Operations Underlie PE Compensation –

BOSTON – When private equity general partners market their funds to limited partners, much is said about performance, but the underlying operating practices get barely a word. The results of the 1998 survey of private equity compensation conducted by William M. Mercer Inc. indicate that private firms play a more active role in the development of portfolio companies than institutional firms.

The differences begin with the sources of investment capital for the two groups. Private firms, due to their dependence on outside investors to fill limited partnerships, generally have smaller funds than institutional firms. These institutional firms previously have relied heavily on parent organizations to fund investment efforts; recently, however, institutional firms have begun courting outside investors to participate in their funds more significantly, augmenting in-house infusions.

Witness the most recent fund raised by Sprout Group, the venture capital affiliate of Donaldson, Lufkin & Jenrette. Closed in April, Sprout VIII netted an astounding $860 million – $750 million from outside limited partners and $110 million from principals and DLJ. New investors included The AXA of France, Colorado Fire & Police Pension Association, Los Angeles County Employees’ Retirement System, Pomona Capital, Stichting Pension Funds APB, Unilever Inc. and Wilshire Associates.

By comparison, when Sprout VII closed in February 1995 at $250 million, there were only five new limited partners, and both DLJ and The Equitable (DLJ’s parent) were limited partners.

“These institutional funds have begun to take in less from the parent with each successive fund,” said Michael Holt, the survey’s director.

As defined by Mercer, the average private firm had $324.5 million in committed capital in all active funds and had raised $164.3 million for its most recent fund, 94% coming from outside investors. The average institutional firm, on the other hand, had a total of $625.7 million in all active funds, and its most recent fund netted $248.1 million. Emphasizing the reliance of institutional funds on parent companies, the average fund received $144.6 million of committed capital from that larger entity.

The preponderance of capital in the hands of the institutional firms obviously leads to those groups making larger investments in more companies. In fact, the average institutional firm added 14 portfolio companies in 1997 with an average investment of $5 million, while the average private firm added just eight new companies with an average investment of $3.5 million.

Venture Capital Most Popular

Among all respondent firms, venture capital deals received the bulk of attention. The average private firm invested 64.4% of committed capital into venture deals, while 99.9% of investments were directs into portfolio companies. Conversely, the average institutional firm placed slightly less than half (49%) of committed capital into venture investments with the other 51% going into mezzanine, buyouts and other deals. Furthermore, institutions committed 24% of capital to indirect investments in other partnerships, according to the survey.

Interestingly, while institutional firms have placed more money in more companies, the staffing levels at private and institutional firms are surprisingly comparable. The average private firm employs 16 people – 10 professional employees and six support staff. Meanwhile, the average institutional firm also employs 16 people, consisting of 12 professional employees and four support staff. Mr. Holt said that result stems from the greater amount of capital institutional professionals need to deploy and notes that the two additional investment professionals handle the greater deal flow at the institutions.

The survey outlines data that serve as a gauge of overall performance. For a firm with 13 to 16 employees, the average partner is responsible for $52.4 million of committed capital and handles about 6.5 deals. The survey said each partner averages 1.8 new deals annually and deploys some $20.6 million into all investments. The survey also showed that junior staffers at all private equity firms are seeing explosive pay increases in relation to more senior principals.

On average, the standard management fee of about 2.5% of committed capital declined slightly, as investors argued against the need for such high rates while fund sizes continue to grow, Mr. Holt said.

“The big pension funds and insurance companies have negotiated more, so fees have come down,” he said, adding that while the percentage may have dipped to about 2%, dollar amounts have not.

The average institutional firm permitted 64.3% of management fees to be paid from committed capital, while 80.8% of fees paid to private firms came from committed capital. However, institutional firms were significantly more likely to allow fees to be reduced by transaction, monitoring, board fees or stock options. Additionally, more than half of the responding institutions returned at least a portion of management fees to investors.

Private firms, however, are much less likely to reduce fees, and 73.1% of private firms do not return fees to investors, according to the survey.