Emerging managers with high media attention are 3 times more likely to raise a second fund.

The Newfront M&A Advisory works with funds of all sizes. We were a start-up in 2012, so we have a soft-spot for emerging managers and appreciate the opportunity to contribute to their success. This blog post provides insight into how emerging managers can gain an advantage when raising that all important second fund. The content comes from a recent article posted in the prestigious Academy of Management Journal.

It is tough to break into the well-established field of Private Equity. Credentials will only get you so far – what investors value is experience and a proven track record. What’s a newcomer with lots of potential but not much in the way of proven outcomes to do?

Recent research by Professors Tom Vanacker, Daniel Forbes, Mirjam Knockaert, and Sophie Manigart points to a simple but surprising solution: boost the signal you are sending.  Their research paper, “Signal Strength, Media Attention, and Resource Mobilization: Evidence from New Private Equity Firms,” was recently published in the highly respected Academy of Management Journal.

Background

Fundraising is a challenge for everyone in Private Equity, but especially so for relative newcomers. Without a past track record to indicate potential future outcomes, Limited Partners are understandably wary of investing in such firms.

One deeper explanation for this reluctance stems from signaling theory, which posits that established PE firms convey critical information to investors in ways that are difficult for smaller newcomers to emulate. While past returns weigh heavily in investment decisions, board composition, team characteristics, and endorsement relationships also send strong signals to LPs to “green light” investment decisions.

Until now, there has been little research on what investors do when new PE firms send multiple signals about their quality. The question is not merely theoretical. In the real world, investors are bombarded with information and rarely reach a decision based on one clear signal. This, combined with the time and cost of evaluating investment alternatives and the fact that there are many more early than late-stage PE firms in which to invest, helps explain why LPs report being faced with information overload.

As a result, investors rely on heuristics and simplifications to help them cope with the uncertainty and cognitive overload they experience. Intuitively, it makes sense that the strongest signal will grab the attention of LPs: investors won’t cross the road with a “walk” signal if they also see a large flashing stop sign. The question for new PE firms is what can they do to attract the interest of investors to their “yellow” traffic signal when more established firms have the blinking green light of an established track record.

To answer this, Vanacker et al. examined the scenario where new PE firms, having managed a first-time fund, need to raise a follow-on fund before having demonstrated significant realized performance at the end of the investment period. This is a critical point for many new PE firms, as investors are more likely to seek more objective performance measures when deciding to reinvest than they did at the initial stages when the new firm’s social ties or human capital signals had to suffice. Lacking a track record of strong realized performance and relying only on relatively weaker unrealized performance signals, a large percentage of PE firms fail to raise a second fund; indeed, of the 205 firms studied between 1999 and 2017, by Vanacker et al., less than half (46%) were successful.

Realized performance has repeatedly been shown to predict a firm’s ability to attract investors—the kind of strong signal that LPs seek when making investment decisions. The high mortality rate of PE firms between the first and second funding rounds also shows that unrealized performance is not a strong enough signal to entice investors. Although certified by external auditors, the valuation of unrealized performance ultimately resides with the PE firm and relies heavily on estimates and forecasts. It’s clear that many investors won’t proceed “blindfolded” through an intersection simply because a firm’s general partners claim that the coast is clear and opposing traffic has been stopped. Can new PE firms do anything else to boost the signal strength of their unrealized performance so that investors will “greenlight” their follow-on funds?

The Experiment

The answer is yes and involves using “information intermediaries” to augment the weak signals sent by new PE firms lacking a past track record. One was new PE firms can increase the signal strength of their unrealized performance by attracting media attention.

Media attention operates in several ways to increase the chances that a new PE firm will attract second-round investors. First, boosting the signal sent to investors makes the fund more likely to be moved into what researchers call the “consideration set”—the funds from among which the investor will ultimately choose to invest in. Additionally, the assessment of unrealized performance operates as a “starting point” for valuing the investment opportunities of the follow-on fund. Firms whose unrealized performance is more highly valued also experience a greater likelihood of LP investment in their funds, helping turn what was a maybe into a yes.

Evaluating unrealized performance is a complex process, and even the best due diligence by investors cannot accurately measure unrealized performance. Vanacker et al.’s research shows that media attention positively affects the assessment of unrealized performance by LPs, further legitimizing and “anchoring” the positive valuation in the minds of investors. In short, media attention elevates the visibility and attractiveness of funds, thus significantly enhancing their viability.

The authors define “media attention” as the number of citations in ProQuest to a specific PE firm. By doing so, they avoid the risk that their measure might include media coverage as a consequence of PE firms raising a follow-on fund.

The Outcome

The mean realized performance of first-time PE funds at the end of their economic lifetime in Vanacker et al.’s study was 132%, with the number significantly higher for those first-time PE firms able to raise a follow-on fund (151%) compared to those that did not (110%). Using a variety of different models that incorporate eventual realized performance, their analyses confirmed that unrealized performance is a weaker signal to investors than realized performance, but also that first-time PE funds with higher unrealized performance were more likely to raise a follow-on fund.

Vanacker et al.’s results show that fundraising outcomes for new PE firms change when media attention boosts the signal strength of their unrealized performance. General improvement to unrealized performance will only moderately increase the likelihood of raising a second fund for PE firms with low media attention; but for PE firms with high media attention, the shift in probability is much stronger. The data also reveal that realized performance speaks for itself, and media attention has relatively little effect on improving its signaling effect regarding fundraising for PE firms.

Conclusion

These outcomes have significant and far reaching implications for new PE firms. For example, they are often advised to convey strong signals to LPs by recruiting prominent affiliates. However, this generates a chicken-and-egg conundrum, as affiliates also rely on strong signals when choosing with whom to affiliate. Vanacker et al.’s findings suggest that firms may be able to overcome that deficit and draw the attention of affiliates by boosting their weak signal strength through media attention.

Doing so might also lead to better returns, as new PE firms with significant unrealized potential might be tempted to show realized performance early on and leave money on the table. Vanacker et al.’s results suggest that these firms should consider the relative costs of boosting the weaker unrealized performance signal instead and let interested investors bear the cost of the due diligence needed to assess its credibility.

While it can be argued that media attention is somewhat out of a firm’s control, new PE firms can still work to attract it through secondary marketing efforts, like speaking at industry events or engaging in customer education efforts.

Full article. Vanacker, T., Forbes, D., Knockaert, M. & Manigart, S. “Signal strength, media attention, and resource mobilization: Evidence from new private equity firms.” Academy of Management Journal, 63: 1082-1105.

The authors of the article are affiliated with the University of Minnesota, Ghent University, and Vlerick Business School (in Belgium), and the University of Exeter (in the UK).