Mega-Funds Will Make A Comeback

Mega-funds remain out of favor with many institutional investors. But a panel of limited partners that I moderated at Buyouts New York last month had no problem agreeing that such funds—of, say, $10 billion to $20 billion in size—would eventually come back into fashion.

That mega-funds are chopped liver right now stems partly from performance. According to year-end benchmarking data from Thomson Reuters, publisher of Buyouts, mega-funds rang up a spectacular 18.7 percent return for 2010, beating the performance of small buyout funds (6.5 percent) and large buyout funds (16.4 percent) over the same time period. But over the longer term, mega-funds have not done nearly as well. Through year-end their three-year performance came in at 0.9 percent, five-year performance at 4.2 percent, 10-year performance at 5.6 percent and 20-year performance at 7.9 percent. Its 20-year performance lags that of all three other size categories.

The Blackstone Group is believed to have taken in close to $15 billion for its latest mega-fund, Blackstone Capital Partners VI LP. Not a figure to be scoffed at, but the fund took well over two years to raise, and it is far smaller than its $21.7 billion predecessor, which closed in the summer of 2007. News reports put the target of Kohlberg Kravis & Robert & Co.’s next fund in the $8 billion to $10 billion range, which would make the pool far smaller than the KKR 2006 Fund LP, which took in $17.6 billion.

A late 2010 survey of institutional investors by placement agency Probitas Partners found just 5 percent saying they would focus most of their attention on mega-funds of $5 billion or more this year, compared with 46 percent that said they would focus most of their attention on U.S. mid-market buyout funds of $500 million to $2.5 billion. Asked their greatest fears regarding the private equity market, a third of respondents said it was that “large firms in the market are becoming generalized asset managers [and] moving away from key investment strengths.”

Giving all that its due, mega-funds are hardly dinosaurs. The $15 billion or so raised by Blackstone Group is still a staggering figure; were the partnership to have, say, 150 backers, every one would have to commit an average of $100 million for the firm to capture that sum. Elsewhere in this issue we’re reporting that Washington State Investment Board has committed $300 million to the latest buyout fund of Providence Equity Partners, which last closed a $12 billion fund in 2007 and is reportedly seeking $8 billion this time around. Making mega-commitments to such funds remains an efficient way for state pension funds to get their annual allocations out the door without taxing limited resources.

And managers of mega-funds have at least one big advantage over their smaller counterparts—enormous management fee streams that can support teams pursuing a variety of investment strategies, anywhere in the world. Of course, some LPs actually take mega-firms to task for arguably taking in more fees than they need, and for broadening well beyond their core strengths to the detriment of performance. But diversification can be an advantage when some markets heat up and others cool down; those firms that can redeploy resources as conditions change can much more easily sell at market tops and re-enter at market bottoms.

Consider Apollo Management, whose seventh core fund closed at more than $14 billion in 2008. Speaking at Buyouts New York last month,
Senior Managing Director Josh Harris said he just doesn’t see private equity deals as all that interesting right now, in part due to the high prices properties are commanding. Instead, the firm is paying more attention to areas like real estate, ocean shipping, asset sales by European banks, sales of reserves by big energy companies, mining assets and mezzanine finance. Needless to say, your typical small or mid-market buyout firm simply wouldn’t have the resources to pursue all these realms; indeed, many would point to their dedication to a fairly narrow investment strategy as a key strength. Sticking to one’s knitting has practically become an industry mantra.

Size may be the enemy of performance—that’s the conventional wisdom, anyway. But so can an overly ossified strategy unable to react to a changing climate.