Private equity is mostly an asset management business. PE asset managers make money by charging a percentage of assets under management + a carried interest on gains after the return of capital. Growth for PE asset management businesses comes in two forms: 1) raising more assets under management (AUM) and 2) more gains as a function of their investment performance.
This model is tried and true. It’s made some asset managers very rich. As a whole, it has also served investors: PE as an asset class has well outperformed the public markets. But as with any model there are limitations and tradeoffs. Squaring this with our own ambitions, personal and professional, is something that we give much thought to. We frequently ask ourselves:
Should we raise a big fund?
Should we buy bigger businesses?
Should we expand our footprint?
Should we enjoy our success and retire to The Villages?
What follows is a candid explanation of how we at TDV think about how our business strategy intersects with our investment strategy. The discourse may be messy, but hey, so are many of the businesses we buy.
#1 We Like Control
When we set out on our own over 7 years ago, it was in part because we wanted control over our own destinies. Both of us had worked in larger firms (investment and otherwise) and were ready to move past executing someone else’s strategy. Institutional capital comes with strings attached. These strings vary but can include: 1) giving up a chunk of the management fees/carry; 2) having to get deals approved by an investment committee; 3) oversight in the form of a board seat or advisory council; 4) all sorts of compliance stuff that comes with taking quasi-public funds (e.g. pension money). Having to manage all of this takes time, resources, and is secondary to what we actually set out to do - which is to buy and operate businesses. All capital comes with obligations and constraints. But the more money raised the greater the controls associated with its use. That’s probably how it should be. But that’s not deal we are comfortable taking.
#2 We’re Business Operators. Not Operators of Asset Management Businesses.
A good friend, who is probably reading this, enjoys extolling the virtues of asset management as a path to making “a metric f**kton” of money. He is not wrong. Most professions follow a similar arch where you go from apprentice -> professional -> manager. Implied in this progression is that you go from doing the actual work to managing the people who do the actual work. In the asset management business, this inevitably means hiring VPs, Associates, Analysts, etc. to the apprentice and professional work. Founders of these businesses essentially graduate to figureheads who show up when it’s time to raise the next fund. Leadership gets farther and farther away from the investment side of the house, as this work is passed on to less experienced, less expensive talent. This tells you everything you need to know about the asset management business! If a firm is allocating top talent to increasing AUM instead of driving investment performance, their priorities are clear: they believe growth of the business is going to come from raising more money (AUM) rather than doing good deals (performance based comp).
We believe AUM should be output, not the input.
And yes, while you need AUM in order to do deals, let us break out the handy calculator for some basic math:
The standard fee structure for private equity managers is 2% of AUM + 20% carried interest (“carry”).
$500M raised = $10M/year in fees before you make single investment
$1B raised = $20M/year. And so on.
$20M/year is enough money to pay 40 people $500,000 a year. Yes, yes, there are expenses and overhead and branded Patagonia vests and not everyone makes $500,000 a year but you get the point - that is a TON of money to go around. Especially considering the top 3-4 people are going to collect 75% of it, and the rest is shared among junior staffers. So you have a situation where the top few people are making $2M/year - again - before they realize a single gain. Making $2M/year sounds great. One day we hope to get there. But alas, these people are essentially full time fundraisers. That’s not how we want to be spending our time. Not because we’re purists - just a personal preference.
#3 Size ≠ Performance
In fact, it’s probably inversely correlated. Time and again, we find ourselves bidding against larger funds in deals. Usually we lose because they are willing to pay multiples that we aren’t. We frequently ask ourselves, “What does Big PE see that we don’t?” Having worked for and among these guys, we’re confident that they use the same version of Excel that we do and are not in possession of some magic wand that turns all investments into 10 baggers. The main difference is that they are investing out of big funds and need to deploy capital in order to justify their management fees. After all, XYZ Pension Fund isn’t paying 2% a year for a PE manager to sit on its hands. As a result, the PE manager ends up doing a lot of deals. Not all of them are great (or even good) deals. But because their incentives are built around AUM, they are compelled to make investments that align with this strategy. Indeed, because there is so much capital chasing so few deals there is significant price inflation in the private markets. But because a PE’s funds frequently last 5-10 years, it takes a long time for investors to fully recognize the true performance. By this time XYZ Pension Fund’s investment team may have turned over; they may have forgotten the original thesis; or they may have moved on to more exciting PE strategies. Along the way, the PE may have raised 2-3 follow-on funds based on the “marked up” performance of its first couple of funds. This allows the asset manager to continue to grow, collect rich fees, and potentially delay answering performance related questions for years to come. Again - no judgment - just not how we want to operate.