Are Private Equity Mega Funds in a Category by Themselves?
Andrea Auerbach
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Yes, but not why many investors may think.
Mega funds are a substantial part of the private investment ecosystem. We calculate, using a definition of a private investment fund that raised $10 billion or more in commitments, that mega funds constituted fully one-third of the estimated $629 billion of dry powder in US private equity alone at the end of 2017 and were responsible for one-third of all invested capital from 2014 to 2018. 1 The basic premise of mega funds is because they are the largest pools of capital roaming the investment countryside, so to speak, they have little competition for the deals they want, can get the best advice, access leverage at the most favorable terms, and attract top talent to their firms and their portfolio companies. The result, one might conclude, should be mega returns.
Yet mega-fund returns are more akin to those of public markets than they are to private equity funds of other sizes. On a three-, five-, ten-, and 12.75-year basis (through September 30, 2018), our analysis shows that global mega funds returned 15.6%, 14.9%, 13.5%, and 10.5%, respectively, essentially neck and neck with Russell 3000® performance on an mPME basis. 2 Mega-fund returns are also more than 60% correlated with public indexes, nearly twice the correlation of funds of less than $1 billion in size. Why might this be?
Take a theoretical $20 billion mega fund (which, coincidentally, is greater than the nominal GDP of 74 countries) that, like a typical private equity fund, seeks to build a portfolio of eight to ten investments over a five-year investment period. The math would imply $2.5 billion per equity investment (perhaps more given the prevalence of co-investment) and, when using market leverage, target companies may need to be at or near $10 billion in enterprise value simply to compel this mega fund to “get out of bed,” to paraphrase supermodel Linda Evangelista. Several companies larger than $20 billion in enterprise value have been acquired by mega funds over the years, with an expectation of more to come. It is also likely that the mega-fund advantages mentioned above helped facilitate these investments in the first place. But private companies in this size range are shoulder to shoulder with large-cap public equity companies, likely already substantial and globally dominant. Their scale can make it difficult to effect truly material change that would certainly impact return potential. Indeed, our analysis indicates the dispersion of global mega-fund net internal rates of return from the median to the 5th percentile is 1,043 basis points, roughly one-third of the 3,041 basis point dispersion for smaller funds. As an aside, the tighter dispersion also indicates less loss, making mega funds a potentially interesting opportunity this late in the market cycle regardless of their overall return characteristics.
Mega funds are indeed in a category by themselves; a category they are originating and continue to grow into, namely that of a “new public markets proxy.” Given the increasing prevalence of large-cap private companies that could eventually go public but haven’t yet (and perhaps never will), investors wanting differentiated equity exposure to complement the public equity investments already in their portfolios, passive or otherwise, can increasingly find that exposure from a mega fund. Our analysis indicates they have essentially bifurcated the private equity arena, offering exposures and returns more akin to public markets than classic private markets. That’s not to say some of the mega funds won’t punch through the returns ceiling and deliver “old school private equity returns” to their investors, but as they continue to amass capital, their increasingly larger prey may not make it easy for them.
Andrea Auerbach, Head of Global Private Investment Research
Footnotes
- Dry powder data include both buyout and growth equity funds.
- Cambridge Associates Modified Public Market Equivalent (mPME) is a private-to-public returns comparison methodology. It evaluates the return that would have been earned had the money invested in private investments been invested in public markets instead.