Marc Andreessen has a fabulous post deconstructing private equity investments. It reveals a lot of the risks and describes how some basic financial engineering might provide similar returns. My favorite is:
What part of the excess return over the S&P 500 index that you are expecting to generate is due to your use of leverage (debt)? Does this indicate that the public companies that you plan to buy are underleveraged?
My hunch is that this expected excess return is pretty high. It’s a post worth reading.
One point he makes that I think is worth contrasting with Venture Capital is the fee structure. Marc mentions in his post, almost incidentally, that:
The General Partners typically take 20-30% of the investment profit plus 2-3% management fees annually, plus often additional fees, perhaps levied against their companies [emphasis mine]
For a little more detail on these fees, here’s what a recent article from Morningstar.com reveals after reading through Blackstone’s S-1:
The third source is transaction fees levied on companies that one or more Blackstone private equity funds have acquired, which are meant to compensate Blackstone for taking a firm private, restructuring or recapitalizing the business, and positioning it for eventual re-entry to the public markets or sale to another party. Though euphemistic sounding (“transaction consummation fee,” “monitoring fee,” “disposition fee”), these fees can be enormously lucrative. Blackstone stands to earn as much as 1% of the enterprise value of the companies it acquires, a staggering sum….
Wow! Anyone that’s been around the Valley for a while knows that any VC that tried to do something like this wouldn’t be in the business very long.
Nevertheless, I’ve actually seen instances of where the ‘VC’ invests, takes a board seat, then gets a directors fee. Often the investment is modest (<$1M) and the fees sometimes amount to 10% or more of the invested capital! Most entrepreneurs recognize this for what it is, a shakedown. I think it might also be a term to describe some PE firms as well.