Is 2023 the Year of the Small-Cap Private Equity Fund?

A variety of factors are making smaller funds popular at the right moment to lead the industry into a hyper-focused, impact-conscious future.

Private Equity has long been dominated by well-established funds that attract substantial amount of capital because of their strong track records. Private Equity International reported $727.3 billion raised among more than 1,520 funds closed in 2022, while also noting that the ten largest funds they covered raised more than $160 billion of that figure – and all of that in what was considered a down year for Private Equity fundraising.

However, there are signs that this division between the haves and have-nots may be poised to break down. Investors are increasingly seeing the advantages of working with smaller funds because of their advantages in three key areas: diversification, specialization, and impact. We may see a turning point where small funds take a much larger share of the overall market, and here’s why 2023 may be the year that happens.

Why investors are gravitating toward smaller funds

As has recently been noted by Forbes, alternative investments are gaining in popularity, as “70% of the investors surveyed expect to increase their allocations to alternative investments in the next 12 months.” Not all alternative asset managers have performed as well as others, but in the areas that have performed well, “smaller hedge funds and private equity funds with less than $250 million in assets under management are in demand.”

Managers with smaller AUM are attractive for a few reasons, one of which is diversification. While larger funds have traditionally outperformed smaller ones in some sectors, investors don’t want to be overallocated toward a specific sector or investing strategy, no matter how tried-and-true it is. Emerging managers allow investors to allocate a portion of their funds to new strategies and sectors, of which one of the fastest-growing is ESG.

Niche funds and impact

If investors are concerned about investing too much capital in funds with broad mandates, hyper-focused niche funds provide an alternative. Among these focuses can be minority-owned businesses or companies started by women and members of the LGBTQ community. Investors who care about these issues can find a fund with an impact mandate that centers on their cause of choice.

The specificity of these funds also perfectly positions them for the ESG-focused future of investing. With ESG funds attracting more and more capital and new regulations on the horizon that could upend many industries, being seen as having an expertise in sustainability, social impact, or diversity could be a key differentiator for specialized funds.

As Institutional Investor notes, competition among PE firms is driving up deal prices, making specialization and specificity extremely valuable as “firms are doubling down on sector expertise and operational plans to improve the companies they invest in. This includes incorporating environment, social, and governance (ESG) factors as a way to add value to their assets.” Investors want funds that are going to actually improve the companies they invest in and follow through on ESG promises, and to do that requires specific expertise that a large fund is less likely to provide than one with a highly-specific focus.

For many reasons, PE funds can be beneficial to struggling communities. The longer holding periods of PE funds mean investors are committed to the companies and areas they invest in, and have the capital to put toward needed improvements and scaling. As Millennials become the next big wave of investors, they want to see their dollars put toward good. A large fund with a broad mandate may not be enticing to them if they can invest in a fund that only invests in companies that fulfill their desire for impact. That means small niche funds, whose influence can continue to grow as more Millennials enter the PE investing sphere.

Why fundraising can still be a challenge for small funds

The main obstacle getting in the way of small funds as they try to take over the market is that all of the above describes what investors would like to do, not what they’re going to do. When it’s time to put their money on the line, investors may be more risk-averse.

As noted by Forbes, “emerging managers will probably have the greatest difficulties raising capital because investors are having to make difficult choices about where to invest. As a result, when forced to choose between allocating to new, emerging talent or re-upping with managers with a proven track record, investors may choose to stick with the manager they know.”

For emerging managers to be successful, they have to do three things: 1) prove to investors that they have the specialized expertise that will make them successful in their chosen niche, 2) demonstrate a quality of service that can rival what is offered by larger funds, and 3) put the infrastructure in place to scale so that when capital becomes available to them, they can take the ball and run with it.

These things are not easy, but the right fund administrator can provide services to set small funds apart in a competitive marketplace.

How JTC helps small funds differentiate

JTC’s Private Equity Fund Administration solution differs from other third-party FA providers because it can be personalized for each fund’s specific needs, with a wide range of services that can be added at different points in a fund’s life cycle.

The first element of differentiation small funds need to demonstrate to investors is that they have the specialized expertise to make them successful in their chosen niche. For ESG-focused funds and impact investments like those in Opportunity Zones, JTC has pioneered methods for measuring and reporting on social impact and helping investors compare impact across investments with different goals. You can show the actual effect your fund is having on communities, and with JTC’s virtual Chief Sustainability Officer platform, you can develop and implement ESG policies without the need for a full-time in-house CSO.

The second crucial element is to demonstrate a quality of service that can rival what is offered by larger funds. Investors are evaluating their experience with your fund from the very beginning, which is why JTC concentrates on providing a smooth onboarding process. After that, investors have access to our award-winning eSTAC investor portal with 24/7 access to fund information at any time, anywhere.

The final element of differentiation is infrastructure so you can take advantage of the capital that is available to you. JTC can help cut costs by improving efficiency from the very beginning, providing value right away. We’ve proven that firms don’t have to choose between scalability and specialized knowledge, and we can help with things like overseas fundraising thanks to our global presence. As you grow, we can grow with you, so there’s no limit on where your success can take you.

It remains to be seen if 2023 will really be the year of the small fund, but with the right Fund Administration solution from JTC, managers of small funds can be prepared to show investors that they have what it takes to succeed and have the right partner to help them grow.

Stronger Together 

Learn more about how JTC can help private equity funds by downloading one of our Private Equity Fund Administration resources!