Friday Letter: Caps off

In the era of the mega-mega fund, a new math has developed for determining an appropriate size for one’s next investment vehicle. It is a complex calculation that always ends up equaling the maximum that LPs are willing to commit.  

Blackstone, KKR, Texas Pacific and Permira all are on the road with giant fundraisings, but these mega-GPs are being coy with their own LPs about how much they are targeting. For these select few franchises, the hard cap has been cast off in favour of the incremental billion.

Several large limited partners and gatekeepers have privately expressed confusion about the amount of capital sought by Texas Pacific Group, for example. While one LP was told that the David Bonderman-led group was looking to raise “on the small end” of the current batch of mega-funds, another LP was told the number was around $14 billion. An LP source says he heard a separate rumour about TPG’s fund seeking $17 billion. These are people who intend to invest in the fund, but don’t know within several billion dollars how large it will be.

Blackstone recently went back to LPs to ask for an increase in the fund’s cap to $13.1 billion, according to an LP source. The fund has not yet closed.

KKR is being non-committal about its new fund’s size, as well. A gatekeeper was overheard saying at a recent conference that he “had no idea” how much KKR is trying to raise, but that he assumed the target was as much as the firm could get. What has been reported on the New York behemoth’s ongoing effort seems to support this. The firm reportedly asked longtime supporter Washington State Investment Board for a $3 billion commitment (but received a lousy $1.5 billion “preliminary” commitment instead).

Not every private equity firm approaches the issue of fund size like this. Many GPs, even very in-demand fund managers who turn away billions in capital, simply compute how many deals they intend to do over a four-year time horizon, how much they expect to invest in these deals, and size the next fund accordingly. This method leaves billions in capital commitments on the table but keeps the firm’s “sweet spot” strategy intact.

But the mega-mega fund managers have a different mindset. They are convinced that size is an advantage in their market, and they are increasingly supported by consultants and LPs in this view. Very large private equity funds have on average performed very well over the past decade. There are a number of theories behind this out-performance. One is that successful investors tend to succeed at raising large funds, and therefore large funds do well because they are run by successful investors. Another theory is that the few private equity firms that can break out of the middle-market scrum and play in the big league enjoy access to a higher calibre of company and of managerial talent. They also don’t have as much competition.

The blessed few franchises to surpass the $10 billion mark are targeting perceived sweet spots that get sweeter as they get bigger. But you can’t tell an LP: “We’d like to raise as much as possible.” Instead you give a vague range in the low eleven figures, press for very large commitments and see where it all ends up.

A telling exchange is recorded in recently released minutes from the Oregon Investment Council. Following a presentation from KKR’s George Roberts and Mike Michelson, in which the two charted the impressive returns that KKR has generated for the pension since 1981, board members voted to approve a $1.5 billion commitment to KKR’s new fund. But Roberts and Michelson clearly want to keep open the possibility of a larger amount. The minutes note that an investment council board member “encouraged the Council to revisit the KKR 2006 Fund prior to closing and possibly consider an additional allocation”. The council agreed to consider this.

You can bet that if Oregon or Washington change their minds and want to commit more, KKR won’t let a hard cap stand in the way.