The Right Way to Right Size?

Though I find myself usually agreeing with Professor Primack, this time I think he has it wrong on the middle market carry issue, both on a couple of points he made as well as some items he passed over.

Mega Funds as a threat?
In Dan’s hypothetical discussion he has the middle market GP arguing that if he maintains fund size at a moderate level that he needs to increase carry in order to prevent key investment staff from being poached by Mega Funds such as Blackstone. Dan rightly denigrates the idea, as many professionals focused on the middle market like investing in the space and wouldn’t feel comfortable – or necessarily have the right skill set – to play in the true Mega end of the market. 

But that’s not where the real threat from competitors lies. In that same issue of Buyouts magazine that discussed the potential move to premium carry was an article entitled Mid-Market Firms Go Mega In Huge Q1. This article covered middle market funds such as Hellman & Friedman, Leonard Green and Sun Capital all raising substantially larger funds, though not of true Mega status. It is these large middle market funds that are much more of a threat, as their war chests for offering higher salaries expand with much larger fund sizes, and their need to expand staff to deploy those larger funds also increases unless they make the decision to dramatically increase average transaction sizes as well. 

Interestingly, one other fund mentioned in that article, Providence Equity Partners, also found itself dropping its carry from 25% on its $4.25 billion Fund V to 20% on its $12 billion Fund VI under pressure from investors, a “size to carry” trade off going in the opposite direction.

“Venture Capitalists, circa 1999”
Dan also compared middle market buyout managers seeking a 25% carry to “Venture Capitalists, circa 1999”, whose raw greed led them to seek both higher carries and larger fund sizes simultaneously. That analogy doesn’t quite hold up, however. Top tier venture firms began to charge premium carries on their funds in the early to mid 1990s during the era of small VC fund sizes. Mega Funds in the VC world were, with few exceptions, creatures of the 1999 to 2001 Internet bubble. That’s not to say that as fund sizes grew during this period that GPs that had previously obtained premium carry dropped their take back to 20%, but that size and carry weren’t linked in time for VCs.

Motivations of LPs
One point not covered was the motivation of LPs, either in the venture capital market of the 1990s or in today’s buyout middle market. Terms negotiations are just that; terms are set not by GPs alone but in negotiation with LPs. Though in this market GPs hold the upper hand, pushing the edge of the envelope too hard can still backfire. The bottom line here is that no experienced LP is likely to give up premium carry solely on the basis of a limit on the size of a fund, or for restrictions on management fees or for a more favorable treatment on transaction fees without one other major factor – a track record of superior performance by the GP. Trading reduced fund size for premium carry is simply not something likely to take hold across the small end of the middle market. As with venture capital, only top tier funds would be able to institute such a change, and continued strong performance will be necessary to maintain it.

In effect, certain LPs are willing to pay differentiated pricing if they believe they are getting a superior product, and have shown a willingness to decrease that price on future funds if that assumption doesn’t hold. For years the general guideline for pricing on buyout funds has been 2 and 20 – a roughly 2% management fee and a 20% carry. There is no particular magic to those numbers, however, and if access to a top performing fund that chooses to remain small becomes exceedingly difficult, differentiated pricing is one way in which to determine allocation.

Alignment of Interest
One last point about premium carry: a GP only receives it if he performs. As noted in the Blackstone IPO filing, for many large funds management fees and their share of transaction fees more than cover expenses and are a significant source of profit. This profit, of course, accrues to the GP whether or not any capital gain is generated for the LP.

If an LP is willing to accept differentiated pricing for top tier GPs, as they certainly seem to have been over the last 15 years in the venture capital world, doesn’t it make sense to use a mechanism that maintains alignment of interest better than others? And for those LPs for whom strict caps on fund size and access to differentiated deal flow at the smaller end of the market are important, could premium carry be the right way to right-size?