E333: Why a $19B Allocator Is Betting on Lower Middle Market Buyouts

Why do most institutional investors still allocate heavily to large private equity funds? Alex Abell of RCP Advisors explains why the lower middle market has consistently outperformed, driven by less competition, faster exits, and stronger value creation. He breaks down the structural reasons LPs stay in large buyouts, including access constraints, manager selection difficulty, and career risk. The conversation also covers how top LPs evaluate managers, what actually predicts performance, and where alpha exists in private markets today.

Speaker names marked ? are inferred from speaking time and the show’s known hosts — they are not voice-verified.

• 0:00David Weisburd?

  So Alex, you're at RCP Advisors, which had 19 billion AUM. And last time we were chatting, you mentioned how LPs are still spending most of their allocation in private equity in the large funds. Why is that wrong?

• 0:11Speaker 01

  The simplest reason is that the smaller part of the market has provided the most consistent outperforming returns over 20 and even probably 30 years. Not only is it higher returns, they generally have in our sort of lower middle market or small buyout market, shorter duration, so usually quicker to distributions. Exits are generally either to larger private equity firms or companies that are owned by larger private equity firms, or sometimes the independent companies. And really, less than 2%, at least for RCP, our exits have been to public markets or IPO, right? So that significantly reduces hold times. And the reality is that the vast majority of capital, as you mentioned, has still been raised in funds, what we'll say is over a billion dollars in fund size. We use a billion dollars as sort of a demarcation line. And while, you know, the vast, vast majority of the capital is being raised in those larger funds,

• 0:55Speaker 01

  it only makes up probably less than 10% of the actual target opportunities in companies that exist out there. And so that mismatch of capital really leads to some structural advantages for the managers that are operating in the smaller part of the market.

• 1:07David Weisburd?

  How would you explain that LPs are very sophisticated investors? If lower middle market has been so good for so long, why are people allocating more to buyout versus lower middle market?

• 1:17Speaker 01

  Because it's hard. And that's the real, the main reason, right? So this part of the market has over 1,200 managers. So it's a very large market to cover. And within those managers, the returns are on average better and sort of the top quartile returns are better. But there's also a left tail, right? So there are the risk of having sort of, let's say, a larger potential distribution of outcomes. And so manager selection, right, becomes, you know, really key and important. And the characteristics of the managers in our part of the market is that they act in some ways very similar to what we see in the best venture capital managers. In that if you're raising a $500 or $600 million fund and you have a very good track record and you have a good team and you're sought after by limited partners, you are probably oversubscribed by two or three times, if not more. So access is a huge issue.

• 2:02Speaker 01

  Being able to cover the market is very difficult because you're talking about lots and lots of managers. And the other real issue for a lot of the bigger institutional investors is that It's very difficult for them to put to work the amount of capital that they need on a per line item basis, right? So if they're looking to invest in private equity funds and buyout funds, then let's say their minimum might be a hundred million dollars. Well, if you're investing in the best $500 million manager, you can't get a hundred million dollars, right? It's very difficult to do. And that's actually frankly, why a lot of institutions use a fund of funds like us or others. As a way of getting that allocation to the smaller part of the market, that is extremely difficult for even relatively sizable teams to do on the run.

• 2:37David Weisburd?

  Another word for manager risk and manager selection risk is career risk. Goes back to the old adage as you don't get fired for firing IBM. And what's interesting, a lot of people, there's a bias to this as well. That's quite interesting, which is if you invest into IBM and IBM goes down, well, IBM went down. But if you invest into a small company and it went down, you made the mistake. So there's this fundamental attribution bias where if you invest in a lower mill market manager and they do bad. The person who made the investment to lower mill managers is seen as making a mistake versus if it's in a buyout, it's blamed on the market and other external forces.

• 3:10Speaker 01

  That's absolutely true. And I would say that, you know, for a lot of folks that might even be pretty active investors in private equity, but don't know our part of the market. You know, they will look, they could look at our names in our portfolio and maybe not even recognize any of them, right? And that's not unusual. And sometimes the best managers are the ones that stay under the radar screen. Unlike big market private equity, you know, the majority of managers that we back actually aren't in the major cities, right? They're not in New York, they're not in Chicago, they're not in LA, they're in secondary, tertiary cities, right? Because that's where frankly, a lot of the smaller companies are, right? And when we're talking about small, we're talking about companies that are generally under a hundred million of enterprise value, right? And so those managers tend to be more local, they tend to be not in New York. Although there are obviously a lot of managers that we do back in New York as well.

• 3:51Speaker 01

  But they, they tend to try to use that fact to ingratiate themselves within our part of the market. Most sellers are actually family owned businesses, right? So our data shows about 75% of the deals that are done in this part of the market are from businesses that are owned by a family or an entrepreneur owner. And that is just a very different type of transaction than let's say a private equity firm to private equity firm transaction where a large bank is involved and holding a big auction, right? And so the, the sort of intricacies of winning that deal of creating value in those companies is a very different type of skillset. And frankly, a different type of opportunity to actually create value. And that's one of the reasons why we see these, these returns in this part of the market be so robust.

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• 5:55David Weisburd?

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• 6:29Speaker 01

  Safer in some ways, riskier in others. So we'll take leverage as an example, right? So in most of the managers in our part of the market and in our data that we show, let's say in companies under 100 million of enterprise value, just to give some numbers, the median multiple, right, on cash flow, that we often see the debt being is around three turns cash flow, right? We usually see capital structures and the deals about 50-50 equity and debt. Compare that to the upper part of the market where that multiple might be six turns of cash flow, might be thirty, seventy, right? I could do that. So in that way, financial leverage is less of a risk. But there's also a reason why the companies in this part of the market are using less leverage, or I should say the managers, when they do these transactions, use less leverage. There's other things about these small companies that makes them inherently risky, right? There are risks involved that bigger companies don't have.

• 7:13Speaker 01

  So for example, if you're a family-owned business that's been run by the same person for twenty years, you may not have the best operations in place, maybe not best practices. Your CFO might be really a controller, right? It might be the cousin of the owner, right? And so there's opportunities to improve these companies, right? So the flip side of that is they are a little bit less, more risky on entry. They may have customer concentration in a way that a five-billion-dollar company doesn't have. But these are also things that are big opportunities, right? So the managers that we back in this part of the market are groups that have very activist ownership structures, right? And strategies, right? They are using operational resources. They are improving what is, let's say, a less polished asset, right? One that has a need for a more professional management team, a real CFO.

• 7:55Speaker 01

  Maybe they have customer concentration, so they might use M and A or other means to sort of diversify their customer base. They may have geographic concentration, right? These are all big risks. But if you can have a manager that attacks these risks, right? And can grow that company and scale it, right? And do it organically, but also through M and A, which is a big part of, not just the bigger part of the market, but our part of the market, there's a lot of fragmented industries. And you can create that value with scale. Then you're selling that asset, which is a much more polished asset, into a much frothier part of the market, right? Where most of the capital is, where they use double the leverage, where their cost of capital is different, frankly. And that leads to what we call multiple expansion, right? So valuations are lower in our part of the market, and there's structural reasons for that, right?

• 8:37Speaker 01

  Because these companies are a little less polished, they don't earn the same amount of dollars per cash flow. But once you fix that, right? And you grow these companies and you scale them, they become really attractive assets. And for every dollar of cash flow you've grown, you get the returns on the growth, but you're usually getting a higher valuation multiple on those dollars of EBITDA as well. And in our data, what we see is that the median sort of what we'll call multiple expansion between when you bought the company to when you sold it in our part of the market is around two turns. So if you bought it for six times, you might be able to sell it for eight times or more. Top quartile is like four turns. So that is what leads to sort of these outsized outcomes in our part of the market. And that also sort of counteracts the fact that you are dealing with companies by their very nature that can be more risky in their operations at the time that you buy them.

• 9:19David Weisburd?

  So brass tacks, when you compare large buyouts versus lower middle market, how have they done over the last couple decades?

• 9:25Speaker 01

  If you think about it as a vintage year basis, right? The top quartile returns in the smaller funds have beaten the top quartile returns in the larger funds. Again, using $1 billion fund size as a demarcation line, 13 of the 16 vintages in that time period. And they've beaten them by over 600 basis points on average. So significant outperformance in IRR.

• 9:45David Weisburd?

  And then on the other side, the other three years, how have large buyouts done and what has been their outperformance?

• 9:51Speaker 01

  So when large buyouts beat small buyouts in those three vintage years, the outperformance was only 250 basis points or so. So again, when large buyouts is beating small buyouts, it's a little bit less magnitude and we see much higher magnitudes in the vast majority of the vintage years historically.

• 10:05David Weisburd?

  And those tend to be almost like interest rate trades. The interest rates goes down and then the lever, basically the company adds value to that. Is that a oversimplification?

• 10:14Speaker 01

  It is a little bit of a oversimplification, but it's not completely wrong either, right? So there's no doubt that in times of interest rates reducing, the amount of leverage that's used in the bigger part of the market, that interest rate reduction and really the sort of healthy functioning of the debt markets in the bigger part of the market are key to having M and A performed, the key to getting exits. And of course, another big part of that for the bigger part of the market is a very functioning IPO market, right? Because in some cases, those companies are so large, that's the only place you can exit them. In our part of the market, because we use such a significant amount less debt in our transactions, the, over the time period where we saw interest rates go up by 500 basis points, we didn't see a major effect. And the other big difference in our part of the market related to interest rates and leverage is that the vast majority of the deals and the debt that's provided in our part of the market

• 10:57Speaker 01

  is not from the traditional money banks and it's certainly not syndicated debt. It is generally private credit funds, right? About maybe 70, 80% of the debt is probably private credit funds. And so they have capital to put to work. They tend to be more risk on. So even in times when the debt markets in the bigger part of the market have sort of seized up, we've seen activity continue in our part of the market in a much more healthy way. Now, sometimes that debt can be more expensive, right? So that's certainly a downside to that. But because our managers are generally using so much less of it in the transactions, it doesn't really, that additional sort of spread, let's call it, doesn't have a significant effect on their decision making around investment activity or how much leverage they're going to use because they already use very relatively small leverage at the time that they make their initial acquisitions.

• 11:39David Weisburd?

  Just to make an apples to apples comparison over that 16 year period, what was the average return for large buyouts versus lower middle market?

• 11:45Speaker 01

  So over the last decade, we've seen significant outperformance in the small buyout market. So the last 10 year returns is around 21% annualized compared to just over 16% for the larger buyout.

• 12:00David Weisburd?

  And you've been in this part of the market really for two decades. You mentioned there's 1,200 managers, so there's much more managers to diligence. How long did it take before you had a good sense for what a great manager looks like?

• 12:11Speaker 01

  It takes a number of years. So I started this role as a limited partner right out of business school and that was 25 years ago. And I started with Hewlett Packard's pension fund. And at that time, you start taking manager meetings. At that point, I was focused on a variety of things, not just lower middle market. And you really build up almost like a muscle memory. So when you first take your first meetings with a GP, if they're good at pitching their fund and their strategy, then you come out of it loving. And what you don't have is the sort of mental comparison of the 100 other managers you met with up until that point, or maybe thousands of other managers you met up to that point. So today, like I think that like having met with so many different managers, lots of different strategies. I started working for RSTB about 11 years ago and started focusing exclusively on this part of the market.

• 12:54Speaker 01

  At that point, you start to realize, you know, like pattern recognition of what types of things are you looking for in a manager that you believe and the data shows leads to outperformance, right? And you only get that from experience and being around people that are smarter than you and have the ability to teach you and mentor you through those years that you're learning how to identify those things.

• 13:15David Weisburd?

  I'm sure you do hours and hours of diligence on every manager, but how quickly do you have a really good sense for this can be good or this is going to be bad?

• 13:22Speaker 01

  Your initial reaction is important, right? So we obviously don't make decisions on just one meeting, but you can tell a lot in a first meeting about whether or not you believe that this is, one, a team that has something about them that's unique, that allows them to create repeatable returns. Is there something about their strategy that you learned in that meeting? And having seen tons of different lower middle market private equity firms, you can start to sort of zero in on the things that you're looking for that can lead to that outperformance. And then finally, what you're looking for is how they go. About executing that strategy, right, the process. And so you can learn a little bit about that in a first meeting. And usually it takes several sort of follow up meetings, the review of their materials. And then of course, like I think that for us, the biggest moment of realization is generally after what we, you know, call an onsite visit where we spend maybe a full day working with that manager,

• 14:07Speaker 01

  meeting other members of the team, going through case studies, really understanding what has led to the performance numbers that you're looking at in those tables, right? And and then identifying something about that manager that, you know, one way I like to describe it is their superpower, right? What is it about what they do that's different than everybody else? That gives them the ability to have not just great returns, but also repeatable great returns, right? Where there's something that they're doing that can consistently be pointed to as a way of generating those outsized returns.

• 14:35David Weisburd?

  You mentioned what you look for in a manager in terms of what makes them great. Double click on that.

• 14:39Speaker 01

  I would say that initially, it's really a qualitative assessment, right? So we're, we're looking for people that have experience and a background that fits the strategy, right? That it makes sense that they are executing on the strategy. And as I mentioned, they have the ability to do something that is unique and differentiated from all the other managers that we're looking at, right? So we may see three or 400 managers fundraising every year. We're going to do 10, right? So, so those 10 managers have to separate themselves out in some way. And sometimes it can be how they source deals that's unique, that it gives them an advantage in buying and finding unique deal flow. It could be operational resources or expertise that they have that is unique, that helps them do all those things that I talked about that add value to these companies, that actually generate really good returns. Sometimes it's the exit and sometimes it's just their ability to

• 15:23Speaker 01

  understand a sector or a certain subsector or market in a way that's much better than their peers. And so we have qualitative assessments that allow us to do that. We meet with them, we talk to references, which are an extremely important part of the process. And then I'll go back to the quantitative, right? So their track record. So one of the things that makes track record so difficult in private equity is that most people rely on vintage or benchmarking, right? And vintage or benchmarking has some problems. Part of it is that. The most relevant fund that you want to benchmark it is their last fund. And I can guarantee you, especially in this environment, their last fund is probably made up of mostly deals that are unrealized, right? They have not actually achieved a return that's real, right? It's a mark and that's helpful, but it's not a realized outcome.

• 16:04Speaker 01

  And so as you start to go back in their historical track record, you start moving farther and farther away, usually from both the people that are actually doing the deals today as well as the strategy, right? Because again, successful funds do tend to raise larger and larger funds. So they may have started off doing companies that are under 100 million enterprise value. Now they're doing companies that are 300 million enterprise value. So part of the way that we try to counteract that is through our data. So one of the things that RCP is very well known for in our market is we have an extensive database that has over 50,000 deals in it. And in those deal data, we have the ability to benchmark not just things like outcome, which is certainly important, but also things like revenue growth and EBITDA growth and what they bought these companies at compared to what the market was buying companies at, right?

• 16:43Speaker 01

  So we have the ability to benchmark these managers in very unique ways that most other LPs frankly don't have the ability to do because we've been collecting data in this part of the market for 25 years. And that we think gives us certainly an advantage in making the picture that we're trying to sort of take of this manager clearer.

• 16:58David Weisburd?

  You've essentially created your own internal benchmark that may be more representative than than just taking something off the shell. Two things really strikes me about what you were saying. One is obviously strategic creep. If you're investing in companies under 100 million, now they're 500 million and your team has all changed. You know, your track record is not going to be predictive of the future. It's just, it's just a different activity. The other thing is this interesting incentive mechanism between TVPI turning into DPI. Professor Steve Kaplan, the University of Chicago, did the study that showed that first, second, third time funds overinflate their TVPI versus more established managers under play. And the intuition behind that is early stage, early vintages are just really focused on raising the next, the next fund.

• 17:39David Weisburd?

  And then later, later funds are all focused on under promising, over delivering because they want to build, they want to take that $10 million check into 100 million, that 100 million to 200 million. They're more able to think long term. Do you find that as well? And is this one of the things that you really have to focus on is, is this TVPI going to turn into DPI?

• 17:56Speaker 01

  That's a really important part of this. And one of the things that you even mentioned in the question is that how people mark their portfolios can be either conservative or aggressive, right? And what we generally see, it's interesting, you know, so I know Kaplan's work on the earlier managers and we definitely see that in emerging managers. But we also see it in, let's say, less accomplished managers that are raising their third or fourth fund or fifth fund even, but where they have some issue that they're trying to deal with in their fundraise, right? Because maybe a partner left, maybe their performance is not that great. And so for them, we see usually more aggressive marks, not surprisingly. Marks that might not hold up to what's going on in the real world today. And what we tend to see is that our best managers tend to sand back. They tend to, they tend to put marks that are much lower than what they probably can sell that company for today.

• 18:40Speaker 01

  In part because they're not worried about fundraising, because our best managers again are highly oversubscribed. They might fundraise for three to six months and be done, right? And truly just existings or maybe some folks that they're bringing in. And they don't have a need to sort of bolster up their track record with marks that could be, let's say, seen as aggressive. We have a number of managers where the average exit compared to what they were valuing the company at, let's say, one or two quarters before, was as high as 100%, right? The, the average across most of our managers is 30 or 40%. And when you look at the upper part of the market today, there's actually, I think, a pitch book analysis that show that you're actually getting a retraction on average in terms of the marks. So if you held it at two and a half X, you might be getting an exit at 2.3X because you were holding an unrealistic valuation.

• 19:22David Weisburd?

  That's a much more precise way to say it, which is it's not second vintage or fifth vintage or 10th vintage. It's if you have much more supply for your next fund, you're going to be aligned over a long-term alignment and long-term reputation. If you don't have enough demand, you might even subconsciously focus on gamifying the next race.

• 19:40Speaker 01

  Yeah, and some of it is definitely subconscious where you're, you're just trying to put on the best face, you know, realistic range, right? That, you know, you think is, is true. And then there's definitely groups that I think manipulate, right? That, that are, that are purposely trying to sort of over mark stuff. Or in some cases in this environment, they've held it at something that might've been true three or four years ago. And in this environment, that valuation has really come down, right? And they haven't, they haven't reduced that valuation over that time period. So sometimes it's not over marking, it's sort of not reducing it when it's appropriate.

• 20:10David Weisburd?

  Steve Kaplan also has a study that only funds in their first or second quartile ever fundraise. Somehow magically, there are no funds in third and fourth quartile that ever fundraise.

• 20:19Speaker 01

  Part of the reason for that is that, again, this goes back to why vintage year benchmarking can be challenging. It's that usually within the first six or seven years of a fund's life, it will bounce around vintages, right? And so Cambridge Associates has one of the benchmarks that a lot of folks use. They even have that in their notes now, I think, that shows that any given vintage year benchmarking, if it's before year six or seven, has problems with it, right? Because it could be showing up as a third quartile fund or first quartile fund that then regresses, right? The other thing that we see managers obviously do is you can cut your data certain ways, right? That is favorable to you. Maybe you were doing four or five different sectors and you're cutting out one sector, which happens to be some of your worst returns, and now you're sort of recalculating your returns and comparing them to vintages, and then your top quartile, right? So we see that kind

• 21:04Speaker 01

  of, let's call it creativity with managers oftentimes. And that's why we see this sort of thing where everybody can kind of fit themselves into a box that can be said is top quartile, or they don't talk about that in their materials, right?

• 21:17David Weisburd?

  It's like the banker's table. Every banker could rank themselves in top one or two spots. Do you find that in your real world experience? Do you rarely find anybody in the third quartile that's out fundraising?

• 21:29Speaker 01

  We will find folks that have third quartile outcomes in their funds that are out fundraising. It often can be a difficult fundraise for them. I think a lot of it depends on how good some of their other funds are, right? So we've seen many managers who might have had a first quartile fund one or fund two, and now their last fund is struggling. And that's a manager that's trying to explain the struggling, right? What's happened? Maybe it's COVID, maybe it's stuff around the tariffs that got put on, whatever that reason could be, to say, hey, look at our earlier funds that did really well. There's last few funds that are struggling. There's reasons for it, and that doesn't represent what we can do going forward, right? And that's a legitimate argument. There's definitely been examples of managers that we've backed where we've done a lot of work to get comfortable with maybe underperformance in one of their funds and what the reasons were behind it.

• 22:15Speaker 01

  And then sometimes we see managers that are restarting. And we call them phoenixes. And what I mean by that is they might have been operating for many years with a set of partners that founded the firm. Their performance is just either mediocre, maybe it's worse than mediocre. But there were some young partners midway through that time period that sort of rose and were really responsible for the deals that were good going forward. The firm sort of changes hands at some point. Those younger generation of partners take over. And then you have to really look at it is that, that those early negative performances may not be representative of what the new leadership is going to do going forward. And we call those phoenixes, right? That rise from the ashes. And sometimes those types of investments can actually be some of our best, right? Because you generally have very experienced, highly motivated people who probably haven't earned a lot of carry yet or economics, right? And they're generally younger and they're in their time of their life where they are,

• 23:00Speaker 01

  they're willing to hustle to try to earn that carried interest. And also they've often learned from mistakes, right? So one of the great things about that is that if, if, if a set of partners, right? Can learn from the mistakes of a, of a more senior set of partners that they lived under, that they did deals under, that can actually be really beneficial to all the folks that didn't lose money on those, on those original partners, right? All the new LPs are going to come in and potentially partner with this new group.

• 23:22David Weisburd?

  Their capital pools tend to be smaller. It's harder to fundraise, so they're able to, to make a count.

• 23:27Speaker 01

  So their, their capital pools may be smaller and we think, again, size is the enemy of return. So, you know, the ability to put less capital to work, less pressure to put capital to work generally leads, we think, to good discipline and decision making.

• 23:39David Weisburd?

  I had this whole episode where I talked about where alpha is in the markets. And the summary is that it's things that are boring and things are hard. But there's also alpha in truly contrarian thinking, which is if everybody thinks that this is a great manager and they're going to go out and raise $2 billion, sure, that might have a good returning fund, but how much alpha is there versus if it's a small fund and everybody's discounting them, they're looking at the headline, third quartile fund. But once you go under the headline and start to look at their deals, see that, you know, there was some, some issue that has been resolved since then. In theory, at least, that's a place where you can find quite a bit of value.

• 24:13Speaker 01

  Absolutely. I mean, we're faced with that dilemma a lot in our investing because our best managers that are under a billion, if they're really good, they generally go above a billion, right? They're raising bigger, bigger pools of capital based on that great track record. And they have plenty of LPs that are really in the back then at one and a half billion or two billion or more, right? So we often say goodbye over time to some of our best managers and that's okay, right? And so for us, you know, on the flip side of that, we have a specific program that's focused on emerging managers, not just our regular core program, but let's say first and second time funds specifically, and usually very small funds, so funds under 300 million in fund size, right? And that's the situation that you just described where often there's not a lot of track record to look from. They've generally spun out of maybe another firm, maybe they've operated as an independent sponsor for a while.

• 24:57Speaker 01

  And the ability to sort of evaluate them comes down to a lot of these more qualitative components that are equally or more important in some cases than the than the track record itself. And you have to sometimes take leaps of faith, right? Sometimes you're backing essentially blind pools in most cases, but you're backing people, right? And that's part of our job is really evaluating those people. And are these people that we think are highly competent, highly motivated people? And that generally leads to good outcomes.

• 25:22David Weisburd?

  You think about this kind of supply and demand and how do you get to this fund three? There's this whole idea that the first three funds are a GP problem, the next funds are an LP problem as I scale, as we talked about. And I wonder why there hasn't been a dispersion of fees? Why earlier fund one, fund twos aren't more flexible on their fee structure, knowing that really what they're trying to get is to a fund three and really building a franchise?

• 25:43Speaker 01

  Some are, and it's not overly common, right? And what we obviously are worried about in those situations is selection bias, right? Oftentimes, there's a reason why a GP is offering, let's say, more attractive fees. And it's because they can't fundraise, right? Without doing that. Now, every once in a while, you have groups that are, let's say, diamonds in the rough, right? Where there's reasons why they're having trouble fundraising that we don't believe sort of correlates to their ability to generate future returns, right? And that's a great opportunity because then we do have the ability to sometimes what we call sort of takes, sort of seeding of those funds economics to help enhance the economics for our investors. It reduces the risk of that manager for sure.

• 26:25Speaker 01

  And then we have the ability sometimes to get that for even more than one fund. Now, what I would say is that most of the emerging managers that we back, because their fund sizes are really small. And because they have good track records, either from their previous organizations or as their independent sponsor activity. A lot of those smaller funds that are emerging managers are actually oversubscribed as well, even even though they don't have all that experience, even though they're not on fund threes and fund fours. And so when you don't raise a lot of capital, right, it makes it easier to create sort of momentum and acceleration. For the folks that are out in the LP world that like those types of early managers, right? So both is true. But here's the reality is that like, most of the economic terms that are given for managers of really high quality. They're on the margins, right? They can definitely help enhance returns.

• 27:07Speaker 01

  But at the same time, if the manager doesn't perform, at least at some minimal level of outcome, right? It doesn't matter how good your fee rate is. So it's very important to have that balance, right? That it definitely reduces the risk of, let's say, a fund not being amazing, and maybe it's just good, right? And if it's a fund ends up being mediocre, right? Which is really what our downside is, right? We think of our downside not as losing money, not as a disaster, hopefully. But our downside should be a fund that's just average, right? Or medium, whatever you want to think about it. And if the economic enhancement can take that median fund and actually make it a top quartile fund. Then that reduces the risk going in and that leap of faith you have to take with some of these earlier managers.

• 27:43David Weisburd?

  What's that spread between a median performance and a top quartile?

• 27:48Speaker 01

  If you look at like the data over long periods of time, right? That spread can be as much as, I don't know, thousand basis points. Let's say median to sort of top quartile performance. And that's a lot, right? So like a thousand basis points.

• 28:01David Weisburd?

  Fees are not going to get you there.

• 28:02Speaker 01

  No, fees are not going to get you there. So like, you know, you need to have managers that, what those fees do and that fee, the sort of, let's say, the benefit of those fee breaks. Or better economics or better economic terms. What it does is it makes, let's say, a, an average outcome be better than average. But it's never going to make it the top decile, top quartile fund. But it does reduce some of your risk, for sure.

• 28:25David Weisburd?

  There's this game theory and signaling to it right now in venture, the top 10 funds are all 2 and 1/2 and 30. So, you know, 95% of funds are having trouble raising anything. And then the top 5% are 2 and 1/2 and 30. And I've had a GP off the record to her nameless, told me that he had to do 2 and 1/2 and 30 because if he didn't go out with 2 and 1/2 and 30, he wouldn't be seen as a premium brand. So there's this crazy signaling effect that protrudes to your point as well. Like, why am I seeing this fund at discount terms? Where's the negative selection?

• 28:55Speaker 01

  Right. That's the worry of the discounted terms is there's not only is there potentially real selection bias, it could be optical, right? It doesn't help them in their fundraise.

• 29:02David Weisburd?

  Is that less of a risk on a first close discount?

• 29:05Speaker 01

  Yes, 100%. I think that if you're in the market.

• 29:08David Weisburd?

  Is that kind of the best practice in today's?

• 29:11Speaker 01

  Definitely. I think first close investors, right, are an anchor investor of size, right? Those are the folks that are generally open to get economics when there is an opportunity for economics, because you want to incentivize like a large first close that, you know, creates a capacity scarcity, right? So, limited partners sometimes take a little bit of time to sort of get off our butts and start doing work on managers. And there's nothing that helps more than a manager you kind of like, and you find out they only have a small percentage of the fund left to raise, right? Because then all of a sudden, you start to flip over from them being in the sort of like negative position of having to raise capital to being in a positive position where there's potential scarcity and oversubscription, where LPs start fighting for their allocation, right? And momentum and having that sort of early

• 29:55Speaker 01

  closes is really key to doing that. And that's why you tend to see a big anchor investor that could be as much as, let's say, 20, 30% or more of the fund as a big part of that. And on the flip side of that, you know, as you mentioned, these premium economics, we do see premium economics every once in a while in managers in our part of the market. As you would expect, they are for people that have significantly outperformed. We tend to like it better when they've traded off raising a much larger fund for more premium economics that have some sort of hurdles in them, right? Where they can, you know, where they're only getting the premium if they achieve the return outcomes that, you know, that match it, right? And in that case, you know, we're definitely more amenable to that idea because at the end of the day, we're all aligned, right? And incentivized alignment is really important. We've also seen premium terms be, I think, more effective

• 30:40Speaker 01

  when GPs are putting more of their own money in the funds. So where they're making a GP commitment that's much larger than what they, let's say, the market is right now.

• 30:47David Weisburd?

  What's the market today?

• 30:49Speaker 01

  Usually 2%. We see 2% as being sort of normal, but we've seen managers that have put in as much as 10 or 20% of their funds.

• 30:54David Weisburd?

  How much do you care about cash versus deferred GP commit?

• 30:57Speaker 01

  Many years ago, when managers started doing that, I think a lot of us in the LP community were a little bit up in arms about, you know, that it should just be cash. And, you know, look, I think that from a practical perspective, there's significant tax advantages for GPs to do it this way. And at the end of the day, it's still their money that's going into the funds as a commitment. And so we're much less sensitive generally to that. We do like to see that at least it's not all non-cash, it's not all deferral. But I think that we've seen a lot of groups go to a sort of 50/50 model, which has been pretty successful. We can get comfortable with that kind of stuff.

• 31:27David Weisburd?

  I want to get the exact numbers in terms of first close discounts. What do you see in the 25th% versus 75th% best practices today?

• 31:34Speaker 01

  Obviously, at the low end, it's zero discount. And I would see that, you know, we see some error between sort of 10 to 20% discounts in management fee and potentially carried interest as well. And sometimes that's just for one fund, and sometimes it could be for a second fund with obviously usually a promise of a certain minimum investment size in the second fund as well as a way of getting that discount. Now, again, so I would say that'd be the normal, the median. We've definitely seen some examples of folks that have discounted more than 20% or 30%. Again, that's when you start seeing a little bit of maybe just optical selection bias, where you're worried about like, why do they have to discount so heavily to get somebody into the funds?

• 32:12David Weisburd?

  It's interesting because you would think, well, why does that matter? You guys are supposed to be the experts, the best in your class. But if you think about your investment, you're investing both money, but you're also investing time, and it's going to get you 1,000 hours. So a lot of GPs don't realize that LPs are really making two decisions. One is where do we do the work? Where do we really do a lot of diligence on? And then who do we invest from that basket? But most GPs don't make it to that second thing, which is we're going to do a lot of work on this fund. And I think the funnel from doing a lot of work to investing is probably, if I had to guess, at least 50%, maybe higher. But the funnel from not doing any work to doing work might be 5% or 10%. So I think that signaling is where that optimizes, which is if I could signal the right thing, if I had the right return, all these things that look good on the headline, and some

• 32:56David Weisburd?

  would say superficially looks good, it's still important because that determines where you do your work to actually get to the right answer.

• 33:03Speaker 01

  I think you're 100% right. I mean, I think that, you know, limited partner organizations in general have relatively small teams, right? And so even a $5 billion endowment might have one or two people that are covering private equity, right? And that's all a private equity. That could include venture, it could include a bunch of other categories. So, you know, we have the luxury of being a, you know, GP ourselves. We have, you know, 30 plus people that are focused on one specific area of the market. And so for us, for most LPs, I, you know, I think getting, I always tell my GP friends that I either went to business school with or, you know, become friendly with over the years, they, you know, getting a first meeting is not hard. What's hard is getting the second meeting, right? Because getting the LP to sort of focus, spend time on you and to sort of be able to be willing to

• 33:44Speaker 01

  address whatever deficiencies they see, right? Whatever their concerns might be, which every manager pretty much has something that they have to get, LPs have to get comfortable with. So it's getting like someone to spend the time on you is, it's really hard. And you're 100% right. Like, once somebody gets to an onsite, even if it's, we sort of categorize our onsite as sort of one of two sort of purposes, right? One is either confirmatory or one is exploratory, right? So either we're still trying to decide, like a lot of different issues, we're trying to get answers to questions versus, uh, we've done a lot of work or maybe we've known the manager for many years, maybe it's a re-up and we're trying to just confirm that what we believe is true. Now, for most LPs, once they get to an onsite, you know, is, there's no doubt that the, the, let's say the selection rate goes, goes up much higher.

• 34:24Speaker 01

  But they're also, their inbound selection rate in terms of what they work on is probably much lower than for-profit type of group like us that has a very large team that can be focused on lots more managers at any given time, right? And so our top of the funnel, we tend to take way more meetings. We tend to take way more second meetings that end up with a smaller funnel that we pick from at the end.

• 34:42David Weisburd?

  There's a subtle distinction there, which is you call yourself for-profit and why does that matter? When you have endowment or pension funds, pension funds have the biggest issue where their salaries are known to every pensioner. So every teacher, every fireman, when they see, why is the CIO making $500,000 a year when I'm making $75,000? Or why does the CIO have a staff of 10 people? Even though it could be economically rational, politically it becomes difficult. And that's why a lot of these endowments, pension funds, foundations are understaffed because of that kind of misalignment between optics and I guess return to kind of return maximizing.

• 35:15Speaker 01

  Yeah, absolutely. I mean, look, I think, and it's hard to make that connection directly, right? So, you know, if you look at performance outcome, you know, it's very difficult to tell whether you would have done better if you had doubled your staff, right? Now, if you think about for some of the biggest, largest organizations and institutional limited partner allocators, the dollars that they're investing is so big that sometimes I wonder if they did some quick math, right? They just, you know, if you were a $200 billion massive state pension plan, right? And you did take one more percent of that AUM and apply it to people, could you get over a percent, right, of outcome in that given year, right? And, you know, I don't know the answer to that. But again, like, that's the exercise I would assume they go through. Now, to your point, it's not always based on pure logic, right, or pure data. There's optical

• 36:00Speaker 01

  components, political components, a lot of these organizations as well. And they have to be very careful, right, for that exact purpose, to show that, like, they are spending a, let's say, appropriate amount of money, but not overspending on people.

• 36:10David Weisburd?

  Well, Alex, I only got through half my questions. We're gonna have to do this again soon. Thanks so much for jumping on the podcast.

• 36:15Speaker 01

  Thank you for having me. Really enjoyed it and happy to come back and talk more.

• 36:20David Weisburd?

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