Private equity funds are getting bigger. A number of compelling factors are driving both general partners and pension funds to organize ever larger buyout funds, and we believe this trend will continue. At the same time, it has become increasingly difficult for a $150 million, middle-market buyout fund to attract pension fund investors. Aren’t the $150 million funds of today (our “rising stars”) the $1 billion funds of tomorrow? As fund sizes increase and general partners chase larger deals, is the middle market being neglected? These are some of the questions we consider in trying to understand who will fill the role of pension funds in backing today’s rising stars of the buyout industry.
General Partner Motivations
In our hometown of Chicago, fund-raising trends are clearly a reflection of what’s happening on a national scale. In 1990, there weren’t any Chicago-based private equity funds larger than $500 million. Today, there are seven, and five are larger than $1 billion. In fact, some general partners are such successful fund raisers they have organized families of funds to leverage their fund-raising capabilities. What’s driving this trend?
Clearly, there are a number of factors leading GPs to increase their fund size. Larger funds benefit from economies of scale and can be more profitable to general partners even if they produce lower rates of return. A $1 billion fund that realizes returns in the mid-20s will probably yield more dollars to general partners than a $250 million fund with returns in the mid-30s. In addition, a $1 billion fund probably doesn’t require four times the resources of a $250 million fund. Personnel costs and overhead simply do not grow proportionately with fund size. A $1 billion fund does not have four times the staff, four times the number of professionals and four times the overhead of a $250 million fund. Yet it typically will earn four times the management fee. Finally, fund raising is an arduous, time-consuming experience that most general partners prefer to minimize. At least part of the motivation for raising a larger fund is the desire to fund raise less frequently.
Most GPs readily admit that their targeted average investment size will increase with a larger fund. With funds larger than $1 billion, the challenge becomes deploying capital. And increasing the average investment size is one way to do this. In doing so, a GP, with each subsequent fund, moves further away from the middle market where his roots lie. Middle- market deals are typically not large enough for a $1 billion fund to pursue unless they represent attractive add-on opportunities for an existing portfolio company. As GPs move up market, they face a new set of deal challenges, including increased competition, higher prices, and potentially lower returns in exchange for greater stability and management depth that typically come with larger companies. In effect, larger deals represent a lower risk/return profile than their middle-market counterparts. But, by moving up market, are large funds missing an opportunity?
Pension funds have their own motivations for investing in larger funds. Allocations to alternative investments have increased steadily over the past 10 years. In addition, the robust stock market (not including the past several months) has led to significant growth in the sheer size of many pension funds. These trends have driven pension funds to increase their average investment size in private equity funds. Several large public pension funds now have minimum investment sizes of $75 million to $100 million. Clearly, investing larger dollar amounts in fewer funds is more efficient and can be monitored more effectively by a pension fund. At the same time, most pension funds do not want their investment to represent more than 20% of the total fund. With a target investment size of $100 million and a 20% concentration guideline, this translates into investing in a minimum $500 million private equity fund.
Historically, public pension funds were at the forefront of backing the rising stars in the private equity industry. Even in the early 1990s, there were few groups that could point to the results of a previous fund. Most were struggling to raise their first funds. As the industry has matured, more and more private equity groups exist with a well-documented, realized track record from their early funds. These groups have become the “brand names” in private equity. Today, they are able to leverage their track records into newer, larger funds. The emergence of these brand name funds has actually made it more professionally risky for a pension fund administrator to back a rising star. Backing a proven GP who stumbles on Fund V will probably not cost you your job. Posting lackluster results after backing a rising star could.
Who are today’s rising stars? We think one category of rising stars is the “fundless sponsor.” Fundless sponsors are operating executives or private equity professionals who have left large companies or funds to pursue smaller transactions on their own. These groups do not have committed funds, but rather finance their transactions on a deal-by-deal basis. Individual deals are typically financed by senior lenders, mezzanine investors, friends, family and a savings account. The best fundless sponsors are adept at finding quality, middle-market transactions. They are highly entrepreneurial and, out of necessity, are aggressive and creative in deal origination. The best groups complete a series of individual deals, building their track record, before organizing and raising their first committed fund.
During the last several years, we have seen an increase in the use of mezzanine funds, rather than private equity funds, as the sole junior capital providers for fundless sponsored transactions. Mezzanine funds found this niche to be particularly attractive as they struggled to invest money in a financing environment dominated by overly aggressive senior lenders and a robust high-yield debt market. However, all that has now changed.
Turmoil in the senior debt market is making it more difficult for fundless sponsors to finance their transactions. Senior lenders with cash flow lending capabilities are increasingly reluctant to lend into fundless sponsor transactions. Cash flow lending is now being rationed to key private equity relationships. In fact, today there are several senior lenders who will only provide cash flow loans to groups with large committed funds, and only when a substantial portion of the fund is uninvested. Further, the dramatic constriction in the senior debt market has provided mezzanine lenders with the renewed opportunity to invest in less risky subordinated debt deals led by private equity funds. While a year ago mezzanine funds were eager to enhance their yields by investing in preferred stock and often leading their own transactions, today mezzanine funds have refocused their energy on servicing private equity sponsors where the returns are lower, but so are the risks. Today, brand name private equity funds not only have a competitive advantage in fund raising, but also in arranging financing on individual transactions.
A Match Made in Heaven?
We think large private equity groups could be a natural fit to replace pension funds in backing today’s rising stars. Large private equity groups bring an ability to raise capital – both at the fund level and on an individual deal basis. Fundless sponsors provide an ability to deploy capital in a potentially higher yielding sector of the buyout industry – the middle market. In fact, isn’t this strategy just a new twist on the well-developed practice of certain private equity groups backing operating executives? Admittedly, executives also add value with their industry and operating expertise. However, they are fundamentally brought in-house to expand deal origination. It’s interesting to note that some fundless sponsors are operating executives while others have experience as principal investors.
How would a large private equity sponsor bring a fundless sponsor in-house? We suggest a large fund could earmark a portion of their fund, for example $100 million, for middle market deals originated by the fundless sponsor. This would essentially be an un-committed fund. This arrangement would enable the fundless sponsor to market more effectively to sellers and investment bankers who screen buyers for financial wherewithal. In addition, lenders and mezzanine investors would be more likely to finance individual deals originated by the fundless sponsor knowing a large fund is the ultimate source of equity. The principals and employees of the fundless sponsor would receive a “management fee,” or their pro-rata portion of the large fund’s management fee. In exchange, all deals originated by the fundless sponsor would come first to the large fund, which would have veto power over all deals. We think the management fee paid to the fundless sponsor is much like the cost of buying an option on the fundless sponsor’s deal flow.
Clearly, the most difficult part of a relationship would be determining how much carried interest the fundless sponsor should receive. As with a fund-of-funds, at issue is the double carry involved with having two layers of general partners. Because middle-market deals should have the potential to generate higher returns than large transactions, there should be room to negotiate. As the only “limited partner,” we would argue the sponsoring fund should legitimately deserve part of the traditional 20% carry of the fundless sponsor. Our best estimate is that a fundless sponsor should receive a carry of about 10% to 15% on invested capital. However, we are convinced that the smaller middle market deals originated by the fundless sponsor will generate greater returns than the larger deals done by the sponsoring fund. As a result, even after giving the fundless sponsor a carried interest, the net returns to the limited partners have the potential of being in excess of those generated by deals done directly by the sponsoring fund.
Wrapping It Up
Large private equity groups have a significant competitive advantage in both fund raising and in arranging financing for individual deals. This advantage has grown steadily over the past few years and, given the factors driving this trend, is unlikely to abate. At the same time, large private equity groups may be covering the middle market less effectively as their average transaction size has increased. We see an opportunity for creative GPs to bring the middle-market deal origination expertise of fundless sponsors in-house. While the private equity industry has never been known for its collaborative efforts, the economics of such an arrangement and pressure to deploy capital may motivate such co-operative relationships.