Private-Equity Firms Are Raising Bigger and Bigger Funds. They Often Dont Deliver
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Private-equity megafunds posted 14.4% five-year annualized returns net of fees, barely surpassing the S&P 500’s 14.1%. Larger funds face challenges in finding sizable investment targets, limiting options and often leading to market-like returns.
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"...Taken together, private-equity funds of $10 billion or more posted 14.4% five-year annualized returns net of fees as of the end of last September, barely edging past the 14.1% return for the S&P 500, according to data from investment firm Cambridge Associates. Buyout funds’ relative performance doesn’t improve much over a longer time frame. Over a span of 12.75 years—the longest period for which Cambridge has sufficient data on megafunds—returns for these large funds was 10.2%, the same as the broader index, its data show. The reasons behind the trend are simple: Bigger funds generally have to find bigger targets to invest their money, which means they have fewer options. It tends to be more difficult to broadly implement new operating strategies at larger companies than at smaller ones. Megafunds, as a result, are often buying the market. The smaller the fund is, the less its returns tend to be tied to the broader market. U.S. funds of less than $350 million had a correlation of 0.38 with the S&P 500, compared with 0.62 for funds $10 billion or more, according to Cambridge...."
Miriam Gottfried, "Private-Equity Firms Are Raising Bigger and Bigger Funds. They Often Don’t Deliver.,"Wall Street Journal, June 18, 2019, https://www.wsj.com/articles/private-equity-firms-are-raising-bigger-and-bigger-funds-they-often-dont-deliver-11560859200
Private-Equity Firms Are Raising Bigger and Bigger Funds. They Often Don’t Deliver.
Blackstone Group LP is in the final stretch of raising what would be the largest private-equity fund ever. Big funds, however, don’t necessarily translate into big returns.
The private-equity giant has capped its latest fund at around $25 billion amid strong demand, according to people familiar with the matter. Collecting that would take the fund past the $24.6 billion record set by Apollo Global Management LLC in 2017. Others also are raising big funds: Advent International said earlier this month it had raised a $17.5 billion fund, and software-focused Vista Equity Partners is raising a $16 billion vehicle.
The rise of megafunds reflects the growing demand for private equity from large investors such as sovereign-wealth funds with hundreds of millions of dollars to put to work. With interest rates still persistently low, the industry’s historical reputation for 20%-plus returns, is appealing—even if it means paying higher fees and having money locked up for long periods.
The problem is that the largest funds haven’t always lived up to the hype. Taken together, private-equity funds of $10 billion or more posted 14.4% five-year annualized returns net of fees as of the end of last September, barely edging past the 14.1% return for the S&P 500, according to data from investment firm Cambridge Associates.
Buyout funds’ relative performance doesn’t improve much over a longer time frame. Over a span of 12.75 years—the longest period for which Cambridge has sufficient data on megafunds—returns for these large funds was 10.2%, the same as the broader index, its data show.
The reasons behind the trend are simple: Bigger funds generally have to find bigger targets to invest their money, which means they have fewer options. It tends to be more difficult to broadly implement new operating strategies at larger companies than at smaller ones. Megafunds, as a result, are often buying the market.
The smaller the fund is, the less its returns tend to be tied to the broader market. U.S. funds of less than $350 million had a correlation of 0.38 with the S&P 500, compared with 0.62 for funds $10 billion or more, according to Cambridge.
Granted, some members of the current crop of megafunds may be more successful than others, for example, if a unique strategy such as Vista’s performs better than the broader market. Even when pooled together, returns for megafunds compare more favorably with other indexes such as the MSCI All Country World Index, which is more global and less technology-heavy than the S&P 500. And they tend to be less volatile than smaller funds because the companies they own have relatively predictable streams of cash flows, Cambridge says.
Megafund managers say their main periods of outperformance tend to come when the market is down—not in a decadelong bull market like the current one. Megafunds also provide one of the few places for large pension and sovereign-wealth funds to invest massive amounts of cash all at once. That offers them a way for them to get exposure to the growing slice of the market that isn’t traded on major exchanges.
“They are definitely serving a role in your portfolio, but it may not be the role you think they are serving,” said Andrea Auerbach, head of the global private-investments group at Cambridge, in an interview. “Size is the frenemy of performance.”
Investors piling into Blackstone’s latest fund can look at its past performance for an indication of where returns may be heading. Its 2011 fund, a $15 billion pool, posted annualized returns of 15.2% net of fees as of last September, public pension data show. That is less than 2 percentage points above the annualized total return for the S&P 500 with dividends reinvested over the same period.
Blackstone’s $18 billion fund raised in 2016 returned a net 22.9% through last September versus about 16% for the S&P 500 over the same period. Some pension funds still consider that fund too young for those results to be meaningful.
For some investors, particularly large U.S. pensions with limited staff and large amounts of money to put to work, there aren’t a lot of alternatives to investing in large funds. Many have responded to limited returns by pushing for more opportunities to co-invest in buyouts alongside private-equity funds, a strategy that can boost returns because they can avoid fees.
California Public Employees’ Retirement System, the largest U.S. public pension fund, which aims to commit between $10 billion and $13 billion a year to private equity, is exploring a new model for investing in it. Under the current plan, the pension fund would become the sole backer of at least two limited-liability companies. These companies would be overseen by outside managers, who would invest directly in companies on Calpers’s behalf. The fund would also continue its regular investments in private-equity funds.
Other institutions whose size allows them to be more nimble have opted to invest mostly with smaller managers. Alaska Permanent Fund Corp., which has about $60 billion under management and commits around $1.6 billion a year to private equity, targets funds in the range of $500 million to $1 billion. It aims to be one of the larger investors in these funds by writing checks of $50 million to $100 million, a position that also gives it access to more co-investment opportunities.
Steve Moseley, Alaska Permanent Fund’s head of alternative investments, said the strategy requires more legwork because he has to oversee more investments and more relationships with general partners. But the state fund’s private-equity investments have posted five-year annualized returns of 22.6% as of the end of last year.
“We discovered that by having more robust relationships with mid-sized and smaller we could deliver better returns,” Mr. Moseley said. “I don’t envy the folks who are managing the giant public pension funds.”