LPs rush to Thoma Bravo funds despite no hurdle

Thoma Bravo is in rarified air: it is one of the few firms able to attract LP capital into new funds without including a preferred return on the pools.

The firm’s newest flagship and third mid-market vehicles are being raised without a preferred return, according to June meeting documents posted by the Rhode Island Investment Commission, which invests on behalf of the Rhode Island State Treasury.

Thoma Bravo Fund XIV is targeting $16.5 billion, Buyouts previously reported, and will focus on making larger control investments in companies between the size of $600 million and $2 billion.

Discover III is targeting $3.5 billion and is focused on the middle market, that is, companies between the size of $200 million to $400 million.

LPs usually want to see funds with a preferred return hurdle, which in private equity is set at 7 or 8 percent, that GPs have to meet before they start to collect performance fees.

LPs see preferred returns as an insurance policy against having the GP collect a share of profits before it has generated a decent rate of return for backers. Several other notable managers have also not included a hurdle in recent funds, including TA Associates in its most recent flagship, as Buyouts reported.

Notably, the two Thoma Bravo funds also have an American-style distribution waterfall. This is unusual because other firms that have formed funds without a preferred return have instead offered a European-style waterfall structure, meaning LPs must be paid back all contributions before the GP starts to collect carried interest.

The deal-by-deal waterfall structure means the GP immediately collects profits on each investment exit, without the additional burden of having to meet a return hurdle.

GPs who use the American waterfall model argue that it’s necessary to give junior executives incentive, especially in emerging funds that need the management fees to keep running.

LPs tend to prefer the European waterfall, as Buyouts has reported. “It’s just a lot cleaner,” one LP said at a 2016 conference. The most recent set of principles laid down by the Institutional Limited Partners Association also described the European waterfall as “best practice.”

Nevertheless, Thoma Bravo appears to be having no problem raising its funds, which charge 20 percent carry. According to the Rhode Island presentation, Fund XIV charged a 1.5 percent management fee while Discover III charged 2 percent. However, an accompanying letter by Cliffwater, Rhode Island’s investment consultant, said both funds charged 1.5 percent of commitments during the investment period and 1.5 percent of invested capital thereafter.

The firm hiked its targets considerably amid a “flight to quality,” as LPs seek to find strong managers likely to find good returns in the aftermath of the coronavirus crisis. Recently, Washington State Investment Board approved a $200 million commitment to Fund XIV, its first commitment to a Thoma Bravo fund.

Thoma Bravo’s funds have a strong track record. According to the Rhode Island presentation, its previous flagship, Fund XIII, a 2018 vintage, already has a 13.9 percent internal rate of return and a 1.1x total value-to-paid-in capital multiple, while Fund XII has a 14.1 percent net IRR and a 1.3x TVPI. Fund XI has a 29.3 percent net IRR and 2.8x TVPI.

The previous Discover fund, Discover Fund II, has a 2017 vintage and is so far not as strong a performer, with a -1.4 percent net IRR and 1.0x TVPI. However, that fund is still early in its life and performance will likely improve as its investments mature. The original Discover Fund is a strong performer, with a 33.5 percent net IRR and a 1.9x TVPI.

Thoma Bravo is also raising its first small-cap fund, called Explore, which will invest in smaller companies between the size of $200 million and $400 million. This fund is targeting $1 billion, Buyouts reported in January.

Thoma Bravo declined to comment for this story.

Action Item: read the Rhode Island presentation on Thoma Bravo’s Fund XIV and Discover III here.