01 Jun 2008

The $4 Billion Question

A Private Equity Firm’s Big Decision
by Julia Hanna


It’s no secret that private equity firms have enjoyed massive profits in recent years. In Private Equity Finance, a course in the second-year MBA elective curriculum, students follow the life cycle of a deal in order to learn more about the complexities and conflicts behind those big returns. The students consider topics such as deal sourcing, due diligence, deal structuring, governance issues, and the all-important question of how private equity firms create value. And in a mini-module on fundraising, “ABRY Fund V” examines a situation every student dreams of: what to do when it becomes clear you can raise $4 billion for your next fund instead of the planned $1 billion.

Professor of Management Practice Nabil N. El-Hage coauthored the case with HBS professor and Finance unit head Richard Ruback. “The case highlights some interesting tensions and conflicts in the private equity business between generating wealth for the firm’s investment professionals via the fee stream, which is strictly a function of how many dollars you manage, and the investors in the firm — the so-called limited partners, who make money only when the firm makes good investments and generates superior returns,” says El-Hage.

As cofounder of ABRY, a media-focused private equity firm started in 1989, Royce Yudkoff (MBA ’80) has enjoyed a 48 percent net internal rate of return (IRR) for investors over the course of the firm’s first four funds. Given that success, investors are ready to substantially increase their capital commitments to the firm’s next fund. ABRY’s fourth fund raised $780 million; its fifth could potentially reach $4 billion. Is this a problem?

In the case, Yudkoff describes his belief that ABRY’s success is due in part to its culture and emphasis on service. He details how the firm has distinguished itself over the years through its industry knowledge, lending contacts, controlling ownership positions, and focus on proprietary deals that don’t involve bidding against other firms in a competitive auction process. Proceeding with the $4 billion fund would bring significant change to how the firm does business. “We currently fund every good idea we have,” states Yudkoff in the case. “You would think either we could hire more people to generate more ideas, or we could pursue auction deals. It takes time, though, to develop experience in this space, and I don’t think we could hire enough people to develop ideas to invest all $4 billion. To match talent and fund size, we would have to enter more auctions.”

Yudkoff believes that pursuing auction deals would result in a lower IRR, with gross returns of 18 to 25 percent versus the firm’s 63 percent gross IRR to date. As an alternative, quadrupling the size of the average deal wouldn’t require many internal changes (a big deal requires about the same amount of work as a small deal) but Yudkoff isn’t convinced that the economies of scale would work that simply. And so, we later find out (though the case is silent on this), he sticks to the original plan for a $1 billion fund, despite the fact that he is probably leaving behind millions of dollars of personal profit.

An in-class poll indicates that about half the students would have made the same decision. That surprised El-Hage. “Very few people would have the strength to walk away from $3 billion to maintain a company’s culture,” he remarks. “When I was a student in the 1980s, I’m sure the whole class would have said to absolutely take the $4 billion.” Yet in a visit to the classroom, Yudkoff emphasized his opposing belief that the best way to prosper over the long haul is to do what is best for investors by focusing on generating a high rate of return rather than the perhaps easier task of increasing dollars under management. Judging by how fast the typical private equity firm has grown over the past several years, Yudkoff and his firm may well be in the minority in how they viewed this choice.

“The course does a good job of highlighting the conflicts that are inherent in this business, such as the tension between investment professionals and their investors,” El-Hage says. “It trains our students to think analytically and fairly about conflict, as opposed to pretending it doesn’t exist.” An essential skill for those entering private equity or any industry, for that matter.


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