Genstar, KPS, Others Seek 25 Percent Of Profits

As more talent and capital move up-market, mid-market firms face this question: How do I keep my top professionals around, when megafunds are raking in huge fees and doing historic-sized deals? One answer: raise their carried interest.

Two relatively small buyout shops in fundraising mode, Genstar Capital and KPS Capital Partners (previously KPS Special Situation Funds), have proposed ratcheting up their carried interest to 25 percent, from the standard 20 percent, sources say. Part of the deal with investors was to keep the fund at a modest size in exchange for the better economics, these sources say. Of course, keeping a fund at a smaller size also increases demand, making the fund harder to access and giving a succesful GP the upper hand. KPS has a $1 billion target for its third turnaround investment fund, while Genstar Capital has a $1 billion target for its fifth buyout fund. Both firms declined comment, and it’s unclear whether they made concessions on other terms.

“There’s a big land grab going on for resources,” said one person familiar with Genstar Capital. “Big firms want more operating talent, more people talent, more consulting talent. You need to make [the middle market] an attractive place to be.” By raising its carry, Genstar Capital is able to do that, said the person.

Other buyout shops that are said to have gone to the fundraising market recently with 25 percent carries are Berkshire Partners, Silver Lake, and Vector Capital. Berkshire didn’t return a call, while the others declined comment. One placement agent with knowledge of the situation said Vector Capital, in the market with its $750 million-targeted tech fund, was able to bump up its carry in part because it limited its fund size. Silver Lake, raising a $750 million mid-market tech fund with Shah Capital Partners called Silver Lake Sumero, gets its 25 percent carry after certain returns are made, said a person familiar with the fund. It was unclear exactly what the benchmarks were.

Jumping to higher carries while keeping a tight fund size has precedent. Media buyout investor ABRY Partners’s $900 million fifth fund, raised in 2005, has a 30 percent carry. Reportedly, the firm had north of $3.3 billion in demand for the fund. Its previous fund had $775 million in commitments.

Meanwhile, other funds have made the move to 25 percent carry as well. One is Sun Capital Partners, whose fifth fund is expected to close on $6 billion soon, beating a $4 billion target. One limited partner said the 25 percent carry comes after a 10 percent preferred return, which is a little higher than the standard 8 percent. Sun Capital didn’t return a call.

The fact that strong mid-market firms are bumping up their carries certainly isn’t all about limiting fund size. It also has to do with demand for well performing managers. KPS Capital is one of the most sought-after funds in the market, according to limited partners. Its current fund posted a net IRR of 55.8 percent through September, according to the Web site of California Public Employees’ Retirement System. Genstar Capital has posted a 33.2 percent return for its third buyout fund, the only Genstar fund CalPERS lists.

Not surprisingly, LPs aren’t quick to budge on carry. According to a recent survey by placement agency Probitas Partners, about one third of limited partners said they would not consider backing a buyout fund with carry of more than 20 percent. In the cases where investors would consider a higher carry, they would weigh the following factors: strong performance, meeting specific return hurdles, limiting management fees and limits on fund size, the survey said.

In fact, LPs have also taken back some ground on profit-shares. Providence Equity Partners agreed to knock its carry down from 25 percent to 20 percent on its $12 billion sixth media and telecom buyout fund. That fund closed in the first quarter at almost three times the size of its previous vehicle.

The moves by KPS Capital and Genstar Capital highlight a broader discussion about whether enormous management fees reaped by megafirms interfere with their incentives to perform. With a larger carry but smaller management fees, KPS Capital and Genstar Capital are arguably better incentivized.