Some LPs Find Less is More

Last updated: Experts Corner

More limited partners are making bigger bets on fewer, smaller funds, says Grove Streetís Chris Yang

A potential shakedown of the private equity industry has dealmakers worried. When it comes to grabbing the attention of limited partners (LPs), the competition among financial sponsors is as heated ever. Thatís because, these days, investors are more cautious and less likely to return to large funds a second and third time.

ďThatís the theory and it makes sense,Ē says LP Chris Yang, a managing partner of Grove Street Advisors. ďThe reality is itís an enormously sticky industry.Ē

As deals begin to percolate in the lower middle market, LPs are beginning to prefer smaller funds, Yang explains. Grove Street is one of those firms. Mergers & Acquisitions spoke with Yang on the trend just ahead of the firmís announcement that it received $650 million in new commitments that it will invest in private equity funds, especially in the lower middle market.

The funds came from four existing clients and one new sovereign wealth fund relationship, and will be invested in diversified private equity, smaller buyouts and venture funds and technology private equity funds. The firm has used funds to invest in Brynwood Partners, a Greenwich, Conn.-based private equity firm, Sightline Partners, a venture firm based in Minneapolis, Harren
Equity Partners, a Charlottesville, Va.-based firm that invests in lower middle market companies, and other firms. The Wellesley, Mass.-based LP has about $5 billion in assets under management.

Are investors less likely to return to large funds a second and third time?

The short answer is yes. The market has spoken. A large fund in 2007 and in early 2008 is very different than a large fund in todayís market. Part of it is because of mega firms raising less capital. It is taking folks longer to raise even smaller funds. Firms are now realizing that they canít put all that capital to work or that people arenít writing checks that large.

Why do more LPs prefer smaller funds lately?

Theyíre more conservative in their use of leverage over long periods of time. The best of small firms will grossly outperform large funds. Anecdotally, thereís also a greater dispersion of returns, but the quality of small funds will vary quite a bit. You have to measure their track record by how they source and execute deals, or how they monitor businesses and sell them. The challenge is finding the right small firm and identifying the better managers. Blackstone, Bain and KKR their best funds were the smaller to earlier funds. Those are the funds that they raised and generated the track record to raise larger funds. The expectation of what theyíre trying to deliver now is quite different than a middle market fund

Is there going to be a shakedown of the private equity industry?

I donít think youíll see a drastic shakedown, but I think itís clear that some changes will be made. Unless something is seriously going wrong at some of these firms, LPs as a collective are limited in their role in terms of what they can do. There are certainly no-fault divorce provisions and thatís basically an opportunity for LPs to shut down a fund.† But that wonít happen unless thereís a reason. If itís performing poorly, those are sort of nuclear options. I think youíll see people fade away or gradually disappear than close up shop or do anything radical. People may just not necessarily raise a new fund, or end up managing friend and family assets. But some of the best performers will just raise smaller vehicles.

How has the relationship between LPs and private equity firms changed?