Dire Straits, a 1980s British rock band, employed a winning formula in the construction of its albums. As did many other successful bands, it included two or three songs on each album that were potential popular hits while the remainder of the album comprised more artistic or politically oriented songs. The epitome of this strategy was the band's “Brothers in Arms” album released in 1985. One song, “Money for Nothing,” included the line “I want my MTV,” which virtually guaranteed regular play on the recently formed music video network. The song reached No. 1 on the charts whereas the politically motivated title track was not even released as a single in the U.S. Nevertheless, the pop music strategy worked well and the album reached No. 1, selling more than 30 million copies.
What does this have to do with private equity?
Put simply, it would serve private equity fund managers well to consider the pop song strategy when constructing their portfolios. That is, give us a taste of what we want, what we really, really want (to paraphrase another British band) — exits. Preferably, give us more than one and the earlier the better. The combination of the use of blind pool investment vehicles and the lack of true market valuation makes the validation of the fund managers' value creation capability through exits particularly important. Being aware of the importance of generating at least some exits from a portfolio prior to raising a subsequent fund is an indication of a fund manager's appreciation of the circumstances faced by limited partners. For emerging managers, early exits can be a strong signal to LPs that the fund managers are moving successfully from a deal-shop approach to establishing themselves as an institutional-quality fund.
For strategies in which holding periods tend to be longer than others, such as for lower-middle-market buyout and growth funds, developing an understanding of the importance of exits to LPs is especially critical. For these types of funds, it might be worth consciously incorporating some shorter-term investment prospects into the portfolio as a demonstration of the fund manager's ability to create value. Our research has shown the holding periods for below-cost realizations are statistically shorter for smaller investments; smaller lemons ripen earlier. If a lower-middle-market buyout or growth fund manager has not incorporated a pop song strategy into its portfolio construction, the manager could easily end up in a situation where the portfolio has several impaired companies and no exits. This would make fundraising very difficult and could force otherwise supportive LPs to pass on the next fund.
When asked why they have not exited a good company, fund managers will often use the argument that the company is growing well and they do not want a potential buyer to reap the benefits of their hard work. Similarly, they might express the opinion that if the company is demonstrating attractive compound growth: “why take money off the table.” While both opinions might be valid, within a portfolio management context, the better decision might be to exit if there have not been any previous exits from the fund. It is worth remembering a quote attributed to financier Bernard Baruch: “I made my money by selling too soon.” LPs generally will not view a general partner negatively for profitably selling a company and subsequently seeing that company continue growing under the next owner. However, they will not view a manager positively if it has passed on an attractive exit offer without a clear path for substantial value creation for the portfolio company, especially as this exposes the eventual exit value of the company to future and uncertain market conditions.
Musical purists could argue that Dire Straits “sold out” by employing a pop song strategy. Perhaps it did, but in giving fans what they wanted, band members were able to produce significant personal wealth while also gaining distribution of their non-pop music more widely than they likely would have otherwise.
The parallel for fund managers is that by generating exits prior to asking LPs to make another fund commitment, they can make their fundraising significantly easier while also allowing more time for the other companies in their portfolio to mature. While the term “pop music” is often used pejoratively, pop music stations and artists abound and would not do so without ample demand from listeners.
To stretch the pop culture allusions possibly beyond the breaking point, the quintessential quote from the 1990s film “Jerry Maguire” was “show me the money.” What fund managers might not fully appreciate is that if they “show LPs the money” (or at least some of it), LPs are much more likely to give it right back to them for their next fund.