Private equity’s packed fundraising schedule has raised concern in some quarters that LP commitments may become highly concentrated in funds of a similar strategy and vintage – a dynamic that isn’t typically desirable in a sophisticated, diversified private equity programme.

Industry data, however, suggests investors should not be overly alarmed.

LP desks are awash with some of the biggest funds ever launched. Hellman & Friedman, which only closed its largest-ever pool, Fund X, last year on $24.4 billion, began pre-marketing its 11th fund earlier this year, affiliate title Buyouts reported. Thoma Bravo, meanwhile, is targeting more than $28 billion across three funds this year; Apollo Global Management is seeking $25 billion for its 10th flagship and Blackstone is reportedly seeking $30 billion for what would be the largest fund in history.

The five largest funds in market were seeking at least $114 billion between them as of April.

Investors with exposure to all these managers and their peers might justifiably be concerned that a large chunk of their 2022 allocations could be swallowed by large buyout funds. According to Oliver Gottschalg, HEC Paris professor and head of research for MJ Hudson’s fund performance analytics division, these strategies typically deliver lower returns than the wider market: the largest 20 percent of global buyout funds raised between 2000 and 2017 generated a 1.8x average return, versus 1.92x for all buyout funds.

“Generally speaking, it is harder to generate top quartile returns with very large funds, because the stakes become very high,” said Sharad Todi, senior investment director at global investment firm Cambridge Associates. “Deal sizes, investment horizons and delivering EBITDA growth – getting all of this done simultaneously gets harder as fund size increases.”

One advantage of large funds is a smaller dispersion of returns, and therefore lower selection risk – an effect that can be achieved for small and mid-caps through diversification. In a 2015 report from Akina Group and Gottschalg, a portfolio of 15 small and mid-cap funds was found to deliver a 1.71x average return versus 1.66x for five large-cap funds, in addition to a significantly reduced risk of losing money.

“The more diversified play in the smaller funds becomes dominantly better [for] risk and return than the less diversified bit in the large caps because of the diversification impact,” Gottschalg told Private Equity International. “If you just write smaller cheques, you can write many cheques, you can diversify more rapidly, and it makes that segment dominantly more attractive. It’s by being able to diversify more in the small guys – but only through that mechanism – that the more diversified small cap portfolio beats the less diversified large cap portfolio [for selection risk].”

Diversification becomes more of a challenge if most of an LP’s managers return to market simultaneously.

“When we construct portfolios, we model a six to 10 years’ horizon, taking into account investment objectives, constraints and risk tolerances,” Todi said. “We also always ensure some level of diversification within each vintage year, as well as strong attention to disciplined commitment sizes each year to ensure vintage diversification. Blistering fundraising frequencies make that difficult.”

The threat to returns could also be compounded by the macroeconomic environment in which these funds have been launched. “This vintage may also be raised right at the top of the peak of the economic cycle globally,” Frank Su, head of private equity Asia at CPP Investments, said. “If you do make a couple of investments at the peak of the cycle, then that will have an impact on the returns, so I think that’s probably more my concern.”

Timing is everything

There may be a silver lining to these mega-funds coming to market at an uncertain time. According to Gottschalg, the largest 20 percent of buyout funds raised between 2005 and 2007 – in other words, those raised directly prior to the global financial crisis – delivered returns (1.61x) that are “statistically no different” to all buyout funds as a whole (1.67x) and, crucially, with a lower coefficient of variation.

Essentially, only having exposure to large caps during recession vintages would not only offer similar returns to a diversified buyout portfolio – it would also be safer.

“This confirms the hypothesis that large cap PE funds were attractive during crisis times as they offer similar returns to smaller funds at lower return dispersion – ie. less risk to have largely underperforming funds,” Gottschalg said.

Recession risk

Private markets participants are increasingly gearing up for the possibility of a recession in key global economies.

Speaking at the Private Debt Investor Germany Forum in Munich in May, Daniel Leger, managing director at US fund manager MGG Investment Group, said the possibility of a recession was akin to that of 2001-02, in the wake of the Y2K scare and the 9/11 terrorist attacks. With deals being done at equity levels of 15x and debt at 7x, “it’s going to get challenging”, he noted. “It raises questions about the ability of borrowers to service the debt. The quality of underwriting will become evident over the next year or two.”

Of course, there are other factors to consider when it comes to returns, including the potential impact of all this capital on entry multiples.

“When you have a lot of demand for investments, the first thing to consider is whether you have enough supply of sources of those returns, and in private equity that means whether you have enough good assets – I would say there probably is a mismatch in terms of the demand and whether you have enough assets in the market actually to address that demand” CPP’s Su said.

“The second is whether we think that PE investors have been able to generate enough value creation after they own the business [and] I think there’s still quite a bit of room for people to attract value, especially with the help of digitalisation. You’re operating in a more complex environment, so a more sophisticated owner actually can bring value to the table.”

Large funds’ resilience in a downturn may be in part due to their resources and experience relative to smaller or less established firms. Those who have been through one recession may also be in a better position this time around.

“Managers that are able to show strong repeatable track records can be expected to do well,” Cambridge’s Todi added.

“Ingredients for this include a stable team to which past returns can be attributed, and which has the right expertise for the future as well; discipline to stick to some core areas of expertise, such as regions or sector or deal types; and a playbook of working with portfolio companies to generate more value than they pay for. Such an approach may still suffer during poor vintages, such as 2005-06, but strong managers can still emerge among the best and in some instances even deliver strong absolute returns.”