The rise of the Alpha Generator - rebranding the 'Emerging Manager'

Guest Post by Heather Hartnett. The future of innovation is global. We discuss it here.

With Dall-E: “abstract style about emerging venture capital managers”

The focus of 99%tech is to highlight the changing nature of global innovation. Often this has to do with the Founders, the models they pioneer and the strategies they use to bring them to life.

In 2013, only 4 cities had created a billion dollar business. Today over 120 have achieved this feat.

One of the other key players in this are venture capitalists (like yours truly) backing entrepreneurs outside of main ecosystems. Many of the leaders are (or recently were) emerging managers.

I loved this (second) guest post by my friend and fellow Kauffman Fellow Heather Hartnett (originally published on Forbes) arguing the typical term “emerging manager” needed a rebrand.

She suggests Alpha Generator.

Where will your alpha come from?

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Guest post by Heather Hartnett

I’ve long been a champion of emerging managers. They see opportunities others don’t and often yield the best returns despite market conditions.

But the term “emerging manager” has lost its utility.

When it was first coined back in the 1980s, industry insiders used it to refer to managers with funds smaller than a certain size. But it soon became synonymous with funds run by women, by managers representing racial and ethnic minorities, and by other groups that are underrepresented in VC.

Today, it’s a catch-all term that can mean so many different things. It even has a do-gooder, save-the-world connotation that sometimes does managers a disservice while fundraising.

I’m not alone in my assessment that the term falls short of describing these managers and their role in VC.

“Emerging managers are the base layer of the innovation ecosystem. The supermajority of these managers focus on early-stage investments,” Winter Mead, founder and CEO of Coolwater Capital, said. “‘Emerging’ does not capture the true importance of these managers in supporting a broader set of the next generation of technology entrepreneurs.”

Now, in a moment of industry turmoil when there are more funds than ever before (over 5,800 as of Q1 2023), and so many funds are merging, these managers need a new name.

The current landscape is crowded, and LPs’ old filters aren’t working

VC is packed with fund managers with less than $100 million to invest — 2,700 of late. That’s not necessarily a bad thing. As Fred Wilson pointed out, and I agree, “we don’t need more firms deploying $10B. We need lots of little venture firms deploying $100M. It results in more choice for entrepreneurs.”

However, with such a crowded field, it’s harder than ever for LPs to discern who’s actually good — who’s going to excel in operating a firm, building a brand that founders trust, and fundraising effectively.

Track record, which is often a misleading headline, has long been a key filter LPs use to evaluate fund managers. But if you have a unique lens or new thesis, you probably can’t point to a multi-year, multi-fund track record investing in that thesis. LPs have also often looked at the firm a manager spun out from. But just because you invested at a larger fund doesn’t mean you know how to build and run your own firm.

To use these outdated filters is to apply old practices to new funds in an increasingly complex environment, which is a recipe for underperformance.

How can LPs account for all the added nuance when choosing an emerging manager?

Matt Curtolo, head of investments at Allocate, said that their firm looks for emerging managers that have “a clear point of view in terms of what you are trying to accomplish and why you are uniquely qualified to accomplish that” as well as “tenacity and grit, coupled with a passion to work through what will inevitably be some difficult times.”

They also want to understand the “why” driving a manager to launch a new fund at great personal risk, he said. “What hole do you see in the market or what inefficiency are you trying to solve?”

Other leaders in VC and private equity reported that they’re looking for managers with that competitive edge. For example, the alternative asset management firm TPG launched a new fund this year called TPG NEXT, which has an aim of increasing the number of diverse-led firms in alternative assets, aligning the industry more closely with broader demographic trends.

“We are foremost focused on talented investors who have a comparative advantage with respect to sourcing opportunities, executing investments and building businesses at the firm and portfolio company level,” Pamela Pavkov, partner and head of TPG NEXT, said. “Many of these talented investors also happen to be women, minorities, persons identifying as LGBTQ, or individuals who are U.S. veterans.”

Pavkov framed the issue in context of a broader shift in the market: “Historically, the industry has evaluated new or emerging GPs on their journey of assimilation as investors,” she said. “Many of managers today, however, are reaching our industry through different pathways than their predecessors.”

“We are focused on underwriting a manager’s potential authentication as entrepreneurs – what aspects of their journey qualifies them for business building? Is there evidence of humility and willingness to embrace feedback? How have these investor entrepreneurs demonstrated perseverance through uncertainty?”

In this new era, if you’re an LP, you need to change up your evaluation criteria. Differentiators can be that a manager has a deep network, a platform where they have an audience and can share their ideas, and a distribution network to amplify portfolio companies. Look for signs that a manager can fundraise. One early-stage founder with an oversubscribed round told me that they prioritized working with partners who had raised their own capital for their fund.

Enter the Alpha Generator: The manager who exists at the intersection of the unique circumstances of the current VC landscape and the shifting needs and priorities of founders and LPs.

The era of the Alpha Generator is dawning

I thought about options for different names — “next-gen managers,” “sub-scale managers,” and “micro managers” came to mind. But none of them rang true, because they all sound sub-par or inexperienced. “Frontier manager” came closer, since it alludes to striking out into unexplored territory and has long been used to describe tech that’s ahead of the curve.

Mead shared his thoughts on a new, more evocative name: “Emerging managers should be called Founder VCs, or CEO Investors, or Fund Builders,” he said. “These individuals and teams not only build networks and processes to source and invest, but they also build and manage investment businesses. They are multi-talented and the successful ones share the qualities of great founders of technology companies.”

I eventually landed on “Alpha Generator.”

An Alpha Generator runs a fund under $150 million AUM that they founded themselves. With their partners, they’ve made several investments in one capacity or another, have had I or II funds or proof-of-concept funds, and are connected to accelerators and angel communities.

They have deep, strong, differentiated networks of other VCs and founders and a disciplined approach to staying small and staying in their stage lane. They know where to look for new categories — and what to look for. They can add value far beyond money.

Firms run by Alpha Generators operate on an ethos that will attract the founders who will be the outliers of the next decade.

Where VC is headed

So what’s next for this class of managers, and the VC world at large?

Mead predicted “significant consolidation” of these managers over the next few years as they look to scale up their firms.

Curtolo said that for the last decade, the market has sent signals that capital was abundant and LPs were willing to invest in illiquid risk assets.

“We’ve seen a lot of that correct, so my general sense is that new fund formation will slow, and we’ll also see a reckoning for many first-time funds that raised in the last few years as capital has become scarcer,” he said. “This is a healthy reset, but the big question is how far will the pendulum swing?”

As LPs look to meet the moment of this necessary reset, it seems to me that very few have the sophisticated filters needed to discern investing in the Alpha Generator space. And that’s a clear indication that now is precisely the right time to do so.

The LPs who have dry powder to deploy now, and who think differently about how they evaluate fund managers, will reap the benefits of the strong vintages of Alpha Generators coming up in 2023, 2024, and 2025.

Investing in venture is about the future and not the past. LPs may be over-allocated from investing during the worst time in venture, but that shouldn’t deter them from investing in what could be the best time.

Put less weight on previous strategy and focus more on finding the managers who are best positioned to capture the value being created over the next five to ten years.