To the victors the spoils

For such an elitist business, there is a surprisingly egalitarian pay scale in the private equity world. Much is made of the huge performance difference but scarcely is this reflected in the fee structure. This anomaly has been accentuated over the last year by two factors. First, there is far more institutional capital looking for a home in the asset class. Second, the industry is becoming more transparent, making it much easier to identify the winners

Events over the past year have provided ample evidence for this. Top performing fund managers have had to turn away billions of dollars of institutional cash. After years of fighting to squeeze every last cent out of suspicious European banks, pension funds and insurance companies, the blue-chip fund managers can now cherry-pick their investors.

It used to be that the very best performers in the asset class had the privilege of limiting institutional commitments; now they are refusing entry altogether. The likes of BC Partners, Permira and CVC have turned down tens of billions of dollars. At the top end of the market, the general partner is well and truly king.

The solutions to this supply and demand imbalance seem obvious.

Either fund managers should dramatically increase their fund sizes to absorb the added capacity, or they should increase the amount they charge their investors.

Funds are getting bigger, but at nowhere near the same pace as institutional demand for the asset class increases. They are constrained in this respect by the wishes of their existing limited partners, who do not want fund managers to lose investment discipline by having to deploy more capital than the market can absorb.

So, why don’t the acknowledged champions reward themselves for out-performing the market like the Silicon Valley venture capital firms have done? Not only this, but why don’t they follow the lead of Benchmark, Sequoia et al and exercise self discipline by cutting fund sizes in order to maximise performance? A carry of 30% must look very tempting when your fund is so heavily oversubscribed.

During this last frantic fundraising cycle, there have been precious few signs of this happening because fund managers and investors alike are acutely aware that private equity is a long-term game. The industry is littered with the corpses of former stars, and both sides are aware that fortunes fluctuate rapidly.

However, while long-term institutional partners do not take kindly to hubris, there is a clear market dynamic at play here that will be more pronounced when these groups return to the fundraising trail in three years time. If the pecking order remains the same at that stage, the temptation to push for a higher share of profits could just be too great.