Investment management organizations can be categorized into two types of entities: asset gatherers and performance shops.
Performance shops are firms whose primary focus is generating the best investment results they can. These organizations tend to have a boutique, artisanal mentality and dedicate significant resources to research, analysis, and portfolio construction, often touting an “edge” – or at least a “differentiated approach” – in these processes. They try to make money by making money.
Asset gatherers, on the other hand, are those firms who expend greater effort towards product development, marketing, and distribution. These firms generally have great narratives, particularly around benefits of scale, and many different products offerings. These firms seem to make money by raising money.
The problem with such classifications is that binary variables often mischaracterize realities which more accurately resemble a spectrum. It’s also often hard to distinguish between the two in real time: Investment firms hire articulate and aggressive salespeople, although no organization ever admits they are going to skimp on the investment work because it’s much easier to hustle down the next big allocator check.
One of the ways I think about determining where on this spectrum an asset manager falls is by trying to measure the resources deployed – or the return on investment – in each of the two functions: sales versus performance generation. While the philosophical contrast is present across organizations throughout all asset classes, it is particularly stark in alternatives, since the fee structure – the standard 2% and 20% – creates a clearly definable revenue stream for each.
First, if we ignore operations (and having started my career in operations, trust me, most firms do), we can argue that the organizational expenditure of effort on performance generation must be equal to 100% minus the organizational effort towards sales. We can try to proxy for this by looking at the size of the sales or business develop teams relative to the total employee count or assets under management, and compare that to similar peers.
A more direct measure looks at the revenue an investment manager receives from fixed asset-based fees versus the revenue to the general partner from variable incentive fees – a perfectly clean breakdown of the returns to gathering assets as opposed to generating investment performance.
A good example of this is the analysis we recently completed for a potential fund II investment with a small buy-out manager. Their fund I, roughly five years old, has generated approximately $30 million in management fees, and $53 million of accrued carry – with nearly 25 full time employees. This firm may not be struggling, but at $6 million a year to pay for 25 people, benefits, systems, office space in New York, and more, they are not getting fat off the management fees. They are betting on the carry.
On the other hand, a very large and well-established private equity shop is coming to market with a $20 billion fund target, which they will almost assuredly hit. They have strong historical returns, are very institutional, and demand for large funds is robust. In 2016, according to data from Preqin, nearly 900 private equity funds closed, raising a combined $350 billion – with a disproportionate amount of that going to larger funds. Nearly 40 percent of the private equity capital raised last year went to the 20 largest funds, and 26 percent went to just the top 10.
So what will this manager earn from management fees as opposed to carry?
Well, with a 1.5% fee on committed capital, this manager is locking in $300 million a year for five years – a guaranteed revenue stream of $1.5 billion just for raising the fund. In this case, they are getting rich off the management fee, and – if everything works out well – super rich off the carry.
There is certainly a role to play for platform providers, but we should question ourselves: Is originating and underwriting four to six private deals each year – even at scale, even with 100 investment professionals – worth $300 million a year in contractually guaranteed revenue? Or is that just getting rich by raising money, instead of by making it?
Christopher M. Schelling is the Director of Private Equity at the Texas Municipal Retirement System.
