Funds Balloon, Manpower Doesn’t

It’s over a narrow strip of land that limited partners and general partners battle for terms, but in today’s market, GPs have staked the better ground. Thanks to heavy demand for funds, LPs often are left to chafe at developments such as firms raising bigger funds without significantly cutting fees or hiring more people.

The evolution of terms has been documented by Swiss advisor, SCM Strategic Capital Management AG, in its report, “2006 Review of Private Equity Terms And Conditions.” The advisory firm reviewed 252 funds, including 30 percent focused on North America, 28 percent on Europe and 21 percent with a global focus. The study included roughly one-third buyout funds and one-third venture capital firms, while the rest of respondents were firms with balanced strategies or were turnaround or mezzanine firms.

The study found that management fee rates have not fallen nearly in proportion to the amount that fund sizes have increased. “Fees are 25 percent less, but funds are 100 percent bigger,” said SCM CEO Stefan Hepp. On average, once a fund size exceeds $1 billion, management fees drop below 2 percent, the study found.

In addition, while 87 percent of successor funds are larger than their predecessors, team sizes have remained relatively stable. Firms raising funds of more than $3 billion had an average of 10 partners and 25 investment professionals in 2006, compared with nine partners and 23 investment professionals in 2005. For firms raising funds of between $1 billion and $3 billion, the average number of professionals actually dropped to 15 from 19 between 2005 and 2006, while the number of partners increased to eight from seven. Many of these firms are doubling and tripling fund sizes, while not making adjustments to their team sizes, the study found.

As funds increase in size and firms don’t hire more team members, general partners argue that they are doing the same number of deals, so larger teams aren’t required, said Hepp. “That’s a point of great debate among LPs—whether that point is valid.” Hepp added that with larger fund size often comes expanded geographic focus. “You’d anticipate the need for more manpower with firms going across the Atlantic to the U.S. There’s more flying time and the need to hire more local know-how,” said Hepp. “But that has not happened.”

The main challenge for limited partners is to distinguish the GPs that can successfully scale up in size from those that can not. Hepp believes that adding seasoned manpower along with a scale-up in size and geographic focus “is a big element in adding to credibility.”

SCM advises pension funds, mostly in Europe, though one client is Ohio State University. Together its clients commit more than $600 million per year to private equity. SCM also raised a $100 million fund of funds in 1998 for some local investors, and a similar-sized follow up vehicle in 2006. But it has no plans to expand the fund of funds business more prominently, said Hepp.

“From the perspective of the LP, it’s a tough market. Despite the enormous growth this industry has experienced, there is more demand than supply,” said Hepp. “This is baffling.”

It’s unclear how long the advantage in negotiating fund terms will stay with the GPs. At the Buyouts Symposium East conference in New York City last month, Nixon Peabody partner Charles Jacobs noted that while the pendulum swings back and forth between GPs and LPs, “it tends to stay a lot longer on the GP side.”—M.C.