Survey says: Size matters not?

You may remember the scene from Star Wars when Luke meets Yoda for the first time. Challenged by Yoda to raise the space craft out of the swamp, Luke objects that it is too big.  Yoda’s response is “size matters not,” and promptly moves the craft safely to land.

 

The initial results of the pfm Fees and Expenses 2014benchmarking survey suggest Yoda’s response that “size matters not” applies to many of our industry’s practices. This surprised us given our pre-survey expectations that smaller firms would charge more expenses to the fund and larger firms would receive more fee income at the management company. Obviously large and small funds enjoy significantly different cash flow positions, with the issue of whether certain expenses can be allocated to the fund or income directed to the management company becoming more critical as the size of the AUM decreases.   

 

Nevertheless, we believe further study is justified. The industry is weighted toward smaller funds and the respondents in this survey were, similarly, weighted towards smaller funds: 7 percent of the respondents were from firms managing $5 billion or more and 17 percent of the respondents were between $2 billion and $5 billion. In terms of the size of the last fund raised, 65 percent were under $500 million and only 19 percent had a fund size over $1 billion. 

 

On the surface, size did not matter whether the expenses were associated with compliance, annual meeting, entertainment, travel, deals or the practice of charging fees (e.g., transaction or monitoring). 

 

For example, a question we thought would clearly distinguish larger funds from smaller funds:

 

“A successful bolt-on acquisition is made to a portfolio company where the management company received a $1 million transaction fee. The fee was below market as an investment banker fee would have been $3 million.  The question was what offset would you apply to the management fee?” 

 

As the results show (see November issue of pfm), 17 percent of funds with more than $5 billion in AUM responded to the first choice (“We have never charged transaction fees like this”) as compared to 43 percent with less than $1 billion in AUM. However, 67 percent of funds with $2 to $5 billion in AUM chose this choice as well.

 

But, like anything else in our complex industry, you have to dig through the layers. Other factors like strategy (respondents to the survey included: 40 percent buyout, 24 percent growth equity, 13 percent debt, 10 percent real asset, 12 percent other) are influencing the responses. In this case, strategy drives the industry practice. 

 

But we were still trying to hone in on where size of a fund or firm had an impact.

 

An area we thought might have substantial differences is how funds of different sizes account for deal costs. Let’s take a look at this question in the survey, which read:

 

“During due diligence and before any letter of intent is signed, the firm hires lawyers, consultants, accountants and other service providers to begin drafting their transaction documents. Who pays for these expenses?” 

 

As the results showed here, if the deal closes, most funds will opt for the portfolio company reimbursement.  However, size of fund comes into play for when the deal does not close. In those instances it seems the larger the fund, the more likely the fund will bear the broken deal costs. This trend bears true across most strategies as well.

 

For the most part, we noticed this trend in other deal expense related questions. Not surprising. Deal expenses have been around for a long time so the best practice is due to industry experience (e.g. if the manager has to incur dead deal expenses, is there a moral dilemma for the firm to go ahead with a questionable deal rather than have the management company incur the dead deal expense?). Larger funds tend to have more institutional investors who have seen some bumps in the road due to unintended consequences of certain expense allocations.

 

While the SEC may be somewhat new to the private investment scene, limited partners and the school of hard knocks have been catalysts for change and enforcer of best practices for years. So, it may be that size is a factor but experience matters as well (after all, Yoda was 900 years old). At PEF, where we handle fund administration for over 125 funds of all sizes and strategies, we know that there are differences between large and small funds in terms of fees they can charge and the leverage they have in negotiating with limited partners. But we also know not to deviate from industry honed best practices. Rather, we need to take the time to explain to the newcomers the reasons why they exist. If you don’t know industry history, you are doomed to learn the hard way.

 

Allen Greenberg is co-founder, and Mark Heil is senior vice president of business development, at PEF Services, a fund administrator for small to middle market private capital funds