$100 Billion-Plus Banner Year for Private Equity Mega-Funds

Private Equity is on track for a record-breaking year of deals, exits, and fundraising, according to PitchBook data.

In the second quarter of 2021, private equity deal-making “continued at a frenetic pace,” the report said, with funds closing 3,708 deals worth an estimated total of $456.6 billion. For context, the entire year of 2020 saw 5,734 deals with a combined value of $711.6 billion.

PE deal activity

According to Ernst and Young and PitchBook, drivers of current deal activity include:

• Increasing certainty due to the pandemic waning in many regions

• Continued low interest rates and the widespread availability of financing

• The accumulation of dry powder, which according to PitchBook, amounts to US$1.3t

• A partially vaccinated population

• High investor confidence in the equity markets

• A “frenzied” demand for high-yield debt

• The regulatory nature of the Biden administration

June’s buyout of Medline Industries, a medical supply company, by a consortium of private equity firms, was cited as an example of the “risk-on” environment for dealmaking. “Clocking in at an astonishing $34.0 billion EV, with the Blackstone Group, the Carlyle Group, Hellman & Friedman, and GIC participating, the deal inspired myriad comparisons to the mega-deals of 2006 and 2007,” PitchBook said in the report. “It is a noteworthy sign of macroeconomic optimism that Blackstone and the other dealmakers foresee an exit route for a company of this size, presumably in the public markets, in the next three to five years.”

According to Ernst and Young, there were seven so-called “mega-deals” worth $10 billion or more, which is a record for a six-month period.

There are also signs that the largest PE firms are seeking other gargantuan deals: After CVC made an initial bid to take Toshiba private at around a $20 billion valuation, which Toshiba rejected, Bain is reportedly exploring an offer for the company. The buyouts of Cloudera, Proofpoint, Culligan International, and Verizon Media Group are four additional examples of $5 billion+ deals announced in Q2 2021.

“We’re seeing a lot of really big exits and that is a result of the public markets really opening up as a good exit opportunity for private equity,” said Rebecca Springer, PE analyst at PitchBook. “That wasn’t the case in the run-up to the pandemic.”

Before 2020, private equity firms “shied away from listing portfolio companies in the public markets due to widespread fears that the market cycle was nearing a recession,” according to the report. After last year’s Covid-19 crash, however, private equity managers took note of the strong public market recovery and became “more aggressive” in listing portfolio companies, PitchBook said.

Exits have been active across all deal types, with trade sales, sales to other PE firms, and IPOs back in earnest.

Global PE Exits Over Time – By Exit Route (US $b)

For a short time, the pandemic nearly brought PE fundraising to a halt, but it appears to have almost recovered as Limited Partners (LPs) continue to allocate money into alternative assets in search of lofty return figures. As for fundraising, PitchBook said activity has been “healthy” in the first half of the year, with 207 funds closing with $179.6 billion.

US PE fundraising continued its recovery in Q2, 2021 as institutional investors moved away from the conservative decision-making they adopted in 2020 and increased their alternatives allocations. Mega-funds (vehicles defined as those that have raised over $5 billion) continued to account for the bulk of capital raised.

So far in 2021, funds over US$5b raised more than twice the capital they did a year ago. The second quarter of 2021 in particular saw a number of flagship funds close, many of which are valued upward of US$10b. What is perhaps most interesting is that even at that scale, many of these funds closed quickly, are larger than predecessor funds, and, in some cases, are significantly oversubscribed.

While 72% of capital raised YTD has been by diversified funds, 14% of capital has a mandate to be deployed in the technology sector, followed by mandates for consumer (7%) and health (5%). Health-focused growth fundraising in particular increased by over 50% in 1H21.

PE Fund Value by Size

This year is looking to be a banner one for private equity's mega-funds, with the likes of Hellman & Friedman closing its 10th namesake fund at $24.4 billion and The Carlyle Group reportedly eyeing $27 billion for its next flagship vehicle—in what would be the largest private equity vehicle of all time.

In all, 14 buyout and growth mega-funds have already closed this year. For context, 18 mega-funds were closed in 2019, and 16 in 2020. According to PitchBook data and PitchBook's Q2 2021 US PE Breakdown, at least seven of those 12 funds have raised over $10 billion each.

Separately, two funds—KKR and Carlyle—have targeted or raised over $10 billion, but not yet closed.

Top 10 Mega-Funds of 2021 that have closed or are expected to close

The mega-fund trend has been growing for some time now, and for a couple of reasons, according to Rebecca Springer.

"Strong public market performance drives increased PE commitments due to the 'denominator effect,' since LPs try to maintain alternatives allocations at a set ratio to public equities allocations. LPs often prefer to re-up with managers with whom they already have a relationship, since this requires less due diligence," Springer said.

When it comes to the question of whether mega-funds generate better returns, she said that overall, they have beaten smaller funds in recent years. "They are less likely to underperform and less likely to overperform relative to smaller funds," she said. Part of that is owing to the greater resources of the larger entities, which allowed them to bounce back handily from the wipeout days of early 2020, when pandemic anxiety kneecapped financial activities.

The resonating shockwaves of the pandemic are still being felt throughout private equity. Springer said the surge in mega-funds isn't a COVID-19-specific trend, but that the pandemic probably did give the funds a tailwind. "Mega-fund IRRs (internal rates of return) bounced back more quickly than smaller fund IRRs after Q2 2020. The larger portfolio assets of mega-funds may have been more resilient to pandemic effects and are more likely to be marked-to-market against public company comps, which meant these funds shared in the stock markets' rapid recovery," she said.

Marking-to-market is an accounting method that values an asset-based on comparable assets with known valuations. In the case of mega-funds, firms are using similar public companies to value portfolio companies, according to Springer.

She said that over the last couple of quarters, mega-funds have also had help from public market strength, in that they are exiting many investments through IPOs, and from stock sales from previous IPOs.

The strong performance of mega-funds only accelerates funding, and the prevalence of these goliath-sized pools of money.

"When mega-funds return capital to LPs after exiting a portfolio company, that allows LPs to turn around and commit to the next fund," Springer said. "And, of course, the extremely strong performance figures for the last couple quarters don't hurt, either."

Success breeds success. While past performance can never be indicative of future results, loyal clientele of past investors are generally willing to sign up for more funds from the same sponsor that already delivered before. These limited partners (LPs) “often prefer to re-up with managers with whom they already have a relationship, since this requires less due diligence,” observed Springer, in a research report.

McKinsey’s research shows that for buyout vintages from 2000 to 2016, the median performance is comparable across fund sizes, from small-cap (less than USD 1 billion) through to super-cap (more than USD 5 billion). However, the dispersion of returns is far more pronounced in small-cap funds. This means it is far more likely for investors to end up selecting a bottom quartile manager, and, by default, much harder to find top-quartile performers when investing in small-cap funds.

There is no guarantee that any investment will or is likely to achieve profits or losses similar to those in the past. Despite this fact, mega-funds have generally provided a tighter spread of returns in recent years, which might partly explain why they have become a more prominent feature of the PE fundraising landscape. Most PE firms launching mega-funds have a longstanding track record of above-average performance. This allows them to continue raising bigger funds and is indicative of their existing investors choosing to re-up.

“Many of my LP clients re-up with their largest managers and that’s not just a function of returns,” says Matt Portner, Partner, McKinsey & Company. “It is a function of everything else they get from those managers; ie returns and lower risk of downside on those returns, co-investment opportunities, risk management, potential access to other asset classes (real estate, infrastructure), good ESG policies. These bigger managers are more like solution providers for the LPs, giving them a lot more than just returns.”

The resilience of private equity was on full display in the first half of 2021. After weathering marked declines in deal volumes, fundraising, and exits in 2020, many firms bounced back with record levels of fundraising, deal activity, and exits. Research indicates that recovering macro conditions and the widespread availability of financing should continue to provide strong tailwinds for private equity as it enters the second half of 2021.