Outsized PE Deals = Troubled PE Deals

When writing about the Elevation Partners portfolio last month, I gave particular attention to its investment in Palm. As one source summed it up: “As goes Palm, as goes Elevation.”

The reason, of course, is that Elevation has invested just over 25% of its $1.8 billion fund in Palm, via a series of commitments. Such over-allocation apparently was permitted by the fund’s LPA, but it is leading Elevation down a path well-worn by other private equity firms. Basically: If you invest 15% or more of your portfolio in a single company, you are just begging to be knocked to the ground.

Remember these moldy oldies: Forstmann Little pumping $1 billion into McLeod USA (not to mention its big bet into XO Communications)? Or how about Parthenon Capital plugging around 20% of its second fund into Atkins Nutritionals (not to mention a $20m deal penalty to Summit Partners)? Or Blackstone Group investing around $3.3 billion into publicly-traded Deutsche Telekom?

And that doesn’t even include the concentrated fund strategies of groups like J.C. Flowers or Garnett Helfrich (some LPs like these because they make the GPs “sweat” more, but I’d prefer the safety of diversification).

The most recent example of an outsized investment was Andreessen Horowitz investing $50 million of its $300 million fund into Skype. It may work out – there’s already talk of a quick-flip or IPO filing – but most of the aforementioned investments also looked good a few months in.

It’s easy to understand why such large investments can severely damage a portfolio. What’s trickier to grasp is why outsized bets so often go so wrong.

Perhaps it’s because something that looks too good to be true usually is. Or maybe it’s the “pot committed” mentality, which pressures firms to throw good money after bad.

Whatever the reason, there’s strong historical justification for LPA provisions that prevent such deals. It’s not the sort of thing that LPs should flinch on during negotiations…