As the denominator effect continues to roil LP alternatives allocations, the fundraising market has taken a severe dip. Fundraising for private equity buyout funds was down 20 percent for the first half of the year, according to a study by Dow Jones – and that was before the public markets' tumultuous past months sunk LP assets under management even further.
“We've seen a couple of funds recently that have gone to budget-based management fees, which we didn't see much of over the last five or ten years. The LPs are saying ‘Give me some more transparency into what it's going to take for you to run the management company, and we'll pay you that for the management fee’.”
Many placement agents and investor relations specialists are calling this market the worst they have seen since the bursting of the tech bubble in the early 2000s. Certain elements of the aftermath of the tech crash do seem to parallel the current climate for private equity firms: the mega funds are sitting on their hands, the pace of fundraising has slowed significantly and some buyout GPs have already had to settle for smaller successor funds.
Smaller funds mean smaller fees, which will affect the budget of a private equity management company. The tech crash, then, could provide useful lessons for private equity firms that find themselves struggling to adjust to the new order.
In the heady years at the height of the tech bubble, some of the brand-name venture capital firms were raising funds close to $1 billion in capital commitments. After the crash, those firms suddenly realised the volume and quality of deal flow didn't justify the enormous pools of capital they had amassed. And they retrenched.
Sevin Rosen Funds raised $875 million in late 2000, but spent just $600 million of it. In 2002, Kleiner, Perkins, Caufield & Byers reduced its $800 million fund to around $650 million. Charles River Ventures raised a $1.2 billion fund in early 2001, and later cut that commitment to $450 million. Redpoint Ventures gave back about 40 percent of its $750 million fund in 2001, and Mohr Davidow Ventures reduced its $850 million fund to around $650 million.
Though no one is yet suggesting that buyout firms in the market today are going to hand back capital, most industry observers agree that managers won't be able to raise funds as easily next time around. And in the absence of leverage, the largest firms may not be able to raise funds of the magnitude seen in 2006 and 2007.
“My guess is you'll see the same thing happen in private equity,” says Paul Kedrosky, a senior fellow at the Kauffman Foundation and a former venture partner at Ventures West. “You'll see an echelon of the industry drop off.”
Dramatic reductions in fund size come with dramatic reductions in fee income.
Only a small percentage of established venture firms actually closed their doors after the tech crash, but many of them had to adapt to newly slim budgets by streamlining operations. Halving a $1 billion fund that generates a 2.5 percent annual management fee, and then cutting that fund in half, puts a $12.5 million dent in the annual budget.
A slow fundraising environment can also take a toll. Raising a smaller than expected fund forces a firm to revise its budget downward, even if it isn't in imminent danger of going out of business. And even if a firm is able to hit its hard cap, if the fundraising process drags on the firm could run into budgeting problems.
Private equity management fee structures typically have two phases. In the first phase, the management fee is based on committed capital. Once the investment period ends, the fee structure usually enters the second phase, in which the fee is based on capital invested, or simply steps down at a fixed rate each year. If one fund enters the step-down phase and the second fund still hasn't held a final close, then a firm could find itself seriously pinching pennies (see table above).
It's worth noting, however, that the big names in both the venture capital and private equity industries are somewhat buffered from a drop in fee income. Management fees often don't scale with fund size, meaning that the mega-buyout funds are generating enough fees to rival carry as a source of profit.
“The management fees that people get at the top end are driven by their status in the marketplace and not the actual costs of running the firm,” says Jonathan Axelrad, a partner in Goodwin Procter's private investment funds practice.
But in a slow fundraising environment LPs have more leverage, and some of them are using that leverage to renegotiate management fees, says Joe Patellaro, a managing director in Citi's private equity services group.
“We've seen a couple of funds recently that have gone to budgetbased management fees, which we didn't see much of over the last five or ten years,” he says. “The LPs are saying ‘Give me some more transparency into what it's going to take for you to run the management company, and we'll pay you that for the management fee’.”
He also notes that given the current lack of deal activity, some LPs don't see the sense in paying a full management fee to GPs who are doing just one deal per year. In the near term, LPs will probably decide to take a more active interest in how these fees are being paid, and how they are being spent, he says.
Axelrad, however, counters that if management fee structures are correctly negotiated, a firm should have enough cash to run its business even if the next fund is smaller or slow to close.
“As the investment manager, you have to source the deals, you have to have the right deal people, you have to have the right network and investment committee and advisory committee. But do you need to be running your own payroll; do you need to be handling the back office? Do you need to be in this location at $50 a square foot versus this one at $30 a square foot?”
“A properly negotiated partnership agreement provides for a management fee step down in the out years that is consistent with the fund manager's having enough money to continue to run the fund,” he says. “To the extent that a slowdown in new fundraising places cash flow stress on managers in certain segments of the market, it is possible that those managers may end up taking home less money or downsizing their firms. However, I don't see that process, by itself, creating a massive dislocation in the industry.”
Right-sizing the firm
Venture capital firms tend to run fairly streamlined operations, and so in the wake of the tech crash there wasn't much that could be trimmed, Kedrosky says. For most firms the best way to cut costs was to cut personnel. A fund that's half the size of its predecessor also doesn't need as many partners to administer it.
“Many of the firms tried to operate off a much leaner structure that was very partner- centric and had far fewer associate level people,” he says. “At the same time there was a push to get rid of what were deemed to be some of the poorer performing partners, but that was a much smaller component because partnership changes are so hard.”
The slump caused Battery Ventures to lay off nine employees, including two investing partners. New Enterprise Associates shed four of its 11 partners in 2003 after it raised a new fund. Mohr Davidow closed its Seattle office that year as well, just three years after it opened.
Back office employees also suffered, says Mark Heesen, president of the National Venture Capital Association.
“At the top of the bubble you saw a number of these firms have in-house communications people, in-house legal staff, in-house recruiters,” he says. “You saw a winnowing out of ‘non-essential’ personnel directly after the bubble.”
Ultimately it was easier to outsource those back office functions than to cut corners in areas directly related to investing, Heesen says.
“The other side of that coin is you did not see a sudden reduction in travel budgets or things like that, because right after the bubble what you started to see was a much bigger interest in India and China, and you saw people hopping on planes and going to those places,” he says. “Looking for deals, that's the fundamental part of what venture firms do, and so those types of activities did not ebb as a result of the cutting back of the management team.”
Not everyone cut their staff after the tech crash though, Axelrad points out. He says he saw plenty of venture firms use less drastic means of keeping the lights on.
“We saw firms slowing their investment pace, investing more conservatively, trying to extend their runways, and occasionally raising annex funds to provide stop-gaps between major fundraisings,” he says.
The average mid-market firm doesn't have much fat to cut either, although some of the mega buyout firms have built up their staffs in recent years. For the private equity firm that finds itself needing to save money, Patellaro recommends focusing on the core competencies that create value for the LPs and outsourcing the rest.
“As the investment manager, you have to source the deals, you have to have the right deal people, you have to have the right network and investment committee and advisory committee,” he says. “But do you need to be running your own payroll; do you need to be handling the back office? Do you need to be in this location at $50 a square foot versus this one at $30 a square foot?”