Limited partners of large and mega-funds in the US leveraged buyout sector must adopt a more selective approach as the market is significantly overcapitalised, a report has warned.
In early August, Apollo Global Management revealed it would begin deploying the world’s largest LBO fund, a $25 billion 2017-vintage featuring commitments from California Public Employees’ Retirement System and Florida State Board of Administration, as early as this year. The fund will focus on three strategies: distressed debt, corporate carve-outs and opportunistic buyouts.
However, large and mega-funds, which focus on deals above $500 million, have on average deployed just $111 billion of $572 billion raised over the past five years, according to the Is there too much capital in LBO? white paper from economic consultancy Wellershoff & Partners. The figures do not include an additional $32 billion estimated to be available through co-investment opportunities.
The overcapitalisation, which stems in part from maturity of the US private equity market and its ability to accommodate larger commitments, has resulted in bloated valuations as funds compete for a limited number of opportunities, the report noted. The average enterprise value for upper mid-to mega-LBOs rose from 9.6x in 2014 to 10.8x the following year.
“The real fiduciary duties remain with the limited partners,” Cyril Demaria, author of the report and head of private markets at Wellershoff & Partners, told Private Equity International. “They are the ones who should equip themselves, who should recruit and should have the discipline and the rigour to select the right fund managers and basically if it’s necessary, reduce their commitments in certain markets which tend to be maturing very, very fast.”
The report recommended investing in niche strategies or first-time funds with experienced managers who are more receptive to investor-friendly terms. Limited partners should aim to reduce management fees in favour of performance fees and restrict the use of instruments that distort performance measurements while introducing additional risk, such as fund credit lines.
Fund managers could also help to deploy the surplus capital by targeting smaller assets for buy-and-build strategies, thus reducing risk and raising value, according to the report. This strategy has increased in popularity over recent years, with the percentage of LBOs featuring add-ons climbing from 54 percent in 2010 to 64 percent last year.
Another possibility is that some fund managers decide to be more proactive and downscale the size of funds, “[though] the last time it happened we’ll remember that it was not necessarily well-perceived, notably by the LP community,” Dr Demaria added. “Others might decide to split funds and create side pockets to do other things with it, so you raise capital and then you explain to your LPs that you have a different strategy.”
US LBO funds account for 47 percent of the private equity market, according to the report. European LBO funds, which were not deemed overcapitalised, account for 22 percent.