Private equity’s ‘mega-fund’ problem

May 4, 2011, 1:15 AM UTC

Private equity’s mega-funds have gotten a worse rap than they deserve. Even from the mega-funds themselves.

Years ago, most everyone in private equity aspired to be part of a mega-fund. You got invited to the best parties, had your choice of CNBC interviewer and could afford to buy just about any company that didn’t rhyme with kugel. Plus, you raked in enough dough to make an NFL owner blush.

Today, however, “mega-fund” is a market obscenity. Those who never rose to mega-status jeer those who did, insisting that mid-market returns were always better anyway. Those who had caviar dreams now pretend that they never did, as if it was all just a giant misunderstanding. For example:

“Mega funds are actually engaged in mid-market buyouts. Most deals that are done are smaller deals. They are sub-$1billion. It’s been that way not just post-crisis, but before the crisis and even in the market we find ourselves in now.”– Jonathan Nelson, CEO of Providence Equity Partners, speaking yesterday at the Milken Institute Global Conference.

“We’ve always focused on… medium-sized deals, more the mid-market deals. We think that’s sort of the sweet spot where we can bring the operating platform, the clout, the leverage with lenders, the proprietary deal flow, the things like that, that only big firms can really — it takes scale to have, but we apply that to the less competitive mid-market, and so our positioning is a little unique there. It’s a big — it’s a big mid-market fund almost.” — Tony James, president of The Blackstone Group (BX), during an August 2009 earnings call

To be sure, both Providence and Blackstone are mega-funds. Providence currently is investing out of a $12.2 billion fund raised in 2006, and reportedly is in market with a follow-up vehicle. Portfolio companies include SunGard, Univision and Warner Music. Blackstone is nearing the finish line on a new fund that has secured more than $15 billion in capital commitments. Portfolio companies include Celanese and Hilton. Even if a majority of their deals are for smaller companies, the majority of their dollars are with the larger ones.

Source: Coller Capital

All of this double-talk is a byproduct of private equity pros knowing their customers — the institutional investors who fill their funds and pay their overhead (a.k.a. limited partners). These folks — particularly some of the public pension systems — have decided smaller is better.

The reasons are myriad. Some limited partners felt burned by rigged revenue-sharing during the buyout boom of 2005-2008. Some felt that mega-firms should have made more concessions during the financial crisis, when liquidity challenges made every dollar count. Others believe a conventional wisdom that mid-market firms out-perform mega-market funds.

For example, Coller Capital’s recent survey of institutional investors found that respondents favored mid-market buyouts to large buyouts over the next two years by more than a 2-to-1 margin (see figure).

So mega-funds have opted to re-brand. Sure some of them have also changed up their strategies a bit — bulking up on growth equity in China, for example — but mostly they’ve simply changed the messaging. Reminds me of something Chris Farley once said about pasting the world “guarantee” on a box of brake pads…

Not sure that the smartest limited partners are falling for it, but at least their bosses are.

I’ve never been one to condone some of the worst practices endorsed by mega-funds, particularly when it comes to inequitable fee-sharing arrangements. But I also think it’s time for some of these firms to loudly reclaim their mega-fundhood. “We’re here, we’re huge, get used to it.”

First, the performance data everyone talks about is spotty — due to a relative dearth of mega-funds. In the most recent Cambridge Associates benchmarks, for example, mega-fund returns were “not available” for 2008 and 2009. Moreover, private equity itself should not really be viewed as an index — because LPs can’t buy a median sample. If you get into the best funds — of any size — you do well. If you get into the wrong funds, you do poorly.

Second, smart limited partners rush in where sheep are rushing out. And vice versa. If everyone is trying to invest in mid-market funds, doesn’t that mean we soon could have a glut of mid-market funds (thus raising valuations and reducing returns)? Mega-funds should make this argument, promise not to repeat past abuses and position themselves as the unlikely loners.

Private equity has never been known for being over-emotional. Apparently until now, where semantic connotations have trumped common sense. Get a hold of yourselves!