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Cost and capital

Cost and capital 2006-11-01 Staff Writer It is often said that in private equity - and in any knowledgeintensive industry - the most important assets go down the elevator each night. This truism is often expressed in the context of a discussion about compensation. In other words, if you don't pay people enou

It is often said that in private equity – and in any knowledgeintensive industry – the most important assets go down the elevator each night. This truism is often expressed in the context of a discussion about compensation. In other words, if you don't pay people enough, they go down the elevator and go work for another firm, or start their own.

Compensating professionals is and should be the biggest expense of a private equity firm. But this doesn't mean that paying the pros is the only expense. And particularly where you and your partners are your own bosses starting your own investment franchise, the co-founders are highly incentivized to put peanut butter in the budget and move to caviar when the carry gets paid.

The November issue of Private Equity Manager focuses on budgeting and GP management, a function that LPs scrutinize as evidence that a firm has truly professionalized. On p. 30, Judy Kuan looks at emerging trends in deal expense management. With auctions more feverish than ever, an increasing number of deals pursued by private equity firms end up ?dead.? How much should be spent on a deal that might end up slipping away, when should the decision to pay for certain forms of due diligence be made, and who should pay for the dead deals? In a successful fund, these questions look small in hindsight, but they speak volumes about whether a firm has established effective controls and systems, or whether it simply spends LP money like a drunken sailor, hoping to stumble across a winning deal.

How to spend LP money responsibly is a question that only the few and fortunate get to address. Every year, many wannabe GPs set forth to found their own franchises, and the startup costs come from their own pockets (or, from the pocket of a sponsor who takes a dim view of a Picasso in the lobby). The trick with a new private equity firm is to have enough capital until the fund reaches that blessed first close, after which the management fee is supposed to cover most expenses. This is a journey that may take 18 months or more, and along the way, lawyers, landlords, systems providers, placement agents, airlines and hotels must be paid. And the GPs need food and shelter. On p. 20, Rob Kotecki guides us through the qualitative and quantitative considerations of a GP startup.

Enjoy the issue,

By David SnowDavid.s@us.investoraccess.com