Makena Capital is a perpetual-capital manager that commits about $600 million a year to PE. Buyouts spoke with Managing Director Brian Rodde, who oversees portfolio management and manager selection in buyouts and VC, about first-time fund commitments.
Some LPs, pensions in particular, try to mitigate the downside risk of first-time funds by committing lower amounts and by betting small parts of portfolios on EMs. What’s your view?
We want to make sure that every investment we make is impactful to our portfolio. We don’t think it makes any sense to make a smaller commitment to a smaller fund [just to avoid] being too concentrated within that fund.
At the end of the day, it can be a fantastic outcome if we’re a meaningful investor to the GP and they are a meaningful relationship for us. A lot of times, if a first-time fund goes on to achieve success, there ends up being a lot of competition for accessing that same manager in their successive fundraises. And so the best way to lock up a scale allocation is to begin with one.
Do you have a percentage limit? Do you fear committing, say, 60 percent of a fund’s capital and then having it go belly-up?
We don’t let the fund size dictate the size of our commitment.
On the venture capital side, we have been 100 percent of a fund before, and that is one of the best investments we’ve ever made as a firm. There is a growth equity manager that we invested in just a couple of years ago where we were one-third of their fund. There’s a small buyout manager where we were a third of that fund. All of those investments were sized more or less the same.
We have a certain targeted range of investment with each manager, and that’s what determines our commitment size, not the size of the manager, or whether or not they are a first-time fund.
We aren’t looking for others to validate our work or do our work for us. We’ve done this enough times to know what we’re looking for, and to have the conviction to invest at scale when we find the right opportunity.
Why invest in first-time funds?
We believe in the potential for first-time funds to outperform. There’s certainly a higher level of dispersion within their performance, but if you’re backing experienced investors, you’re able to cut off some of that left tail risk and of some of the downside of that dispersion, while capturing some of the upside. If you’re backing groups that you’ve worked with before, if you’re structuring a strong alignment of interest, you can mitigate a lot of that downside risk and then just be left with that kind of asymmetric upside.
Our first-time fund investing program has generated returns that are meaningfully better than the portfolio in total.
Why do first-time funds have a better shot at delivering above-average performance for LPs?
We call it the “chip on the shoulder factor,” where people are out to prove themselves to their community of peers, former colleagues, and the broader private equity community.
There’s a stronger alignment of interest, because almost all of the wealth being created via that first-time fund is going to be the carry, as opposed to the management fees.
There’s [also] no legacy portfolio for first-time funds to manage. All they have to focus on is doing their first great deal, and the one after that, and the one after that.
How many managers do you stick with as they age? Do the same benefits carry through into successive funds?
If we are making a first-time fund commitment, we expect to make a commitment to that firm’s second fund because by the time they come back to raise Fund II, there won’t be a lot of validated data points that will show whether [that investment] is working out poorly or extremely well. So you really have to trust that the judgment that led you to partner with them in the first place still applies.
In fund three, four and beyond, we continue re-underwriting our managers with each successive fundraise, and so long as they continue to meet the bar for our portfolio, we will continue investing with them.
We have firms in our portfolio that we’ve been partnered with, going back to our predecessor firms, for 20, 25 years, because they continue to meet our bar for partnership. But those are more the exception than the rule. Firms that can continue to generate outstanding return, the likes of which they might have made in their earlier, smaller funds, are few and far between.