#ImpInv Investors take note: First Funds out-perform Follow-ons

Within the broadly defined field of “impact investment”, the risks of new managers and first funds are often given as good reasons for not investing. If this has been one of your excuses for not taking a stake in social enterprise, base of the pyramid or any other flavor of sustainable investment, it’s time to rethink your position. First funds outperform follow-ons, by a significant margin, if you will accept data from the International Finance Corporation (IFC) as evidence. Frankly, you should and here’s why.

The IFC invests in a large number of new private equity, venture capital and special purpose investment funds. It claims to have backed around 10% of all emerging markets funds coming to market since the 1980s. I wouldn’t be surprised to find out that the percentage of new #EM funds backed by IFC is higher than 10% when all the sector, global and special purpose fund structures   are tallied up. Since 2000, about 50% of approvals were for first funds run by new managers. As of late 2012, IFC’s private equity portfolio stood about US$ 3 billion committed to about 180 funds.

At 2012 presentations to the World Pensions Council in February 2012 and the African VC Association in April 2012, David Wilton, Chief Investment Officer, Manager Global Private Equity, IFC presented the information shown below. You can read his latest paper Why Emerging Markets Private Equity? September 2012 for more interesting tidbits.

IRR on Funds between January 1, 2000 and June 30, 2011

Investment Fund Grouping	IRR
IFC All Funds*	18.5%
IFC Private Equity Funds only	22.0%
IFC First Funds	21.0%
IFC Follow-on Funds	14.5%
Cambridge EM PE Top Quartile***	19.8%
Cambridge Asia EM PE Top Quartile***	21.7%
Cambridge US PE Top Quartile***	17.41%

* IFC data on approximately US$ 3.6 billion of fund investment
*** Data for Cambridge Associates includes all PE Fund types excluding Forestry, Infrastructure, Real Estate, and Secondary Funds.

IFC gives a couple of reasons for first fund out-performance, key amongst which is early-mover advantage. The first guys and gals to define a new investment niche can cherry pick amongst capital-starved enterprises. I happen to think that there is generally so much capital scarcity in emerging markets that smart investment managers can always find good deals. Regardless of whether this last statement is true, first funds looking at new non-exchange traded markets have an early-mover advantage over later entrants.

The IFC also notes that fund manager skills are key to achieving top tier performance. Although it is tempting to think that “manager” refers to the firm, for the most part it refers to key investment decision-makers. Do the people at the top have the skill set to find, make and manage investments while running a transparent, compliant and insightful fund? Where outsourcing will make up the skills gap, are proposed third-party providers top tier? If you have these two pieces of the puzzle, the fact that the firm is new may not be a relevant decision factor. If you have the right people, you have a human capital advantage.

I have one more piece of the puzzle for you. Investors spend less out-of-pocket  on first funds. The investment world effectively penalizes new managers via somewhat arbitrarily determined “best practice” management fee structures. On paper, at least, less money spent on the manager equates to more money flowing back into shareholder returns. New managers are expected to pay the bills (their own, the fund’s and the firm’s) during development and fundraising, and then deliver a complex hands-on strategy on a budget unrelated to the cost of developing portfolio and delivering  performance.

First funds are generally on the small side too, which is seen as a risk mitigant despite further complicating the issue of fees and budgets. Sure, the new managers typically are eligible for some kind of carried interest upside, but that’s not going to come into play for five to eight years. In the interim, some of your best talent is going to need to moonlight to cover family expenses, buy their kid a new bicycle or save for education or retirement. Wouldn’t you rather they be able to devote all their waking energy to your portfolio :o)

By the time funds two or three are on the horizon, successful managers are working on changing the investment terms to reduce the pain they’ve been feeling. I’ve had successful fund managers tell me that fees on the next fund were going up because their wives will divorce them if they’re not able to send their kids to private schools. Don’t think that this is a luxury issue! In many emerging markets, private school is necessary if you want your child to have decent job prospects later in life. Impact investment managers shouldn’t have to penalize their families as a way of proving a business model. For now, however, net net, later funds are likely to have a higher cost and diminished early mover advantage, both of which will produce lower returns to investors.

If you want consistently high performance, work on setting appropriate fees and operating budgets, and aligning manager/shareholder incentives on all funds, but especially the first one. In the meanwhile, if you just want high performance from your next investment, think about taking a stake in a new impact investment fund. A lot of top tier human capital is eying new market opportunities and they need your commitment to turn their vision into real-world returns.

By Lauren A. Burnhill aka @LaurenOPV