Pain Points

Along the way, the kids on the block started calling old DiPietro “Boch.”  I didn’t know what it meant, but always guessed it was short for some term of endearment in La Bella Lingua.  And it was a great nickname for the generous old guy: whenever a Spaldeen would crack in two – a pretty frequent occurrence in our stickball marathons – the cry would rise up from the boys to his ever-open apartment window: “Aaayyyyy, Boch!  Yo Boch! Bocheroonie!  You got a spare Spaldeen up there?”  Sometimes it took a minute or two, but eventually, a pink rubber ball would fly out of that window on the third floor and go bounding onto East 2nd Street below.  I swear he bought those things by the case. 

Boch had seen a lot since boarding a ship for America all by himself in Palermo on his fourteenth birthday.  And he loved to tell us stories; his favorite was about how he snuck into a game at Ebbetts Field on the very day he cleared quarantine at Ellis Island.  But the thing Boch liked best was dispensing advice to the growing boys enjoying some post-stickball lemonade on his stoop.  “In life,” he often warned forebodingly, “someone’s always got you by the coglioni.  The only thing you can control is how hard they squeeze.”

It’s advice I ponder frequently, doing the voodoo I do. 

* * *

Lately, I’ve been a bit bummed out, though: “don’t waste a good crisis,” the new mantra goes.  So let me ask this: why aren't we using this epic downturn to fundamentally re-frame the relationship between GPs and LPs?  Instead, people are battling along the same lines across which LPs and GPs have been skirmishing for years.  It's like World War I: fierce battling yields a few acres of pockmarked muddiness.

But what if it doesn't actually matter if the fee offset is two-thirds or three-quarters?  What if it really doesn't make a difference whether the no-fault is triggered by 66% or 80% in interest?  Maybe the the LP-friendly/GP-favorable axis needs to be discarded in favor of some entirely new, orthogonal continuum that re-thinks how interests are aligned?   

Let me put a finer point on it: currently, LPs worry that the carry system grants GPs a free option in times of frothy markets; LPs ask: why pay an incentive to people who simply capture beta?  GPs on the other hand bellyache about how long-dated carry payouts can be; after all, those wacky hedgies get paid every year (watch those high watermarks, boys).  But what if we rethought the way in which carry is paid?  What if we instead paid people on a deal by deal basis, but only when they beat the opportunity cost of an appropriate public index?  And let's acknowledge that the public markets are a fast rabbit, so we should pay people a substantial portion (25%? 50%?) of the excess return above equity-substitute cost of capital.  You would have true-ups every couple of years to ensure that groups didn't get paid more than X% of the net profits on the fund.  

Something like that could be a win-win: LPs get a formalization of private equity's return enhancing essence while GPs pull carry forward (increasing the PV!) and could even get paid on flat (or down!) investments, as long as they exceeded public market comps. 

While we're at it, we could also get everyone on a budgeted fee (now I'm getting Pollyanna -- sorry: I've exceeded my daily Diet Coke allotment).  Pay yourselves well, folks; this is America and there's a market for your services, but let's not be bonusing back millions of dollars in excess fees . . . let's focus on cap gains, not W-2 income.

Of course, there are a million reasons why we'll never see a radical departure from the status quo: the fundraising "haves" don't need to mix it up while the "have nots" may be perceived as desperate for offering something new.  And indeed, LPs find themselves trapped in a prisoner's dilemma.  Most perniciously, the legal and accounting costs of a new structure could be prohibitive.

But, unfortunately, the most difficult hurdle to surmount is that any out-of-box thought would "make people's heads hurt."  It's a common complaint.  The status quo is easy to support and difficult to dislodge.  Maybe old Boch was right?  Maybe by trying to avoid headaches, we're sealing our destiny to keep squeezing each others' coglioni?

But what if we used this juncture in the short history of the private equity business to do something extraordinary?  What if we tried something new to make us all better off?  Almost a half-century ago, President Kennedy exhorted us to go to the moon, not because it was easy, but rather because it was hard and surmounting the difficulties would bring out the best in us.  Maybe trying something new might beat the squeeze-off to which we've otherwise consigned ourselves?

Comments

[mark s.]

I love it. There's nothing like the inspiration that comes from sitting around for hours in airports after a dozen annual meetings.

I obviously couldn't have said it better myself--why not rethink the entire relationship. My question, is it really the L.P.'s that should lead such a transition? Think of all the MFN b.s. we would get for submitting a different structure. Conversely, if a GP leads, they would be potentially perceived as desperate. Not sure, but I love the idea.

[Lee]

Interesting. An LP/GP negotiated budget (instead of fixed mgmt fee) and deal-by-deal carry structure is something I've mooted w/ other VCs. From a GP perspective it breaks the incentive of simply increasing AUM (often w/ disadvantage of strategy creep) and places greater emphasis on cap gain which I think is a good thing for us.

The benchmark rate on carry is an interesting wrinkle though not one I've thought about much. What's the appropriate benchmark for different flavors of PE? Mega buyout might be S&P but early-stage venture might be something different (small cap indices? NASDAQ?).