Too Big To Invest? The Downside to Mega Fund PE

Earlier this month, New York Times' DealBook ran a really interesting story on the implications of being a massive, global, and public private equity fund. I highly recommend anyone interested in PE, and particularly anyone interested in megafund PE, gives it a read.

These firms, which include Apollo, KKR, and the Blackstone Group, are sitting on an enormous amount of dry powder that they need to put to use in the next twelve months. To be more specific, they are sitting on $200 billion of dry powder with only one year to invest it.

This presents a number of problems to the funds and highlights some of the less glamorous aspects of private equity.

Let's highlight a couple aspects of traditional private equity investing that some of WSO's readership might not be aware of and the issues they can lead to:

  1. Private Equity funds have a limited time horizon for investment or the capital must be returned to the limited partners. The time horizon is typically five years.
  2. Private Equity firms earn a management fee, generally 2% of the total size of the fund, in addition to the fee they earn on any investment upside achieved upon a liquidity event.
  3. Raising new funds requires three things: successfully putting money to work in new platforms and add-on acquisitions, showing continual progress in value creation through periodic portfolio reviews, and profitable exits with above-market returns.

If a private equity firm manages to invest wisely and produce strong returns for its limited partners, it will have no issue raising new funds. When problems seem to occur, however, is when a firm's historical investment success goes to its head and it starts to grow too big for its britches. Investment success often leads to bigger funds being raised, which leads to larger deals as well as bigger management fees.

Now, larger fund size and bigger fees sounds great on the surface, but because of the limited time horizon for investment, private equity firms may find themselves scrambling for deals. And, unfortunately, the universe of quality deals has an inverse relationship to fund size - the bigger you are, the harder it is to invest intelligently.

This is precisely the dilemma the mega funds discussed in DealBook's article are faced with. There is no reasonable way that $200 billion can be put to work in one year's time. Fund lifecycles do not pause because of global economic uncertainty. And with so much money chasing such a limited universe of viable deals, you can bet that purchase multiples will skyrocket. The long-term effect of the next twelve months on these funds could be devastating. LPs don't want to have their money sit idly while fund managers collect fees and they certainly don't want to see their money sunk into overpriced dogs with fleas that will inevitably require write-downs. Frankly, I'm not sure how this leads to anything but smaller fund sizes in the long-term.

Speaking more broadly, the problem of too much money chasing too few good investments is endemic to private equity at all levels. The sheer number of firms in existence is staggering. I spent two years at a truly solid lower middle market private equity fund and was blown away by the level of competition for deals in the space. This can't last forever and I foresee a very serious contraction over the next decade.

On a broader note, I think these issues highlight some of the downsides to working in PE and should be thoroughly considered by any prospective monkeys looking to make the move. While the work in PE can be interesting, the lack of flexibility in terms of what can be invested in is very limiting. You don't have the luxury of kicking back and waiting for the economy to improve and good deals to come along, you have to grind and work on just about anything that meets the minimum investment criteria and returns threshold, often knowing you'll be outbid by some fool who has no choice but to put his money to work.

It is in this regard that I imagine Family Offices and Holding Companies to be superior to traditional private equity. Working in a family office, meaning you invest the funds of a super wealthy family's estate, or a holding company, like Loews Corporation, definitely has its upsides. Unfortunately, these jobs are fewer and far between.

What do you think? Am I overstating the issues that mega funds and Private Equity in general face or are they even more challenging? Do you agree that PE is set to contract in the long-term? Let me know in the comments.

Comments (22)

Oct 25, 2012

From my limited observation, I think you are spot on in terms of the challenges that megafunds and PE in general face in the near future.

The # of deals is a huge factor into why I have never really considered megafund PE to be a potential move for me in the future.

Oct 25, 2012

The only LPs investing in megafunds these days are 'mega-LPs' that need to write $250m+ tickets and are therefore limited in the GPs who can accommodate them. I write tickets of c$25m and don't even look at the megafunds and won't until there is a bit of creative destruction in the industry.

Oct 25, 2012

So isn't the inevitable outcome an industry wide downsizing with less deal flow?

Oct 25, 2012

or more # deals but smaller deal size

Oct 25, 2012

I think it will be cyclical. A period of poor performance (driven by too much capital chasing too few quality deals) will result in lower levels of fundraising, which will improve performance and then fundraising will kick up again.

Long term I still believe PE offers a great return profile and is a helpful diversifier for institutional portfolios - big is not beautiful however!!!

Oct 25, 2012
samoanboy:

I think it will be cyclical. A period of poor performance (driven by too much capital chasing too few quality deals) will result in lower levels of fundraising, which will improve performance and then fundraising will kick up again.

Long term I still believe PE offers a great return profile and is a helpful diversifier for institutional portfolios - big is not beautiful however!!!

I think the smartest firms are those that resist the temptation to grow the size of their funds, within reason at least. I think it'd be more effective to stay in your sweet spot and invest where you're most comfortable as opposed to always moving upstream. The fund I worked at had a 20+ year track record of investing in the lower middle market with excellent returns. They definitely could've moved upstream but didn't see the point. They like what they do and are smart enough to stick with it.

I remember back when I was still in banking and I was meeting with some middle market firms, one of them had recently doubled the size of their fund (from something like $300M to something like $600M), they ended up getting crushed and had to lay off a bunch of people. Bigger is not always better, especially when you're great in your space.

Oct 25, 2012
TheKing:
samoanboy:

I think it will be cyclical. A period of poor performance (driven by too much capital chasing too few quality deals) will result in lower levels of fundraising, which will improve performance and then fundraising will kick up again.

Long term I still believe PE offers a great return profile and is a helpful diversifier for institutional portfolios - big is not beautiful however!!!

I think the smartest firms are those that resist the temptation to grow the size of their funds, within reason at least. I think it'd be more effective to stay in your sweet spot and invest where you're most comfortable as opposed to always moving upstream. The fund I worked at had a 20+ year track record of investing in the lower middle market with excellent returns. They definitely could've moved upstream but didn't see the point. They like what they do and are smart enough to stick with it.

I remember back when I was still in banking and I was meeting with some middle market firms, one of them had recently doubled the size of their fund (from something like $300M to something like $600M), they ended up getting crushed and had to lay off a bunch of people. Bigger is not always better, especially when you're great in your space.

This is exactly what happened at Heritage Partners, the first PE firm I worked for and was fired from within 6 months (proceeded to fire ~50% of the investment professionals over the next 2 years, so that softened the blow).

They started out with a specialty in smaller family owned business, had some great returns and as a result, the funds exploded in size (i think started around 300mm and jumped to 800mm at one point) and they were forced to write bigger checks into non-family owned businesses - ie away from their strategy.

That being said, I just took a look at their new website and the team and it looks like all of the old founding partners have gone and maybe they are refocusing their strengths with a smaller team and smaller fund sizes. I wish them the best - I like all the people there that are left :-)

Oct 25, 2012

I agree with there being too much capital chasing after the same deals. Things get bid up and it's almost impossible to feasibly make return hurdles.

The industry will have to downsize. There will be less funds, and smaller funds

Oct 25, 2012

I definitely think this is an interesting article that I saw when it came out. I'm not in PE specifically but to me this also highlights the IMMENSE conflicts of interest that exist for PUBLICLY owned PE firms. Your shareholders don't want to see that money given back to any LPs because there goes some of that mgmt fee but the LPs certainly don't want investments for the sake of putting excess money to work. Agree that funds have probably gotten too big and we may see a shakeout as a result but to me that will work itself out as business cycles do. The shareholder vs LP relationship is far more troubling to me.

Oct 25, 2012
cheese86:

I definitely think this is an interesting article that I saw when it came out. I'm not in PE specifically but to me this also highlights the IMMENSE conflicts of interest that exist for PUBLICLY owned PE firms. Your shareholders don't want to see that money given back to any LPs because there goes some of that mgmt fee but the LPs certainly don't want investments for the sake of putting excess money to work. Agree that funds have probably gotten too big and we may see a shakeout as a result but to me that will work itself out as business cycles do. The shareholder vs LP relationship is far more troubling to me.

I agree wholeheartedly. There is no reason for these firms to be public. It's such an insane conflict of interest that they need to manage expectations of both shareholders and LPs. Completely unworkable over the long haul, in my view.

Oct 25, 2012

If you're not big enough, how could you swallow a large deal like the proposed buyout of Best Buy by founder and 20% co-owner Richard Schulze assuming it ever gets done ?-That's a $10 Bn+ co. with $50 Bn in Revenues.

Oct 25, 2012

LPs willingness to pay 2+20 for a zero alpha investment vehicle will quickly approach zero.

Once you have bx, kkr , carlyle etc... all bidding for the same asset in auction process you are only left with beta, why investors keep paying 2+20 when they could just buy the s&p500 with some leverage and replicate the returns profile of any megafund I don't understand but hey.

Oct 25, 2012

Good discussion point. I think we'll see a few different strategies employed:
1. Megafunds moving down market to more typical MM investments and looking at more emerging market opportunities.
2. More PE funds exiting portfolio companies by selling to other PE funds, helping to book returns for LPs (likely lower than initially hoped for) and help other firms put capital to use. Around 70% of current PE portcos were acquired before 2009.
3. Renegotiating terms with LPs. Most megafund LPs have specific investment mandates and can't take the money back unless they place it with another PE fund.
4. Combining on deals with other PE funds.
5. Modest multiple expansion, and I wonder how much the recent NY Times expose will make firms skittish about not bidding up other megafund deals.

Oct 27, 2012
Bowser:

Good discussion point. I think we'll see a few different strategies employed:
1. Megafunds moving down market to more typical MM investments and looking at more emerging market opportunities.
2. More PE funds exiting portfolio companies by selling to other PE funds, helping to book returns for LPs (likely lower than initially hoped for) and help other firms put capital to use. Around 70% of current PE portcos were acquired before 2009.
3. Renegotiating terms with LPs. Most megafund LPs have specific investment mandates and can't take the money back unless they place it with another PE fund.
4. Combining on deals with other PE funds.
5. Modest multiple expansion, and I wonder how much the recent NY Times expose will make firms skittish about not bidding up other megafund deals.

Who are the main "megafund LPs"? Besides CalPERS, are there other sort of brand name megafund LPs as there are megafund PE shops or are they mostly just more random pension funds?

Oct 27, 2012
Banker88:
Bowser:

Good discussion point. I think we'll see a few different strategies employed:
1. Megafunds moving down market to more typical MM investments and looking at more emerging market opportunities.
2. More PE funds exiting portfolio companies by selling to other PE funds, helping to book returns for LPs (likely lower than initially hoped for) and help other firms put capital to use. Around 70% of current PE portcos were acquired before 2009.
3. Renegotiating terms with LPs. Most megafund LPs have specific investment mandates and can't take the money back unless they place it with another PE fund.
4. Combining on deals with other PE funds.
5. Modest multiple expansion, and I wonder how much the recent NY Times expose will make firms skittish about not bidding up other megafund deals.

Who are the main "megafund LPs"? Besides CalPERS, are there other sort of brand name megafund LPs as there are megafund PE shops or are they mostly just more random pension funds?

In the Canadian space you have the following players which are quite large and heavily involved in PE:
CCPIB - 165 billion AUM
OTPP - 117 billion AUM
OMERS - 55 billion AUM
CDPQ - 151 billion AUM
AIMCo - 50 billion AUM

Morpheus: Have you ever had a dream, Neo, that you were so sure was real? What if you were unable to wake from that dream? How would you know the difference between the dream world and the real world?

Oct 25, 2012

Hi the King, can you post a link to the deal book article? Also when was that Forbes magazine in this posts article picture published?

Oct 25, 2012

I think in a number of these instances, the funds will just extend their investment period. With consent of the LPs, it's not unheard of for investment periods to get extended for 1 or 2 years; the LPs would certainly rather that happen than have the GP stuff money into subpar deals. Think of it this way, there are still funds that got started in 2006 that can still in theory invest in new deals.

In regards to the comment on why don't LPs just invest in the public markets and generate the same returns? Have you seen the public market returns over the past 10 years? Private equity is where LPs are forced to turn to come even close to hitting their return targets. Plus, there is very little chance that a blackstone or a kkr will lose your money; they may not generate a 2x+, but they won't lose your money. And you're not investing in mega buyout for outsized returns in the first place (or at least you shouldn't be).

Oct 25, 2012

i think we'll see more moving portco's from fund 2 to fund 1 etc.

Oct 26, 2012

Just a hypothetical question.. Why can't a PE fund manage its unused cash more effectively? Similar to the Treasury of a Commercial bank.. I worked as a trader intern for the treasury of a large commercial bank where we traded the un-utillized cash at the bank. However
I never managed to understand why PE firms don't have effective liquidity management systems in place. Could someone please shed light on this?

Oct 25, 2012

To the question above. The PE fund doesnt actually have the cash on their balance sheet. They call the capital from investors usually right as they make an investment, and in most instances utilize a line of credit from a bank to bridge any timing delay. If the PE fund actually held all the cash on its balance sheet, the IRR would be terrible; an investment made 2 years after the fund was formed and held for 4 years would be 6 years instead, which is huge when funds are measured relative to their peers on IRR. It would be inefficient use of capital.

Oct 26, 2012
Oct 29, 2012