Unimpeded by the small matter of a global pandemic, private equity fundraising broke new records in 2021, with $733 billion added to the coffers, according to Private Equity International data. Hellman & Friedman held the year’s largest close, amassing $24.4 billion for its 10th fund. Indeed, mega-managers dominated, with the 10 largest funds raising almost $150 billion between them – around 20 percent of the total.

And the mega-market juggernaut shows no signs of slowing. As of January, the top 10 funds in the market by size were seeking $180 billion, with at least 15 funds targeting north of $10 billion. Fund sizes are climbing steeply across the board, averaging $530 million in 2021, a nearly 50 percent increase in just five years, per PEI data.

“The flow of capital into the large funds has been particularly notable recently,” says Hamish Mair, managing director and head of private equity at BMO Global Asset Management. Mair attributes this flight to scale, in part, to the pandemic. “With in-person meetings restricted, large incumbent managers with high profiles and extensive fundraising resources have been able to make more progress than lesser known groups, which rely on making a positive early impression, something that is far harder to do in a virtual environment,” he explains.

Mair also points to the comfort that a recognisable brand can offer investment committees. “The ‘no-one ever got fired for buying IBM’ mentality plays into the hands of these private equity household names,” he says.

A white-hot M&A market means that capital is being deployed and returned at record speed, as well, leading managers to swiftly launch successor vehicles. “Investors are facing upwards of 45 to 50 re-ups this year, limiting the bandwidth available for forging new relationships,” says Paul Newsome, private equity partner and head of investment solutions at Unigestion. “With mega-funds and brand name, hard-to-access mid-market funds at the top of investors’ lists, everyone else is struggling and having to extend their fundraisings.”

Big spender

As allocations to private equity continue to scale, many LPs are looking to put larger tickets to work, with the mega-market a natural beneficiary. “The amount of capital that the big investors such as sovereign wealth funds need to invest today is fuelling mega-market fundraising,” Newsome says. “These LPs are looking to write larger and larger cheques and the most logical home for that capital is the mega-market.”

“The big pension plans need to write cheques of $300 million to $400 million,” agrees Rishi Chhabria, partner at Campbell Lutyens. “At those ticket sizes, it simply doesn’t make sense to be picking stocks and trying to build out a diversified pool of lower mid-market managers, as the risk of getting something wrong and the administrative burden outweigh the potential benefit. In addition, mega-managers have consistently performed at, or above, the median quartile.”

Niche appeal

In an environment where money has been incredibly cheap, there has been strong performance across the board. Public market buoyancy has supported valuations, meaning mega-funds have been able to defy the traditional perceptions of risk/reward trade-offs.

“Historically, investors in mega-funds were happy to forgo a bit of alpha for lower risk. But market conditions have meant that mega-funds have performed just as well, if not better, than smaller, more specialist funds,” says Gabrielle Joseph, head of due diligence and client development at Rede Partners. “The question is, if some of the buoyancy comes out of the public markets and if interest rates rise, will we start to see that leverage-driven performance wane, and more specialist, value-creation orientated managers become more appealing?”

Joseph says that investors are already starting to delve more deeply into the use of leverage in due diligence, and appetite for deep sector specialism is strong. Healthcare and technology have proved particularly popular.

Healthcare’s defensive characteristics are likely to stand it in good stead in the more challenging economic environment that many are predicting. BMO’s Mair says: “A worldwide health scare has underlined the importance of healthcare and we have seen a lot of money going into the sector.”

Yet, as Joseph notes: “There is a limited supply of skilled healthcare managers.”

The prospects for technology funds are more nuanced. “There has been an unprecedented boom in everything tech-related,” says Joseph. “The largest software buyouts, eye-catching B2C unicorns and even early-stage tech VC have all been riding the same wave over the past 18 months, buoyed by the enormous amount of public market liquidity pouring into the sector.

“The digital trend will continue unabated and, given geopolitical tensions and a changing macroeconomic environment, I think we will see a doubling down on stable software companies, with no raw inputs, no supply chain and no exposure to consumer purchasing power and inflation squeezes. Some of the enthusiasm we have seen for unproven, unprofitable tech will wane, however, as more cynicism and a more sober assessment of risk emerges.”

Indeed, Chhabria believes that a softening in appetite for technology is, in fact, translating into the beginnings of a revival in old world private equity strategies, with some investors recircling their efforts around industrial buyouts.

Meanwhile, interest in impact investment – and climate strategies in particular – is also soaring, buoyed by investors’ own net-zero commitments and EU regulation, which is helping to address the ignominy of greenwashing. The current geopolitical situation has only intensified calls for greater energy independence, which should favour localised renewables production and the private equity investors supporting that.

However, it is also possible that Russia’s invasion of Ukraine could temporarily slow the energy transition. “We are hearing that the UK might delay closure of coal power stations due to the energy crisis and there are even rumblings that Nigel Farage is demanding a referendum on net zero,” says Joseph. “It is important to keep a close eye on signs like that.”

Managing processes

But can the appeal of niche specialists really dampen the allure of the buyout behemoths, or are these mega-funds destined to grow and grow?

According to Joseph, the biggest question to address is how many deals need to be done and how labour-intensive it is to manage those. “There is a huge difference between a low operational-intensity infrastructure fund and a highly operationally intensive buy and build strategy,” she says. “LPs need to see that any single pool they invest in has a firm hand on the tiller and interests are aligned. That becomes hard if you end up needing a huge team of people deploying capital, managing deals and in the exit office, and the usual incentivisation structures become more diffuse and [harder] to keep properly aligned.”

For Mair, the key is how well the private equity house has transitioned from firm to institution. “The larger the fund, the more important it is that there is a replicable process in place that works almost independently of the people who are implementing it,” he says. “Raising more and more capital without having gone through that transformation from a firm of individuals to an investment institution will lead to diseconomies of scale.”

Of course, the macroeconomic backdrop also has a bearing. “We saw fund size records getting broken almost every week in the run up to the financial crisis. To some extent,
history is repeating itself and, if the downturn that many are predicting materialises, it may not end well,” says Newsome. “Those heavily leveraged, mega-buyouts will be the first to get burned.”

In fact, Joseph is already seeing some heat coming out of the fundraising market. “At the start of 2022, we had never seen so many GPs looking to go out fundraising in a single year nor so many looking to scale so significantly,” she says.

“But we are starting to see evidence of some fundraising launches being pushed out, partly in recognition of how tight LP allocations are and partly because public market volatility is impacting M&A. Managers that had planned eye-catching exits ahead of launch may have to delay those liquidity events. Meanwhile, geopolitical tensions and macro changes are slowing dealmaking, which means the imperative of running out of cash to deploy is starting to ease.”

“We are starting to see evidence of some fundraising launches being pushed out”
Gabrielle Joseph
Rede Partners

Chhabria, meanwhile, believes private equity fundraising growth will be tepid over the next 12 months, given the macroeconomic environment, with attention instead turning to more defensible, inflation-linked strategies such as infrastructure and private ­credit.

But mega-managers need not be overly concerned. Despite a recognition that deep sector expertise and value-creation ethos trumps scale and leverage in a downturn, investors are unlikely to turn their backs on the biggest in the business. “If there is a prolonged downturn, then investors will seek solace in brand names,” says Newsome. “That’s the irony. It is human nature to go with what is known and familiar, even though specialist and emerging managers tend to outperform in difficult times.”

Will retail investors flock to the mega-market?

The democratisation of PE could unlock significant capital for GPs, but doubts remain regarding retail investors’ risk appetite.

Several mega-managers struggled to deploy the vast sums of money raised immediately prior to the financial crisis and there are fears that history could repeat itself. But Campbell Lutyen’s Rishi Chhabria is sanguine. “It is possible that fund size growth will slow if the economy corrects,” he says. “Otherwise, I don’t think we have yet reached a tipping point whereby the market isn’t big enough to sustain these large vehicles.”

Indeed, Chhabria believes that mega-funds are poised to receive a new injection of capital, this time from retail investors. “The mega-managers are equipped with the brand name and technology that will allow investors to tap into this asset class, aided by groups including iCapital and Moonfare,” he says.

Rede Partners’ Gabrielle Joseph, however, is more sceptical. “I agree that mega-funds are the natural beneficiaries of democratisation efforts. However, we typically find that market chatter around retail access to private equity goes hand in hand with phenomena such as special purpose acquisition companies and an increase in take-privates,” she says. “We sometimes call them the harbingers of doom because they can herald the very top of the market.

“When you start to see more volatility in performance, you may well find there is less enthusiasm to have your grandma invested in a locked-up private equity fund. If we really want to democratise access to private equity, we will have to come up with a more consumer friendly way for the asset class to be consumed and I suspect that will result in the creation of hybrid, private equity-light products, rather than traditional 10-year funds.”