The mega-billion dollar private equity funds of 2006 will likely turn out to be much better for their general partners than for their limited partners.” This is the view expressed by the hedge fund Highfields Capital in a letter sent to its investors, which points out: “It is hard to fathom how paying a control premium well in excess of the public market price and layering on management and incentive fees can yield anything other than mediocre (or perhaps worse) returns absent a huge increase in the ability to exit at a much higher multiple.”
Yet Hamilton Lane, a leading private equity advisor and discretionary manager, is very happy to have as much as 35-40% in mega funds for certain portfolios according to Duke DeGrassi, the managing director of the firm’s European operations.
The most significant theme in private equity investment is the rise of mega funds and it is not surprising that this has led to some heated debate. Alchemy’s Jon Moulton describes them as “dinosaurs” at industry conferences and, like dinosaurs, he says, their future may be limited as they will eventually be wiped out by smarter, smaller creatures. Yet Wim Bergdorf of AlpInvest, one of the world’s largest private equity investors and responsible for the private equity investments of ABP and PGGM, argues that by 2010, funds greater than $1bn (€764m) will make up 75% of the invested volume in private equity and that 10-12 firms will dominate that space, giving rise to a huge concentration.
But what has given rise to the mega funds, which can now be $8bn or more in size? Hamilton Lane’s Duke DeGrassi sees that the market is awash with liquidity. “There is a huge amount of capital looking for alpha, for extraordinary returns. The groups raising mega funds have been in the business the longest and done the best deals.
“They are smart and disciplined. The mega firms are the best and the strongest, they have the best access to the best executives and advisers and are able to buy bigger and bigger companies.”
This is a view echoed by David Hutchings, the new head of private equity at Albourne Partners, who says most firms have fabulous teams with smart people. “The size of deals means that they can afford to hire the best consultants and clearly attract the best staff,” he adds.
However DeGrassi admits that while mega funds certainly “have more resources, that doesn’t necessarily mean that all of them are good at private equity investing. Manager selection remains a critical component of successful private equity investing”. One firm that is often cited though, as being good is KKR, with a clear competitive advantage through its ownership of Capstone, an operational management consultancy. “You have seasoned operating executives actually going into a company and doing whatever needs to be done. KKR is a firm that is spending a significant amount of capital in terms of people they put into companies,” says DeGrassi.
Hutchings adds that while a chief executive is getting strategic advice from KKR directly, Capstone will provide operational advice and firepower on just-in-time manufacturing and so on. “So KKR are an invaluable resource for the company with its own operational consultants at Capstone who will support the CEO of the company and provide resource to him. I like that,” he says.
David Hughes of Invesco Private Capital also argues in a recent note that: “Although it is too early to determine how 2003-2006 funds will eventually fare, anecdotal evidence suggests that mega funds are performing well in the current environment, particularly since many partnerships have been able to recapitalise their companies and pay out a dividend after only a year or two of ownership.”
Hughes sees the key advantages of mega funds as their ability to deploy large sums of capital; having fewer competing bidders since transactions require a large equity component; targeting companies that are often stable businesses with strong cash flows; being able to focus on long-term operating improvements without quarter-to-quarter earnings pressures; having the ability to attract high quality management teams through strong financial incentives; and being in a position to call upon extensive resources from investment banks which earn lucrative fees on deal financing and exits.
Clearly, this does come with some drawbacks, which include the increase in financial risks through leveraging, and the reduced investment in businesses caused by increased debt burdens. The multiple fees charged to portfolio companies can damage returns to investors. Moreover, the practice of ‘club deals’ where a number of mega funds combine to target ever-larger acquisitions means reducing LPs’ diversification among buyout groups.
Wim Bergdorf of AlpInvest has pointed out that the dispersal of returns will be fundamentally different between the mega-buyout firms and the small and mid cap sector. In the latter you have a huge number of operators with very different strategies so it is natural that there will be a wide dispersal of returns.
In the case of mega funds, with acquisitions undertaken via a syndicated process in a small pool of participants, the distribution of returns will understandably be narrower. Investors therefore need to consider what value there is in diversifying among a range of mega funds.Despite the current rapid increase in size of funds and of acquisition targets, there is still some way to go. “Part of the debate is - just how many large targets are there that you can do anything with? Inevitably there is an upper limit.
There was some recent debate as to whether Microsoft could be bought and broken up. The length of that debate was surprising and perhaps indicates that it was not hypothetical. It is not difficult to see $30, $40 or $50bn funds,” says Hutchings.
Perhaps what will be the determining factor is complexity, with size just being a proxy for the complexity of an organisation. With multiple product lines across many countries, it can be difficult for any private equity firm to have an influence beyond the most senior level of management.
But, as Hutchings puts it, we are in untested waters now in terms of the growth and development of private equity and the size of deals. “Everyone is hunting for a hypothesis and perhaps we should revert to some traditional principles.”
Looking back in history, however, immediately brings about comparisons with the conglomerates of old. Invesco’s Hughes points out that the 45 companies in BlackStone Group’s private equity portfolio have combined annual revenues of $72bn and employ around 350,000 people.
He also makes the point that “much of the LBO activity of the 1980s consisted of raiders taking over diversified conglomerates and selling off divisions that were not related to the core business”, and adds that most conglomerates have traded with an imbedded discount in their share price.
Indeed, the comparison starts becoming even more pertinent when you consider that the latest fad has been for megafirms to list their funds which resulted in those of KKR and Apollo trading at a discount in the early days after flotation”, according to DeGrassi, who does not see listing as a long-term trend because it puts a lot of pressure to get capital invested quickly.
“Listings have been driven by liquidity in the market and the fact that firms don’t like fundraising and would like permanent capital,” he adds. But as Hughes points out: “If the market falls, many buyout funds may suddenly have to confront the fact that they do not have the expertise to run such a diverse set of
Given the size and increasing prominence in the press, the biggest threat to the existence of the mega funds is likely to be government intervention. It is unrealistic to expect that the type and size of deals now being completed will not attract attention, as indeed they have done.
Club deals have already caught the attention of the US department for justice, which is probing to uncover any instances of potentially uncompetitive behaviour amongst some of the largest and best known names. However, with private equity accounting for 20% or so of all M&A activity, with Hank Poulson, the ex-head of Goldman Sachs now in the US government, and with Gordon Brown’s close relationship with the sector in the UK, the private equity industry may be feeling relaxed. “Certainly, it is unlikely that anything material will happen in the US, so it seems unlikely for it to happen in the UK and the rest of Europe, although there may well be upsets along the way,” says Hutchings.
Perhaps the greatest opportunities ahead lie in taking the undoubted successes of the megafirms to new markets, particularly Asia.
China and India are often seen as the next grand opportunities for investment. “We think we understand China at our peril,” points out Hutchings. “Indeed, recent regulatory changes are working against the buy-out sector. Thus the industry is likely to develop there in new ways rather than simply mimic the accepted western model.”
He adds: “In Asia, the prime opportunity for mega-buyouts is more likely Japan. There is huge potential in the economy. But just as the large buy-out market developed in Germany before the middle market primarily because management at large firms had often been to US business schools and hence understood the dynamics of the buy-out process, so to is a considerable part of Japanese management now in a similar position - far more than in China. Japan is the world’s third largest economy and has just been through more than a decade of problems leaving an economy in dire need of restructuring. That is where the opportunity now lies - but when?”