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The funds of the future

Many investors won't touch first-time funds, however good their potential. This is a mistake, argues Eiger Capital's Roger Pett. They are missing out on some great investment opportunities to invest in some of tomorrow's star performers.

In common with any investor in private equity, I want to be in top quartile funds. It's a real objective, as the evidence demonstrates that top quartile performance will more than compensate for the illiquidity of private equity as an asset class.

Of course, top quartile funds are extremely easy to find - show me a fund manager who doesn't claim to run a top quartile fund. So how else should investors look for good investment prospects? Most currently look at track records first and foremost. This is missing the point. Investors should be looking not at top quartile historical performance, but top quartile potential performance. There can be a big difference between the two. Remember the time-honoured phrase, ‘past performance is not necessarily a guide to the future'? It's particularly pertinent in the fast-moving technology area, where quantified past performance is based on investments made five to ten years ago, in the technologies of five to ten years ago. The figures can hardly reflect investments made today in tomorrow's technology. The skills needed to invest successfully in the next five years will be different from those required five to ten years ago.

The key for investors is to assess a potential fund investment on the basis of its capacity to achieve excellent performance. This is down to the people. But it's not what they've done in the past that matters, but what they can do in the future. Looked at this way, you'll see that many of the most promising funds are first-timers.

Many investors are deterred from first-time funds because they want to see a proven track record. They want hard evidence of performance, evidence that the team can work together and evidence that they know how to manage a fund. But what investors may end up buying into is a team with an overhang of problems from previous funds and one that has perhaps lost the hunger to succeed. They may also be more interested in crystallising the tangible carried interest from earlier funds than in laying down the investments for the future. In short, their interests may not be fully aligned with those of the investors.

On the other hand, what we see in first-time funds is a freshness of approach, commitment, dedication and a determination to succeed that is rarely matched in more established managers. The key is to capture that spirit in a team that understands its market sector, can work together, has access to deal flow and can put in place proper administrative structures, perhaps with external support. Harness these attributes and you have the potential for exceptional returns.

Investors should without doubt consider first-time managers. But they should do more than that. They should be preferred for part of any balanced portfolio. No doubt my desk will now be swamped with every proposal from anyone who has never run a fund before. But let's be clear. I'm not saying that all first-time funds are good; I'm saying that that top quality first-time funds are good.

Naturally, good first-time funds are not easy to find. There are many ‘wannabe' fund managers out there and only the very best of these are worth backing. Determining which of these will be the best takes a due diligence exercise that has different characteristics from the assessment of established funds. But not that different. Whether the fund manager is setting up his first fund or his fifth, the criteria are the same. It is the way of assessing the criteria that differs. A first-time fund will offer no track record. But the managers will normally be able to display relevant investment experience, just not within this team. Contrast this to an established manager presenting a long track record, where the test is to establish the relevance of that track record to the future, not to the past. You won't see evidence of working as a team in a first-time fund, so a higher level of due diligence must be carried out in this area. Assessing the team both individually and collectively, through detailed interviews and mock examples, is essential in gaining confidence that the team can stand the stresses that it will face. This is often taken as read in established managers, yet it shouldn't be. The management team for each fund should be reviewed equally rigorously to ensure that it is right for that fund. The past is merely a guide - times and skills change.

Admittedly, there can be additional risks involved in backing first-time funds. The test is whether rigorous professional due diligence can minimise the risks and whether the benefits of freshness and commitment can generate levels of return that more than compensate for the risk. No doubt one day this might be the subject of academic research. As yet, though, the sample population is probably too small to be meaningful. Yet the truth is that we all know managers who have been extremely successful with their first fund.

My case, simply, is that the best of these first-time funds are worth backing. The approach to due diligence is slightly different from the one that many investors in funds are used to. It requires trustees and other decision makers to have the confidence in the skills of their executives to identify the best opportunities for the future, and that may well mean backing those without a proven track record from the past. And, of course, never forget that the next generation of star performing fund managers has to start somewhere.

Roger Pett is managing director of fund of funds Eiger Capital.

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