A Probabilistic View Of Established Vs. Emerging Managers In Private Markets August 19, 2021

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A well-informed decision starts with an understanding of base rates. What is the probability of an outcome based on historical data? And then using base rates to suitably calibrate conviction. Limited Partners investing in private markets tend to favor established managers and avoid emerging managers. As the asset class has evolved, that approach includes a fairly large bet against historic base rates. 

“WE ONLY INVEST IN TOP QUARTILE MANAGERS”

We all apply some variation of this theme in our manager selection. I’ve talked to hundreds of LPs over the years and I’ve never heard “we look for average.” Many manager selection processes are built around finding high performing firms based largely on historical results and recommit to the winners. This process obviously favors established managers with existing track records. Early studies supported this thesis. A 2005 paper from Kaplan and Schoar noted, “we document substantial persistence in fund performance…General Partners (GPs) whose funds outperform the industry in one fund are likely to outperform the industry in the next; GPs who underperform are likely to repeat this performance as well.”[i]

But what if the cornerstone assumption of persistence in this asset class is wrong? Without persistence, selecting a top performing manager ex-ante requires a different mindset, different diligence and introduces much more uncertainty into the equation. It should also create higher degree of willingness to consider emerging managers.

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