Bain Two Ways

Targeted at $2 billion, Bain Asia Fund II is unique in that it gives investors a choice between two very different sets of terms.

Milan Kundera made this heartbreaking observation: “We can never know what to want, because, living only one life, we can neither compare it with our previous lives nor perfect it in our lives to come.”

Something similar might be said of investing: We’ll never be entirely sure how to allocate capital, because the peculiar set of circumstances and opportunities before us today have never before existed and will not again be created. And so the best we can do is attempt to measure the risks and determine our appetite for them.

For a large group of private equity investors, a standard quandary – “should I commit to this fund?” – has just become a double challenge: “Should I commit to this fund, and if so, with which set of terms?” With their latest Asian fund offering, the leadership of Bain Capital have entered into a grand experiment that will force limited partners to spend even more time and energy pondering “what to want.”

Targeted at $2 billion, Bain Asia Fund II is unique in that it gives investors a choice between two very different sets of terms. What might be described as Choice A has a 1 percent management fee, 30 percent carried interest, 10 percent hurdle rate and a “GP catch-up.” Choice B cuts back on the carry while raising the management fees – it has a 2 percent management fee during the investment period, and this “steps down” to 1.5 percent thereafter. It features a 20 percent carry over a 7 percent hurdle rate, and it also has a catch-up.

In a nutshell, Choice A gives Bain a bigger share of profits in exchange for a lower regularly charged management fee (which is based purely on the size of an investor’s capital commitment, not on profitability). And in Choice A, Bain only gets to pay itself carry if it “hurdles” over a 10-percent compound return. As any private equity market participant can attest, a 30 percent carry is well above the market-orthodox rate of 20 percent, while a 1 percent management fee is materially less than the standard 1.5 percent to 2.0 percent range. Bain Asia’s Choice B is therefore much closer to market orthodoxy on terms.

Which Bain Asia fund would you choose? If you instinctively opted for the lower carry, your instincts have not served you well. A veteran private equity number-cruncher recently took both Bain Choices out for a spin and determined that an investor would be slightly more likely to get a higher net return with the 1-and-30 model.

Austin Long, the co-founder of private equity consulting firm Alignment Capital Group, was intrigued enough to learn of Bain’s dual partnership offerings that he took the time to run them through a performance-simulation method he invented. The simulator (should it be called a “term-inator?”) randomly created 10,000 different fund performances, and then applied the same 10,000 scenarios to each version of the Bain Asia offering.

Each of the 10,000 fund performances has a different and randomly created set of portfolio investments with regard to hold period, capital weighting and gross return. If you set the standard life of a private equity partnership at 15 years (many live much longer), then you might say that Long simulated some 300,000 years of Bain Asia performances in order to test how investors in each fund offering fared.

30 Beats 20s. . . Barely

The first and most impressive finding from this 3000-century test-drive is that when the 10,000 performances applied to each Choice are pooled, the competing average performances are remarkably close. In the (1-and-30) Choice A simulation, the mean IRR is 17.3 percent. In Choice B, it’s 15.9 percent (this is after fees and catch-up). The median IRR for Choice A is 16.4 percent, while Choice B is 15.1 percent.

Bain clearly took care to create two sets of terms that, at least on a probability basis, treat its two classes of LPs roughly equally. (A person close to the firm says Bain decided to offer, for the first time, a fund with a 20 percent carry because doing so opens up the opportunity to win investors who have in the past avoided Bain because of its historically higher-than-normal carry. The firm has made no decision on terms with regard to any other future funds. Fundraising for Bain Asia II only recently began and the firm is gauging investor reactions with keen interest).

Of course, the results get more complex and more interesting when you get deeper into the weeds of fees and catch-up. Long cautions that while his results show that Choice A investors have a slightly higher probability of getting a better performance, much more research would be required to pinpoint exactly why Choice A tends to produce better results. That said, Long offers some educated guesses.

One possible explanation for the superiority of Choice A has to do with the corrosive effects that annual management fees have on net fund performance. Over a fund’s investment period, higher management fees mean less capital is being put to work in portfolio companies. Choice A is therefore better able to generate cash returns than Choice B, in part, because the former class of LPs are working from a greater pot of cash. And in most cases, this greater pot of investment capital trumps even the lower profit-take of the competing Choice.

A mitigating factor in favor of (2-and-20) Choice B comes in the form of the GP catch-up, a term that is governed by a particularly shadowy statistical regime. Put plainly, while on average the net performance of Choice A is slightly better, there is a slight probability that the wild-card mechanics of GP catch-up will cause investors in Choice A to take an expensive hit.

Long’s findings will no doubt further a few thought-trends that have been gaining momentum across the private equity market, among them:

• Management fees on large funds should come down – these regular tolls can seriously erode net returns. The difference between a 2 percent and a 1 percent management fee is often so much that not even 10 percentage points of profit-sharing can cover it.

• Twenty percent carried interest should not be sacrosanct – it’s time for all parties to private investment partnerships to experiment, because it is clear that any number of vehicles can get investors where they need to go and in alignment with the fund managers.

• Giving investors choices might open up the private equity market even further – every customer has different goals, appetites and internal rules. Some want chicken salad with toast on the side, not a sandwich – and don’t try to argue with them about it. Some simply cannot commit to a 30-percent-carry fund because it’s off-market and looks bad. Others love the confidence implied by a 30-percent carry over a 10 percent hurdle. “Go for it,” they say.

Indeed, an important human element missing from Long’s simulation is confidence. Investors commit to private equity funds that they expect to do well. They don’t expect the many dismal outcomes that Long’s simulator randomly creates. They expect great returns because the firm’s history shows great returns (on average). The GPs also expect great returns, but they undercut this confidence by insisting on more-than-enough, “tails-you-lose” management fees. Likewise, LPs who refuse to consider higher carry for superior performance could be accused of expecting and underwriting mediocrity.