Thursday, February 6, 2014

Private Equity Done Right

Private Equity Done Right

I spend a great deal of time on this blog criticizing money managers and institutional investors.  There is, of course, plenty to criticize.  Recently I ran into a private equity manager who reminded me that some firms remain true to their investment expertise instead of trying to expand for the sake of generating fees.  So for at least one day, I want to share a positive story about money management.

This manager has raised a series of funds over more than a decade.  I don’t think there’s anything particularly unique about his fee structure.  I suspect the management fee is around 2% and the carried interest is 20%.  The principals are as interested as any money manager in making money for their investors and themselves.  What differentiates this firm is its discipline and focus.  While the firm’s success would have allowed it to raise bigger and bigger funds, each of its subsequent offerings has been roughly the same size.  The manager clearly understands the source of its investment expertise and the capital requirements of the target companies it invests in.
Sketchbook #4 (2001)
All too many successful private equity managers will try to raise a subsequent fund that is 50% or 100% larger than the previous one.  Larger funds are great news for the managers because the management fees and carry pool will be significantly larger.  Obviously, the growing stream of fees will support bigger salaries, offices, and perks.  However, it also means that managers will either have to do bigger deals or more deals.   Inevitably, money managers dilute their talent, begin to invest in companies that aren’t within their realm of expertise, or throw too much capital at portfolio companies.  In other words, when managers continually increases the size of their funds, there are multiple ways in which the managers’ funds will eventually produce disappointing results.

However, being disciplined about fund size also requires are a great deal of operating discipline.  Since the revenues generated from management fees aren’t escalating, the manager doesn’t have the wherewithal to boost salaries or dramatically expand staff.  The investment team has to be focused on generating gains because carried interest and returns on invested capital are the only ways to build wealth.

About ten years ago, one of North Carolina’s venture capital managers called me to say they were raising another fund that was going to be the same size as the previous one.  Because they’d been successful, I wanted to double North Carolina’s investment with the manager, since $15 million wasn’t large enough to make much of a difference in our $60 billion pension plan.  However, in order to maintain the firm’s investment discipline, they didn’t want to raise more money.  Although I couldn’t invest more money with the manager, I respected their decision.

Most private equity managers turn into asset gatherers, because amassing ever-larger funds is very good for them.  It was refreshing to meet with someone who has stayed true to his discipline and expertise.

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