The Mega Deal Shortfall: Bigger Isn't Always Better

LPs should take a hard look at mega private equity and its ability to generate outsized returns

In sifting through the fire hydrant of recent headlines, mega private equity fund closing announcements hardly seem like a rarity. A record high of 32 mega funds — greater than $5 billion USD — closed in the U.S. and Europe during 2019 and 2020. Despite this, transaction volume that fit the bite size of these funds has markedly fallen off — a trend that was well in-motion prior to the pandemic.

Considering that the competition of mega funds extend well beyond each other to include pension funds going direct, large corporates, and public market syndicates (IPOs / SPACs), it is unlikely that conditions improve. Using data from PitchBook, a crude multiple of three-year’s worth of mega fund dollars raised against mega buyout annual transaction value highlights the growing disparity:

While private market valuations remain stretched, equity allocators face a common public market trope in TINA — “there is no alternative”. The Russell 2000 carries negative earnings in aggregate. U.S. and European public market indices are at or near all-time-highs. The overwhelming amount of dry powder, lower transaction volume, and lack of equity alternatives, present a challenging environment for mega fund LPs; however, there are options LPs can pursue to mitigate the less than favorable realities.

Longer Capital Commitment Periods

To the extent mega fund GPs deem the current transaction environment to be inhospitable, capital commitment periods may be extended. Whether these GPs await higher volume, lower multiples, and/or more attractive targets, they will be quick to point to their exercising of prudence as an active manager. Depending on an LPs ability to adequately manage capital commitments, longer commitment periods could be met with impatience or support. Cash drag within a private equity allocation can easily turn into a material source of underperformance, especially in today’s low-rate environment.

One alternative is to look to liquid marketable securities as a short-term home. However, a pullback can offset or overtake the opportunity cost of staying in cash products. In practice, a combination of cash and public equities can be used as a stop-gap; however, neither are without implicit and explicit costs. If an LP views private equity as largely undifferentiated from a broader “equity bucket”, the GP’s decision to extend the capital call period will be viewed more favorably.

To make matters slightly more complicated, these longer capital commitments will not be captured in the IRR calculation, as the return period begins once capital is called, not when capital is committed. LPs will need to devise new means to evaluate the returns from GPs who extend drawdown periods. These new metrics should incorporate longer time periods, cash flow generated on the funds prior to the capital call, and ideally reflect the risk assumed in generating the interim cash flows.

Higher Multiples

The historic rise of private market transaction multiples has been well documented, and oft-predicted as an enduring trend. Pension funds and other asset owners continue to allocate to private equity, in large part because expected returns in other asset classes are less encouraging.

Looking at U.S. buyout multiples broadly, PitchBook data show multiples increased from 12.7x in 2019 to 14.1x in 2020. This lift is likely a function of lower supply (with sustained demand) and sellers successfully emphasizing pre-pandemic EBITDA while reported multiples reflect 2020 EBITDA.

Marketing materials suggest that mega funds are able to acquire portfolio companies at lower multiples than their mid-market brethren, as larger transaction sizes serve as a barrier to competition. Given the excessive amount of dry powder and lack of mega fund targets, it is reasonable to expect that this discount will be compressed or eliminated over the near to medium term. Mega fund buyout multiples will likely climb to mid-market levels with a much higher ceiling for heavily sought after transactions, particularly in technology.

While there is some evidence supporting enhanced returns from sector-focused funds in the mid-market, mega funds are overwhelmingly generalist. Although exceptions do exist, diversifying across vintages presents a more viable alternative in reducing the impact of current market valuations. The reality, however, is that private equity funds continue to be price-takers when bidding on enterprises generating above $5 million EBITDA, and will be for the foreseeable future.

It is easier than ever to allocate to “blue chip” managers given today’s travel constraints. Strong brands and reasonable track records encourage cursory diligence practices and lend well to the “sleep-at-night” factor. Managing a smaller stable of GPs, or a single GP, is much less challenging from an administrative and monitoring perspective. That said, the decision to allocate to mega funds should be viewed as a matter of convenience, not on the expectation of outsized returns.