GP, improve thyself

There has been much hand-wringing of late about the fact that it is becoming much more expensive to be a private equity firm, and that these trends will favour the largest firms and possibly make small shops an endangered species.

Two regulatory proposals in particular are scary for small firms. First is the US Treasury proposal that all firms with more than $30 million in assets need to become registered investment advisers. PEM’s Jennifer Harris estimates that the initial cost per year of being an RIA is roughly $280,000. This is chump change for Blackstone but a serious dent in the budget for a small buyout firm or venture firm, of which there are many.

Next up is the SEC’s proposed ban on the use of placement agents in dealing with government entities like public pension funds. As you’ll read in the Pro Notes section of PrivateEquityManager.com, Pillsbury Winthrop’s Kimberly Mann argues that this ban is likely to go through because the SEC already enforces a similar framework for the municipal securities industry. US public pension capital plays such a central role in the global private equity market that this prohibition would likely mean greater expense and logistical complexity for small firms in the US, Europe, Asia and beyond. It is possible for, say, a middle-market Polish private equity firm to build ties with pension investment staff across the US on its own, but it will sure take a lot more time and money to do so.

But even if these measures are not enacted, small firms will still need to spend more to stay competitive. Limited partners are demanding better, more invasive reporting, and this means hiring staff internally or spending more on service providers. Deal fees now mostly go to the LPs, cutting off a source of operating income; items that were once charged to the fund are now charged to the management company (see Kevin Ley’s “Put it on my tab”). Finally, GPs cannot assume that the next fund will be bigger, and therefore the CFOs of these firms must plan spending in a potentially shrinking budgetary environment.

These are challenges that no one imagined during the years of regulatory benign neglect and uninterrupted growth and multiple expansion. But it’s worth noting that most private equity GPs claim to be experts at helping small- to mid-sized businesses grow through challenging and changing environments. The managers that succeed at transforming their franchises into leaner, more effective organisations will be positioned for enviable growth when the good times return. There will be others, of course, that won’t be able to figure out how to make their own mid-sized businesses more competitive. One wonders whether those same firms ever had the wherewithal to add more to their own portfolio companies than equity, debt and the hope of multiple expansion.