For the uninitiated, fund investors are limited partners or LPs who pay the general partners, the GPs, fees to manage the fund and source deals, do due diligence etc. The GPs earn a 2-3% management fee every year and also something called a carried interest, which is about 20% of the profits.
So Dan argues that the GPs' thinking that the size of the fund (which typically is around $1bn for the ones doing this) would not allow them to invest and recruit in talent that will get poached by the larger $20bn and upwards funds. So they need to charge higher carry to be able to compete with them. Contending this is unethical, he goes as far as comparing it with the fund sizing during the bubble era.
"I’d go so far as to argue that bubble-era VCs were actually more ethical than today’s LBO crop (in terms of this specific issue). Why? Because VC carried interest increases did not get stapled to fund sizes. Instead, VC fund sizes grew purely as a function of perceived market opportunity/valuation. Such perceptions were wildly inflated, of course, but not intentionally so."
I commend Dan for his courage in openly admitting what he sees wrong in a newsletter that is primarily read by the people he is complaining about. But I don't see why this practice is unethical. It may be wrong and we do need a discussion on what is an appropriate size of carried interest for different sized funds. However, if the LPs of the funds who have done this are okay with it (since the LPs now only receive 75% instead of 80%), shouldn't the funds be fine to do it. In fact by doing so, I'd guess the GPs are under more pressure to perform and would have to work harder or actually recruit the talent they are talking about recruiting by raising the carry. They need to get higher returns so that they can justify this practice when they raise their next fund. So if they achieve 40% IRR instead of 30% on the last fund, they can argue that hey, we raised the carry, but we gained more as well.
We must also remember that the players (the LPs) in this industry are not rookies. They are not typical lay persons like you and me. They are not the person who can be easily taken advantage of. The LPs are managers of large pension plans or endowments who have significant pressure on them. They also have to the top attorneys and the best legal firms. If they can find a reason to go along with the increased carry, I am sure they have their own reasons. If an LP thinks this is stretching it too far, they have the means to sit down and negotiate with the GPs or the choice of not investing in that fund. Its as simple as that. In the end, every thing boils down to supply and demand. Doesn't it? Then should we really be worried that this practice of increasing the carry from 20% to 25% is unethical?
Tagged: Buyout Funds, Carried Interest, Private Equity, PEHub