reserves Investment Management Board. Of the remaining six, five represent various public pension plans in Illinois and the other is from Maryland.
Beyond that, the California State Teachers’ Retirement System also invests in emerging managers, although it does not have a formal programme like its peers. In addition, it is likely that some European pensions have similar programmes, although they would seem to be less formal and much less publicised.
Clearly, there are some emerging managers out there with weak strategies, poor business plans and/or no investment track record. These rightly do not deserve the support of investors. However, there also are a number of emerging managers that have their act together and do deserve true consideration.
Emerging managers do not want special favours, they just want an opportunity to compete. However, the biggest barriers to competition are still fear of change and comfort with the status quo. If pension plans continue to invest primarily in household names based on comfort factor, they are doing an immense disservice to their beneficiaries.

In addition, the big boys of the industry were once emerging managers, so it is important to support the next generation that one day may take their place. If investors do not take that leap of fate and pledge their support, many of these firms will never exist and the next great investment strategy may be lost forever. Hopefully, as the comfort level with the concept of emerging mangers improves, more money will find its way into the hands of these firms.