In pursuit of fees

Today’s Wall Street Journal asks, why are private-equity firms raising mega-buy-out funds?

Consider the compensation structure of a $19 billion fund, which is the size Goldman Sachs is targeting for its latest fund. Typically it will take about 10 years for that money to be deployed and then returned to investors. The fund manager typically takes a fifth of those profits each year for the last five years of the funds, after clearing certain minimum-return hurdles.

But there’s more. Private-equity funds also charge an annual management fee of up to 1.5% on the money they put to work. For a $19 billion fund, that could be as much as $235 million in a year. In addition, most private-equity firms charge transaction fees, a bit like investment bankers do, for putting together their deals. Blackstone is charging its investors some $200 million for completing the $39 million takeover Equity Office Properties.

Using a model developed by Private Equity Manager, a trade publication, it is possible to project how these fees on investors’ money add up. Over 10 years, a fund like the one Goldman is aiming for could throw off $7.8 billion to its managers. That’s equal to about 40% of the assets committed to the fund.

To be fair, the pension funds and institutions that commit their money to big buyout funds are happy to pay fees like these if they can double their money – as has been the case historically. But with so much money chasing outsized returns, it’s not clear that will be the case in the future.

You have two cows…

Mark Gilbert adapts the old jokes about having two cows under communism, capitalism, etc. and explains the wonders of modern finance (via Paul Kedrosky),

Carbon-Emissions Trading

You have two cows. They produce 1.2 tons of methane gas per day. After a hefty donation to the re-election campaign of your local representative, the government gives you enough emission permits for six cows. You sell three permits, buy another cow, and apply for a European Commission grant to build a methane-gas power station.

Interest-Rate Swaps

You have two cows. You pledge one of them to me as collateral in a swap for some of my pigs. I pledge the cow to my neighbor as collateral in a swap for some of his sheep. He pledges the cow to his cousin as collateral in a swap for some of his cousin’s goats. Better pray the livestock market doesn’t crash and we have to try and round up that cow.

Paul Kedrosky’s take on venture capitalists,

Venture Capital

You have two cows. One is male, and one is female. Mike Moritz says he loves both cows and will buy 35% of the pair for $100. After the deal is signed he tells you to kill your female cow, and then says your male cow must produce a baby cow within three months or you’re fired. Three months and one day later he fires you, takes your remaining cow, and transfers it into a milking machine company which then goes public on Nasdaq, earning him $10,000,000. Citing a lactation preference in the term sheet, however, he keeps all but $0.10 of the proceeds. “No hard feelings,” he says, “and be sure to come back the next time you have cows.”

Venture Capital Financing

A useful perspective on venture capital,

Venture Capital

You have to ask yourself if venture capital is a realistic financing option for you. Most entrepreneurs who pursue venture capital don’t qualify and merely end up wasting a lot of time (on average from 6 to 18 months) and energy in a futile pursuit.

There are problems associated with attracting venture capital as well. A venture capital firm will in most cases fire the founder and founding team within months of a financing round. The Wall Street Journal pointed this out in a article by Barnaby Federer from September 30th, 2002:

“If you ask a VC what value they add, and you get
them after a few drinks, they’ll say, ‘We replace the CEO’ “,
he said. And that, he indicated, does not vary
with the economic climate.


More here.

Another useful site is Startup Junkies. We have previously discussed the Venture Capital Model in Conservation.

Read this book

One of the best books about start-ups and venture capitalists is Charles Ferguson’s High Stakes, No Prisoners. As a business ethnography it is up there with Tracy Kidder’s The Soul of a New Machine, and it is much better on analysis. Most business books should never have been written. This one is good.

Charles Ferguson on

Apple vs. Microsoft
“Watching Sculley go up against Gates was rather like watching a rich playboy who was ordering his yacht to attack a carrier battle group.”

Venture Capitalists
“Andy Marcuvitz is a heavyset guy who wears badly fitting suits. He has no discernible personality, sense of humor, or compassion–ideal traits for a venture capitalist.”

On the website one of the customer reviews is by someone named Jane Smith, who says she has “actually dated” Charles Ferguson. She states that “with a talent and intelligence like that, he could have gotten a lot more for Vermeer, a lot more for himself and he’d be a happier human being”. No comment.

She also says that he is “50-ish, balding”. Hey, what is wrong with being 50-ish and balding?

The Venture Capital Model in Conservation

Wouldn’t it be wonderful if you could set up a private equity firm, invest in businesses that generate biodiversity conservation benefits, and use the proceeds to fund new ventures?

The idea has occurred to several people. It is unlikely to work.

Private equity investing is a non-scalable craft where industry knowledge and social connections are important.

Venture Capitalists succeed by paying very close attention to a limited number of investments in businesses they understand. Even so, they expect failures. To make up for failures their hurdle rates are high, e.g. returns of 30 to 50% per year. These rates of return are unlikely to be widely available in conservation businesses. Look e.g. at the fund-like Verde Ventures’ portfolio.

Scalability is crucial. If you tell a VC that you want to open a tea room and sell tea and cakes, you will not get funding. If you tell him that you have a plan to do for tea what Starbucks did for coffee, he might be interested. Most conservation-related businesses are small and not scalable.

Before investing, a VC has to ask himself, “If this venture can take off and become huge, can it do so with the existing management team?” VCs are notoriously ruthless (they would call it “pragmatic”), often “adding value by firing the CEO”. This is unlikely to be socially acceptable e.g. in a community-based venture.

The VC must have a clear exit strategy. He must generate proceeds that can be invested in new ventures. In contrast, conservation typically needs patient investors who are in it for the long run.

Finally, most private equity firms are located in enterprise clusters, rich environments where world class talent is available. Examples of clusters are Silicon Valley for computers, Milan and Paris for fashion, and Hollywood for films. In contrast, Verde Ventures, for example, is all over the place, both in terms of geography and industries.

For further reading, see also the paper by Louis C. Boorstin, Delivering Social Value via the Private Sector: A Framework for Market-based Interventions. He writes,

To date, IFC’s most consistently successful environmental interventions have been market development programs aimed at changing the behavior of lenders, companies and consumers related to specific environmental activities. These projects have yielded social benefits that are sustainable, replicable and in some cases highly leveraged. The programs have employed a range of knowledge sharing, capacity building and risk-sharing tools – but rarely capital funding – to engage with existing market institutions, including local financial intermediaries, project developers, industry associations and utilities.

IFC environmental interventions that have primarily provided capital funding for investments have shown more mixed results. The weakest performance has come from private equity funds expecting commercial (i.e., very high) or near-commercial rates of return. Three such funds were closed down prematurely by their investors because they could not identify and complete enough transactions meeting pre-agreed investment criteria. However, IFC has also supported more successful “fund-like” vehicles that have the flexibility and patience to accept lower returns and/or to meet the market’s need for a wider range of financial instruments (i.e., not just equity) while also providing limited technical assistance.