Notes from the undermarket

A little over 20 years ago, I was a newly minted private equity principal sitting in the office of one of the founding partners of what would become one of the world's most successful LBO firms. We were investing with our own capital in a joint deal; he had a fund. I asked him what fundraising was like for a first-time fund.

His whole body stiffened and his eyes were suddenly aflame. Among a multitude of caustic items that flew out I recall his metaphor about the search for initial limited partner supporters as being ?a naked crawl across a field of broken glass interrupted only for periodic and thorough salting of all bleeding wounds.?

Cut to the present day – my partners and I are doing that crawl (fully clothed however) as a 20-year continuing team. Just like the founding partner, we have confronted the objections faced by initial firms in any business. We have been inspected, dissected, neglected and rejected by a host of institutions who say they have an interest in traditional private equity?but really don't.

Many of the objections had little to do with the merits of our team history (which has been verified to the satisfaction of some of the toughest institutional hands in the business), nor with the solid fundamentals of our now underserved market segment, nor with the growing stack of qualified deals that are being brought to our doors.

In a market so focused on finding private equity performance differentiation (the hedgies call this alpha) it seems remarkable that so many investors spent 2005 for the most part ignoring the small buyout sector – a sector in which nearly all the successful multi-generational LBO and growth firms built their return foundations, and in which the multi-year return statistics lead by a wide margin.

Many, many experienced and thoughtful LPs know the value of small fund investing. But their allocations to this high performance category are proportionally down. So what's up? There are structural impediments to raising a small buyout fund that were not around even five years ago. The reasons for these impediments are numerous and some have merit and others are less meritorious. They include limited staff resources of most LPs, the economic incentive structures of many large advisory and aggregator firms, and a great garble of confusing language that has sprung up surrounding small funds.

Limitations and allocations
At most of the LPs we've visited, we've found a strong appreciation for small buyout investing coupled with an almost universal frustration as to how to access it in a cost-effective manner. Most of these departments are staffed with between only three to five professionals. Some have even less.

Let's take a typical large institutional program, putting out $500 million in a year, and investing in no more than between 8 and 10 partnerships in a year. The average bite-size is thus $50 million per fund (for 10 funds in a year) scaling to $62.5 million per fund (for 8 funds a year). Instinctively, logically and quantitatively, it would make sense for the staff to be expanded to provide coverage of those higher-performance market segments where the payback is justifiable.

Thus if one $50 million chunk of this plan's annual buyout allocation was set aside for being committed in $10 million increments to five small funds with historically favorable track records, the incremental expense of adding a single additional professional should not be at all meaningful in the return calculations. But as one public department head told us: ?Fuhgeddaboutit?

In addition, many institutions have rules against being more than 20 percent of any given fund. With our $500 million a year example above, a 20 percent max automatically imposes a minimum fund size on them of $312.5 million ($250 million if they do 10 funds). Any smaller buyout fund is dead on arrival the minute it comes in the door. For a program doing closer to $1 billion a year, those minimums double, constraining them almost exclusively to the big buyout sector. Under any scenario, this is not the best way to determine an asset allocation nor is it the best way to drive portfolio diversification.

Advisers go large
Advisers are a critical, value add participant in the private equity manager selection process (did you expect me to say otherwise?) Seriously, the system cannot function without them even if (a few of my fellow small-fund colleagues will tell you) some of them can be simultaneously publicly supportive and privately dismissive of small buyout funds.

When institutions put their private equity consultant contract bids out, it is still rare that fund size diversification parameters are written in with measurable standards. The language in most agreements that typically gets signed does not strictly enforce fund size standards to support portfolio diversification.

Why would anyone want to do the extra work (and almost all of these folks do an impressive amount of analysis and background checking) on a whole bunch of small buyout funds if, for the same fee, they can justify doing the same work on just a few larger ones? Without clear parameters set by the institutional clients here, who can really lay blame on an adviser for following along with the increasing fund sizes of their favorite GPs?

Language disconnections
Imagine the impact on pro football team standings in the NFL if the measuring chains were flexible. No more 10 yards defined by forged steel links – just allow the field officials to stretch it to 14 yards or shrink it to 3 yards at will. Now here's a pop quiz for readers – what's the definition of ?small? when it comes to buyout funds?

A great many large institutional investors we've spoken with believe buyout and growth funds between $350 million and $550 million are ?small? funds. Authors of a number of recent articles in trade journals are confident the range is more between $400 million and $1.5 billion. A principal of a giant buyout firm confidently proclaimed at a December conference here in New England that ?small? funds were those ?with under $3 billion of capital.?

When I checked our own firm's market data I had a minor epiphany – many funds of funds have declined us because we were not ?middle market? focused. I always thought the buyout segment known as the ?middle market? extended all the way down to funds above $100 million, but I guess I'm wrong.

By late 2004, middle market buyout was all the rage and as such had been redefined in many aggregator firms. Now funds with targeted sizes of $300 million to $600 million and even above were considered to be working efficiently in the ?lower middle-market.?

Might I suggest a more powerful definition of ?lower middlemarket.? According to Thomson Venture Economics data, the top performing funds over the last 20 years have been buyout funds working with capital bases below $250 million. These ?small buyout? funds show an aggregate IRR of 26.7 percent – the top performing group. Mega-buyout funds ($1 billion plus) clock in at 9.7 percent.

Another misconception pundits like to repeat is that small buyouts are ?riskier? than larger buyouts. Since most initial funds begin in the small category, wouldn't it make sense that, like any start-up business, the failure rates will be consequently higher here also? Successful initial small buyout funds have a habit of exiting the category through capital migration on either their second or third fund. What happens to the return histories of all those start-up ?businesses? that couldn't cut the mustard? They don't migrate – they stay and skew perceptions. Even with this orphan effect, the overall category returns are what they are, and what they are is long-term better than any other.

Often the term ?emerging manager? has been applied differently. A number of new programs have recently been initiated to identify and support minority led managers raising small initial venture and buyout funds. This makes sense – as far as I'm concerned we can't get enough diversity in the GP ranks quickly enough. But to make headway in diversity here you've got to encourage certain groups while not excluding others and these programs typically indicate that economic performance is the paramount manager selection criteria. I take exception, however, to programs that focus on small funds and publish standards mandating they are open to all qualified firms but then discriminate in their selection process. Isn't this really contrary to the reasons these programs were started to begin with?

Small is beautiful, less is more
Mark Twain famously said ?everybody talks about the weather, but nobody does anything about it.? Thankfully, that's not true in the small buyout sector even with the above mentioned structural barriers. There are advisers and funds of funds, experienced and not, who are dedicated to seeking out and identifying managers in this segment. Maybe not so curiously, most have themselves exercised restraint in their own asset base or client aggregation. When you meet the right groups in this field (take heart small managers) they are typically straightforward and supportive.

Some very large public and private LPs have also established internal programs and expertise to maintain their allocations here. Endowments and foundations continue to focus a fair share of their program resources in the segment.

Remember managers, there's a reason to rely on your own experience and cap your capital and plow only the richest soil. While some today claim falsely that small buyout just can't ?move the needle,? I'd challenge them to examine the foundations of their own larger LBO GPs. Did funds I, II and III move the needle enough for you then?

I'll sign off here paraphrasing a particularly astute, multidecade practitioner in private equity investing who insists that ?all private equity is arbitrage, and when everyone is doing it, the arbitrage is gone and so with it go the returns.?

So come on managers – the glass is thirsty for blood but things are improving. Join the crawl

Ted Carroll has been a media industry private equity principal since 1984. He co-founded New York-based BG Media Investors in 1997 and Noson Lawen Partners in 2004.