“We’re more threatened by people who want the same things as us than by those who don’t. Ask yourself, honestly: whom are you more jealous of? Jeff Bezos, the richest man in the world? Or someone in your field, maybe even in your office, who is as competent as you are and works the same amount of hours you do but who has a better title and makes an extra $10,000 per year?” - Luke Burgis
The story of Blackstone is not new to many, at least not for those who are in the private equity and investment banking space.
Schwarzman and Peterson pitched to over a hundred LPs before getting their first bucket of gold from Prudential. The rest is history.
This was the same with the founders of Carlyle, who raised their first pot from junk bond king, Michael Milken. During a talk at the University of Maryland, David Rubenstein whimsically shares how he metaphorically “got down on his knees” to raise his first fund.
Today Blackstone and Carlyle are probably the largest private equity firms in the world. I use ‘largest’ loosely because a few million gap between first or second place is insignificant when you start comparing hundreds of billions. That was about 40 years ago. Since then, numerous private equity funds have come to market, raising fund after fund.
The economics of running a fund are pretty simple:
Find important people out there who are either rich or being entrusted by a lot of rich people to manage their money. Be sure to get their buy in and trust. And then charge a 2% fee for promising to make more money in five years or more, as compared to putting it in some fixed income and equities over the same time horizon.
Then you go out there, search for some under-valued businesses, do your due diligence before buying them, improve it, sell it after five years or so, and split the profits from the sale. 80% goes to your investors, the house gets a 20% cut.
Private equity in the early days were simpler and founded on the goodness of encouraging more wealthy individuals to fund the businesses of war veterans returning from World War II.
It was called “development capital” which later became the foundation for venture capital. Over the years, to cater to the evolving creativities of the capital markets and the risk appetites of different investors, the business model evolved into private equity.
Development and growth capital are both important catalysts in driving entrepreneurship and innovation, filling the gaps that traditional bank funding cannot provide. Without them, there would be no light bulbs, digital banking, electric vehicles and autonomous drones, etc.
But most of the people I meet today who want to be a part of the private equity club are in it largely for the prestige and bragging rights, less so for the hard work and sweat of building businesses.
The private equity domain, colloquially also called the buy-side, is such a sought after end game for many investment bankers and young business graduates that so few really think about what it really means to run one.
Over the last few months I spoke with quite a number of folks who have the intention of raising a fund at some point of time in the future. Aside from the prestige, many believed that just collecting the 2% management fees is itself an attractive proposition to be in this trade.
Apparently no one cares about the carry.
The carry is only there to demonstrate the fund's track record and justify ongoing commitment by the LPs to the fund, and its subsequent funds.
There's a line in the movie Wolf of Wall Street that goes something like this:
“So if you got a client who bought stock at 8 and it now sits at 16, he’s all f$%king happy. He wants to cash in, liquidate, take his f$%king money and run home. You don’t let him do that. What do you do? You get another brilliant idea. A special idea. Another 'situation.' Another stock to reinvest his earnings and then some. And he will, every single time. ‘Cause they’re f$%king addicted. And you just keep doing this, again and again and again. Meanwhile, he thinks he’s getting shit rich, which he is, on paper. But you and me, the brokers, we’re taking home cold hard cash via commission, motherf$%ker.”
Securities houses run by stock brokers are there to make money on the cut of the transactions and not the profits. There is no skin in the game. Only the incentive to keep the snowball rolling.
Sure a 20% cut of the profits can be attractive, but that's at least a five year wait with some uncertainty of how much that amounts to. Meanwhile the management fees are already in your pocket.
Apparently, it is even common place for some funds out there to operate entirely on management fees.
Many of those I spoke to also believe that after raising a fund, they would be able to sit back and pilot decisions from afar and atop, while recruiting credentialed individuals to run the show and do the grunt work.
Having worked for nearly 18 years now, I sometimes wonder how realistic that is. It’s hard to take your foot off the pedal, and you don’t want to as well, not at least when you are starting a new fund.
Don’t get me wrong. I’m not here to pour cold water on chicken soup.
Some publicity and bragging on the media can be helpful for running roadshows with LPs. After all, most institutional investors out there want to know that the fund managers they are investing with has been heard of in industry circles. No one wants to put money with a nobody.
It’s the same publicity game.
I just think many people are more drawn to the limelight of raising a fund than the process of running it.
In a hypothetical parallel dimension, you can still make lots of money using your own capital by employing leverage, minus all the publicity and industry recognition. For example, a captive investment fund raised entirely from family and friends. You could still make serious money for them and yourself, albeit quietly, but would you still do it?
Ultimately you need to ask yourself this: Do you really like the business of investing? Or do you just want to look like an investor?
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