Are the mega funds that have come to dominate the private equity landscape, dinosaurs? This was the question that Jon Moulton of Alchemy posed provocatively at the recent Super Investor conference in Paris to an audience of 500 representatives of private equity firms, investors, intermediaries and service providers.
Moulton amusingly took the analogy further. According to him “both were first discovered in the US and then seen elsewhere”. He then went on to argue that the future for mega funds, as was the case for the dinosaurs, is limited as “big creatures need big targets to eat, but dinosaurs got wiped out by smarter locals – they had inferior intelligence and social habits”. While the Victorians believed that dinosaurs became extinct “because they ate each other”, Moulton again sees a parallel in the private equity industry with the growth of secondary transactions between private equity funds.
The issue for investors, however, is what sort of returns can be expected. Harvard Business School’s Josh Lerner pointed out that if you examine the dispersion of returns within different asset classes, ignoring the top 25% of funds and the bottom 25% of funds, then the range of returns seen is typically only 1% for bonds and 3% for listed equity markets but a massive 15% for private equity.
So investing in the right categories of private equity is not nearly as important as investing in the right fund. This might explain why the conference had a strong focus on giving limited partners (ie, investors) and general partners (managers) plenty of opportunities to not only get to know each other well, but also to voice their concerns on public platforms.
How does one get into the best funds or at least avoid the worst? Lerner points out that while there is very little evidence of persistence of returns in public funds, there is an enormous amount of persistence in private equity funds, both positive and negative. Investors in the bottom third of funds for example, have historically had a 61% probability of remaining in the bottom third through reinvesting in the subsequent fund.
Stephan Breban of City Capital Partners sees any attempts to profit from this in the selection of superior funds as futile.
He says that with each fund taking seven to 10 years to invest and then realise all its investments while fundraising takes place every three to four years, “by the time you know the returns for fund one, the private equity firm would have launched fund three or four and the original team will have changed dramatically in their own wealth, structure, appetites to work, etc”.
Because of this, it is not surprising that the fund of funds industry has proved to be so attractive a strategy for investors, with the promise of access to the better funds as well as the ability to have diversification across sectors with relatively small investments.
What is clear is that the mega funds dominate in the fund-raising arena with figures being quoted showing that $1bn (e850m) or larger funds are taking 80% of private equity capital raised in 2004/05, while $2bn and larger funds have received 60% of capital raised in Europe. Additionally, there have been at least 10 funds worldwide in 2005 that raised more than $5bn each and two funds in the US that raised over $10bn.
In Europe, both mega buy-out funds, as well as mid-market funds, have done well while the contrast with venture is stark. According to Moulton: “Venture is tiny and struggling and fundraising is difficult whilst the private equity industry is evolving to buy-out and related areas.”
While the market has improved greatly in the past 12-18 months, it is not clear that there is liquidity in European venture, especially on the IT side. Until businesses have matured with decent cash flows, you cannot sell them.
Despite Moulton’s doubts, there are many who would argue that there is no reason why the strategies of the mega-buyout funds should necessarily fail. Maarten Voorvort from AlpInvest (Europe’s largest LP which manages the private equity investments of PGGM and ABP) has seen much more competition among private equity firms for businesses with a $500-800m enterprise value than for businesses valued at over $1bn.
As a result, mega funds are operating in an environment with less competition, an argument also expounded forcefully by the US buy-out firm Thomas H Lee, which recently closed a $10bn fund. In addition, the average size of large buy-outs has grown faster than the average size of large buy-out funds, so supply has outstripped demand. The sustainability is there because the supply of assets should grow whilet competition remains limited.
Adding value is key to gaining exceptional returns, whether through strategy, financing, or acquisitions – with the private equity firm acting as an M&A department, building management teams and acting as a sounding board for senior management. Jonathan Russell, head of 3i’s European buy-out business argues that private equity is a much more powerful value creation environment for all but the very largest companies in Europe. As for limits to size, “there are no downsides on managing a large fund but it is dependent on your infrastructure. Are you an asset manager driven by fees or are you driven by capital gains?” Where does it stop though?
AlpInvest’s Vervoort sees the limit as driven by complexity. “At some stage, you are competing with public markets. If you take enterprise value as a proxy for complexity of an organisation, the question is what can you do as a buy-out firm with that complexity? The investments have multiple product lines in lists of countries. It can be difficult to have influence beyond the first level of management.
In multinationals, being an outsider can make it difficult to give you influence.” However, he adds: “GPs who have a broader skill set could be at an advantage, but it is not proven.”
The issue for many firms is whether they need strategy skills in-house. While one school of thought says ‘I need operational skills inside my team’ another believes ‘they are important but I don’t need them inside my team’.
Vervoort sees two issues in this debate: “Can you build critical mass if you only have one operational guy and 25 financials? That is not enough. On the other hand, someone who has a transactional background does not get on well with someone with an operational background. I can say I need those skills but I will hire them and liaise in a smart way. We see both models working and in both cases it is part of the heritage of the firm in question”.
Ultimately, despite the large amount of press given to the private equity industry, much of it very negative, the largest buy-out firms employ only 250 or so people while, as 3i’s Russell points out, private equity accounts for just 2.5% of the aggregate market capitalisation in Europe, giving the industry plenty of room to grow and hence more and bigger mega funds.