PE mega fund momentum poses return risks

Apollo’s new $24.6 billion record buyout fund is likely to be followed by others, but the size of new private equity funds could lead to lower returns for limited partners.
PE mega fund momentum poses return risks

The record-breaking launch of a new $24.6 billion buyout fund by Apollo Global Management will likely be followed by other mega-sized private equity funds, offering aspiring asset owners more investment possibilities at the potential cost of returns.

Apollo’s new private equity fund may be the biggest ‘mega fund’ so far, but it's far from the only one. Alternative research data provider Preqin defines mega funds as those with over $4.5 billion in committed assets, and notes that 10 such funds have launched so far this year, with more to come in what promises to be a record-breaking year for commitments to new private equity funds. Fund sizes are generally on the rise; Preqin notes the average private equity fund size amid the economic doldrums of 2011 was $273 million, while it stands at $625 million so far this year.

Mega funds are emerging in Asia too. Japanese media telecoms giant SoftBank is finalising its global Vision Fund, which raised $93 billion in its first close in May. If aims to reach $100 billion, which would make it by far the largest private equity fund in existence. And last year China launched its Rmb200 billion ($26.66 billion) China Venture Capital Fund Corporation, a state-owned venture capital fund that is the world’s largest to date. 

The proliferation of such funds is in large part down to the desire of eager institutional investors across the globe to improve returns through private equity investments, combined with a desire to minimise their risks by only offering capital to private equity players with the best credentials.

“We are seeing a maturation of the industry where there are many LPs (limited partners) and too many fund managers, and they are often short of internal staff to keep track of all funds, so they want to give money to high conviction managers and get close to them and do co-investments,” said an Asia-based chief investment officer of a pension fund. “As a result, all the good managers are getting most of the dough, but mediocre managers may struggle to get their target fund sizes.”   

The reams of money being offered to leading private equity firms offers them a high class problem. They can increase their firepower by accepting it and creating mega funds, but at the same time so can their top-tier rivals. More importantly, they face the pressure to allocate this capital at a time when there are relatively few leveraged buyouts taking place.

There is another issue too. “If you refuse money from LPs, you risk offending potentially good clients, and they could end up taking their money and giving it to your rivals,” said the CIO.

That combination is likely to lead erode returns.

Discipline issues

Leading private equity funds could in theory reduce these risks by only accepting as much capital as they can expect to invest.

But the CIO argues that some of the leading firms are motivated to take as much as they believe they can handle. Top notch companies such as Apollo, KKR, Carlyle Group and Blackstone Group, are publicly listed, and the market typically bases the valuations of these companies on their demonstrable cash flows. This tends to come from annual management fees, plus the net profit they make from selling companies for more than they bought them for.

The trouble is the latter is hard to predict, so funds are incentivised to maximise the former. Raising large amounts of assets helps achieve this.

The upshot is that the leading private equity firms have more money available than ever, and can raise larger funds. But this could well raise the cost of investments as the leading firms have the firepower to bid more. They may also have to buy into companies with less exciting prospects, have to sit on investments for longer before selling, or end up having to hand money back.

And that is without considering the dangers of an abrupt deterioration in market conditions. After all, the last peak in the asset accumulation by private equity funds was 2006 and 2007, just before the global financial crisis of 2008.

“As a whole the industry is seeing strong performance metrics. But it’s weighted towards those making sales now, as opposed to those raising assets,” said a spokesman for Preqin.

There are already signs that IRRs are slipping. The Preqin spokesman noted that top tier private equity funds have often historically been able to command internal rates of return (IRRs) in the high teens to low twenties in percentage terms, but this has slipped to the low teens in some cases. The median private equity IRR in the 2014 vintage (the most recent available) stood at 9.5%, compared to 14.2% in 2012.

“You have to look to the 2010 to 2012 bracket to see the highest returns [of the past several years],” said the spokesman.

Risk vs. return

Given the illiquidity of the asset class, this is beginning to raise questions of whether private equity funds offer enough returns to justify the risks. Some investors, such as Hong Kong-based insurer FWD, fear that there is not.

“If you have a lot of money chasing the same assets, then you should expect lower returns,” he told AsianInvestor in an exclusive interview in our June/July edition. “We’ve seen many press releases about the pursuit of the illiquidity premium, but it’s been bid down to zero in many instances.”

The Asia CIO agrees with this view. “If some funds are generating low teens net IRRs, they may not warrant the 500 basis point excess return versus a public equity benchmark such as MSCI World,” he said. “People may well ask ‘what are we doing, paying to lock up our capital for 10 years and pay the GPs (general partners) high fees, for such a pickup?’” 

The proliferation of mega funds looks set to continue, but they are a symptom of the desperate hunt for yield among the world’s institutional investors. And as this search intensifies, returns look set to keep slipping. Asset owners will need to consider this as they weigh offering more millions of dollars towards leading private equity players. 

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