Megafunds – A New Normal?

Megafunds – A New Normal?

We look at how megafunds have become a driving force for gigantic deals in the private equity space and what this "new normal" means for the PE industry as a whole.

McKinsey’s annual Private Markets Report for 2017 showed Private Equity firms that raised over $5 billion for buyout funds had grown by a stunning 93% in 2017, climbing to a total of $173.7 billion of fundraising. These so-called “megafunds” are reshaping the PE industry, with ramifications across not only how business is being done, but which deals are being made as well.

Who’s responsible?

The big drivers of this push towards gigantic deals have been pension funds. After a decade of a low interest rate environment after the Great Financial Crisis, pensions have sought to boost returns by looking outside their traditional asset allocations of primarily stocks and bonds. This shift towards alternative asset classes – a practice pioneered by Canadian pension funds – helps to diversify asset allocation structures and take advantage of long-term macroeconomic trends. By nature, pension funds are very long-term investors, so they are natural partners for many large PE projects with long expected lives, such as infrastructure. Further, as stewards of enormous sums of money, their investments must be quite sizable to have a measurable and meaningful impact on their bottom lines, lending themselves well to larger projects.

What’s the impact?

However, given that pension fund mandates tend to be more conservative than the stereotypical private equity investor, they are moving the needle on what kinds of deals are targeted by the megafunds they are helping to create. They tend to shy away from excessive risks, seeking out fewer blockbuster deals and more consistent, solid (if unspectacular) gains.

This is a fairly new move for an industry that has traditionally been focused on eye-popping gains in investments that are generally considered to be higher risk. Because of this new influx of more conservative cash, many larger firms are moving towards much less “sexy” investments, if more consistent: think airports, port authorities, highways, public-private-partnerships, office towers, etc.… These opportunities align well with most pension funds, but have been a bit “outside the box” compared to what most PE firms would consider their primary targets, forcing them to look for scale at an enormous size and consider more macroeconomic realities in what has traditionally been a far more idiosyncratically focused industry.

What about the mid-market space?

Obviously, most of the deals mentioned earlier would be too large to be considered mid-market. But, though the trends seen in the mega-cap space are less pronounced in arenas where less staggering sums are at stake, the ripple effects can be clearly felt. Other investors may be more inclined to look to the mid-market area, for fear of being “crowded out” by the enormity of pension funds in competitive situations due to the raw financial firepower they can throw at a project. With large PE firms chasing after huge sums of pension money to boost fees by targeting more stable and less spectacular deals, other PE investors may see the mid-market space’s more traditional landscape and outlook on deals as more aligned to their risk/reward profiles.

At the margin, this could encourage larger market players to look at the mid-market space to juice returns instead of going head-to-head with the new behemoths in their home market. Since mid-Market M&A will still likely be far more focused on a more “traditional” PE transaction, and this is something that larger players are comfortable with, this may cause valuations to rise in the mid-market space.

The mid-market space may also see some of the pension money coming its way, as the funds add exposure to alternative asset classes. As noted above, these investors can be very risk averse and may be hesitant to jump into new waters feet first, wishing instead to test the waters with smaller allocations that will fit the mid-market transaction size. Of course, competition for this money is expected to be fierce, given the potential upsides for PE managers of landing a pension fund as a client.

Is this going away?

Even with interest rates looking upward and the returns on stocks and bonds normalizing, it seems unlikely that pension funds will pull back from Private Equity as an asset class altogether, given its benefits towards diversification, as well as term-matching. As such, this trend is likely here to stay and the waves from mega buyout funds will continue to crash upon the shores of the market as a whole, bringing with it both risks and opportunities.