The Wrong Way to Right-Size

Buyout firms have begun horse-trading size caps and carried interest on new funds, according to Buyouts Magazine. The article – which I’ve since confirmed independently with several LPs – alleges that numerous firms have raised carried interest on new funds from 20% to 25% (which LPs hate), in a de facto exchange for keeping fund ceilings below anticipated subscription (which LPs love).

It may seem equitable, but it’s not. Moreover, it’s intellectually dishonest.

This tradeoff gimmick is mostly coming from upper-middle-market firms, which make the following argument: “We only want to raise $1 billion for our next fund. That’s more than we raised last time, but it’s reasonable due to market opportunities, number of partners, etc. Our concern, however, is that even a $1 billion fund will not generate enough management fees for us to prevent top talent from getting poached by the $10 billion to $20 billion mega-funds – who obviously have a much larger fee stream. So we only have two choices: Either raise our fund size substantially (which we think there is enough LP interest to support), or increase our carried interest from 20% to 25%. We opt for the latter, because it’s fairer to our dear limited partners.”

Still sound aboveboard? Ok, then here’s a question: If a firm believes that $1 billion would best optimize its strategy and personnel, why would it threaten LPs with the prospect of raising more than $1 billion? Wouldn’t the probable result be suppressed IRRs? Sure would, which is why the only legit explanation I can come up with is short-term greed. If you’re searching for a reference point, try “Venture Capitalists, circa 1999.”

In fact, I’d go so far as to argue that bubble-era VCs were actually more ethical than today’s LBO crop (in terms of this specific issue). Why? Because VC carried interest increases did not get stapled to fund sizes. Instead, VC fund sizes grew purely as a function of perceived market opportunity/valuation. Such perceptions were wildly inflated, of course, but not intentionally so.
Instead, VCs actually believed their own BS. Buyout firms offering decreased fund sizes in exchange for raised carry clearly do not. In other words, it’s BS without qualifiers.
Finally, let me briefly address the crux of this mid-market argument: That such steps are necessary in order to retain key talent.

I understand the sentiment, but think it’s ultimately a red herring. If a firm like Blackstone wants to poach a mid-market investor, it will always be successful if compensation is the individual’s deciding/motivating factor. Raising carry on a $1 billion fund from 20% to 25% might narrow the chasm a bit, but not enough to build a bridge. The reason that most mid-market pros stay put is because they prefer the mid-market biz – which is yet another argument for sticking to fund-size knitting. If your performance is strong enough, LPs will likely consent to the carry increase anyway.