Should you invest in emerging managers?

Welcome back and happy Sunday!

When you’re reviewing real estate opportunities, you’ll often encounter newer GPs who are raising capital for their first few deals.

These “emerging managers” come in shapes and sizes - some might be leaving Blackstone after 20 years, others might still be in their last year of undergraduate studies.

I’ll address 5 separate topics today:

• What separates an emerging manager from an established one

• Pros of investing in an emerging manager

• Cons of investing in an emerging manager

• What to look for with emerging managers

• Should you invest in emerging managers

Today I’d like to discuss this at length, and hope to help you form your own opinion on whether these types of investments are a good match for your investment mandate.

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First, I’ll start with a quick story. Some of you may know that I worked for a Public REIT before going out on my own (more on that experience here). The really unique aspect about this particular company was that we specifically looked for properties leased to NON investment grade tenants.

In other words, instead of buying a building leased to McDonalds or Starbucks (which are investment grade), we’d buy something leased to your favorite neighborhood furniture store or gym (i.e. a non investment grade tenant).

Now, isn’t that crazy? It’s more risk… right? It is definitely more credit risk, but it’s also more reward (as measured by cap rate, in our case) - when underwritten properly. In a sense, we (at STORE Capital) were digging in a riskier pool of tenants to carefully select ones that we wanted to partner with for the best risk-reward profile. More on the single tenant net lease business here.

Just like STORE Capital was in the business of “tenant selection,” any LP looking to invest in emerging managers is in the business of manager selection.

Any LP looking to invest in emerging managers is in the business of manager selection

The question in your head should always be risk vs reward. Personally, I “parse” the analysis into 3 independent sections, which I’ve written on before and they’ll be mentioned again below:

• Execution - track record and counterparty risk

• Alignment of Interests - coinvest, waterfall, and fees

• Property - valuation and business plan

With the meme behind us, let’s get to our five questions:

• What separates an emerging manager from an established one

• The only acceptable answer here is track record and experience

• Notice that they’re not the same, and I intentionally separate the two for deals I send through www.gplpmatch.com

• E.g. would you rather invest with someone who has been investing on behalf of an employer for 5 years (i.e. has investing experience, but not much), or someone who has been a broker for 30 years (i.e. has been in the mix of deals for a really long time, but has never been in the principal seat themselves)? Note that both have experience, but it’s not always easy to compare the two and experience isn’t created equal

• At the end of the day, track record is by far the largest factor here - even if someone is experienced in real estate in general, this doesn’t mean they’ve been a principal on investments

• I would recommend reading Track Record Audit for more on how to vet a track record

• Mitigants, of course, would include if such emerging manager has handled full cycle deals for a previous employer

• Pros of investing in an emerging manager

• Better economics

• Emerging GPs often offer stronger LP terms: higher preferred returns, better splits, lower fees. The reason is simple - their investor network isn’t deep and neither is their experience.

• Example: A seasoned sponsor might offer an 8% pref and 70/30 split, while a newer GP might offer a 8-10% pref with 80-90% split.

• It’s important to note that alignment goes both ways - don’t be too aggressive on a promote structure to the point where the GP isn’t incentivized to look after your investment!

• More alignment

• Early GPs often have a lot more to lose if things go wrong - they may have personally guaranteed debt, invested a larger chunk of their own money, or staked their reputation on the deal

• More access

• It’s often easier to get direct access to the GP in order to ask questions, understand them as a person and ask about their larger vision/thesis

• You can ask detailed questions, negotiate terms, and get better visibility into the deal

• Speaking of negotiating terms - just a broader point I keep coming across … there’s no such thing as a minimum investment amount in practice. If you want to invest less, just ask - worst case scenario the GP says no!

• Room to grow

• If the manager succeeds, you were there early - that may mean early access to future deals, better allocations, or preferential terms down the line

• Cons of investing in an emerging manager

• No track record

• No past full-cycle deals means you don’t really know how they operate in tough (or even favorable) environments - this is what I call execution risk, which is the first of three LP pillars for a reason

• Because there’s heightened execution risk, you have to be compensated for this somehow - typically this means a higher participation of upside should the project work out

• While the upside is greater, you should not forget that downside might also be greater - and as I always say in LP investments at large, don’t invest money that you can’t afford to lose and do enough due diligence to not lose your money

• Flight risk

• An experienced GP has made a living within this world and is less likely to change careers while still being a steward of your capital; this is not the case with emerging managers where flight risk (to a more rewarding career, deal, or opportunity is higher)

• The largest mitigant for this is strong initial alignment of interests

• Less sophisticated reporting

• You may see delays in communication, inconsistent reporting, or confusion about distributions.

• Not every GP has built investor ops from day one – and that can be frustrating but you’ll have to be patient

• What to look for with emerging managers

• Beyond the deal itself, the biggest thing here is a combination of grit, humility, and willingness to share the upside with you

• If it feels like they can’t admit that they’re new to the business, this is likely a reason to pause

• It’s important to note that an emerging manager might put in less than market on a coinvest, but that dollar amount might be very material to them personally - this might practically carry more weight from an alignment perspective relative to a larger $ contribution from a more established GP

• Should you invest in emerging managers

• Ultimately, of course, you’ll have to decide this for yourself but one thing that’s clear is that you’ll have to spend more time on diligence

• This is what I was referring to above - 1 out of 16 emerging manager deals is likely good, but that really depends on the sample size you’re looking at - and if it’s a bad one, then all 16 deals won’t be great. The only way to round out your sample size, is increasing deal flow

• Here are some tips on how to mitigate the additional risk:

• Be careful to determine what exactly they do and don’t have experience with

• When asking about coinvest, ensure that it’s their money and not financed or borrowed from family; Personal Guarantees play a role here too

• Does the underwriting hold up on its own? Would this be a good deal even without their involvement?

• PS - you might come to appreciate the GP as a person, but don’t confuse investment decisions with charity

• Start small - more on investment sizing here

• Don’t over allocate to a first-time manager (or to anyone for that matter)

• If you’re having some early success, be careful to not double down too early

I hope this helps and have a wonderful weekend!

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