Careful what you wish for

LPs love the US mid-market at the moment – but there are genuine concerns that the amount of capital flooding into this segment could depress returns

Earlier this week, Cambridge Associates released data showing that distributions rose dramatically in the second quarter of 2012 – marking the first time in 20 years that distributions outpaced capital calls by more than 2.5x.

That got us thinking about capital calls and capital overhang. At the end of 2010, Cambridge calculated that US private equity firms still had about $445 billion in dry powder left of the $915 billion they raised between 2005 and 2010.

This made a lot of limited partners (and others) nervous: if GPs were sitting on this much capital, would they find themselves under pressure to put it to work in the coming years – thus pushing up entry valuations and dragging down returns? Many firms have tried to avoid those pitfalls by negotiating investment periods with LPs (which has itself become a hot-button issue).

This past June, Cambridge released a revised estimate for full-year 2011. The good news was that the capital overhang figure had fallen to $343 billion net fees, which it attributed to the fact that mega-funds (i.e. $5 billion-plus) had been deploying capital, but had largely stayed off the fundraising trail through the end of 2011. The bulk of the overhang – around 44 percent – was concentrated in larger funds of $5 billion or more.

But the numbers are now on the rise. At the end of the first half of 2012, the US private equity overhang had crept up to $354.8 billion – and this figure is expected to rise further still, given the hundreds of firms on the fundraising trail. In particular, a number of mega-firms in the market are expected to boost totals: both TPG and Apollo Global Management are reportedly seeking $12 billion for their latest buyout funds, while Kohlberg Kravis Roberts is expected to close on around $8 billion next year for its Fund XI.

Perhaps the most interesting question is how this will affect the US mid-market, which is currently very much in favour with most LPs. Cambridge reckons this segment had an overhang of nearly $58 billion midway through 2012 – although since there's an increasing tendency for large funds to seek smaller deals, the amount of dry powder targeting the mid-market may actually in fact be much larger.

The other issue is investors' own ‘herd-like’ tendencies; as more and more LPs seek exposure to mid-market private equity, there's a danger it could drive up fund sizes and encourage some genuine mid-market funds to start investing above and beyond their core competencies.

All of which should start ringing a few alarm bells. Part of the reason LPs like the mid-market is because managers can generate dealflow through proprietary relationships rather than intermediated auctions. The more crowded the segment becomes, the harder this gets. And if you end up with a bunch of GPs all trying to spend their funds at the same time, pushing up valuations, it won't take long before the consistently high returns this market segment has yielded in recent years become a thing of the past.

PEI takes an in-depth look at these and other issues with its forthcoming US Mid-Market Handbook, published alongside our December/January edition.