My employer, VCFA Group, was the first firm formed to purchase private equity interests on a secondary basis and has raised approximately $750 million over the course of its 25-year history. At a time when other secondary firms are closing on multi-billion dollar funds (Goldman’s latest secondary private equity fund was in excess of $3 billion), VCFA has stayed focused on doing smaller and more complex transactions. VCFA’s latest fund closed at the end of 2006 with $250 million dedicated to purchasing interests in venture capital funds and was highly oversubscribed.
Why would anyone want to stay small when management fees alone can make General Partners extremely wealthy? I think that there are five myths surrounding smaller funds that are pushing many unsuspecting General Partners to the siren of the mega-fund.
Myth #1: You can only get rich by having a larger fund.
I believe that this first myth of the mega-fund has come from the shift of investor focus from multiples to IRR. If a private equity firm generates steady returns in the mid-to-high teens (a highly attractive scenario for many pension funds), a larger fund is necessary to generate wealth for the General Partner. However, if a General Partner has sufficient skill, generating multiple-based returns will be the road to riches. It is important to remember that the partners in most of today’s well-known funds became extremely wealthy with pools of capital that would seem miniscule today. Moreover, Limited Partners will reward high-multiple generating investors with frequent pools of capital.
Myth #2: Larger funds are faced with less competition.
I have seen many arguments that the largest end of the leveraged buyout market will show the greatest returns due to lack of competition. The reality is that all markets in private equity are fiercely competitive. Moreover, larger transactions will increasingly attract hedge funds and other potential non-traditional participants. But, more to the point, how many participants do you really need in order to make a transaction competitive? The founder of my firm, Dayton Carr, is fond of saying that compared a boxing match may not seem competitive compared to the New York City marathon, but who wants to get into the ring with Lennox Lewis? It only takes one competitor to make a transaction highly competitive. Sometimes even just the threat of such a competitor is enough to drive up price.
Myth #3: Small funds are stepping stones to a larger fund.
While it is certainly true that many of the world’s best private equity investors have migrated from small funds, many also have maintained a smaller size. A number of former principals at larger funds recently have “spun out” to create funds that are at a similar size to older smaller funds. As a secondary firm, we have seen countless examples of late 90s venture funds that saw large funds as the future. Many of the principals of these same funds have since returned to much more modest funds, having realized that the model was simply not the same. While leveraged buyout funds are likely to scale somewhat better than venture funds, I predict many leveraged buyout professionals will have very similar emotions in the future.
Myth #4: A fund must get big to attract the best talent.
While larger fees certainly afford funds the ability to pay higher salaries, cash compensation is only one part of what attracts great talent. Smaller firms and funds are able to build work environments and a strong culture that can frequently offer much greater rewards. For junior employees, smaller firms often offer greater responsibilities and leadership opportunities. Many of my friends who have joined large firms have told me that they felt like “cogs in the wheel.” Junior employees may also have the ability to receive carry in a fund earlier in their careers.
Myth #5: Larger transactions are more interesting than smaller transactions.
Some of the most interesting transactions arise in smaller deals. Our recent deals have included creative leverage, novel payout structures and unique risk sharing structures. Unfortunately it often takes the same resources and skills to close a small deal compared to a large deal. This means that many of the smaller fund managers are working that much harder for their Limited Partners.
While there are certainly advantages to having a large fund, many of the most commonly held beliefs about the benefits of being large are nothing more than myths. Smaller funds and firms offer great opportunities for General Partners and Limited Partners alike. So when the next record setting private equity fund closes, don’t forget the opportunity at the small end of the market.