Large-cap Buyout Binge Implications

After sorting through about ten potential launch topics, I decided to write my first post on the growing concentration in mega and large-cap leveraged buyout funds in the U.S market. One could make a convincing argument that the returns from this small group of funds will be less variable than the returns from the broader U.S. buyout market, due to a combination of club deal concentration, competitive prices and the larger exposure to market / economic risk provided by $5-10 billion companies.

According to several data sources, commitments to U.S. buyout funds in 2005 and 2006 that closed — or are expected to close — on more than $3 billion represent over 50% and 60% of each respective vintage’s cumulative buyout commitments, despite representing less than 10% of the number of funds raised per year.

The future implications of this concentration are significant.

No matter what the performance, return data for these vintages will be heavily skewed by pooled average returns. If the “mega funds” outperform the broader U.S. LBO market, the clear winners are large pension plans (and their consultants) who, due to the size of their programs, are heavily concentrated in the large LBO space. This could lead to a revision to Josh Lerner’s piece on investment performance by organization type…

The likely losers in this scenario are the small and mid-cap buyout managers, who would probably face an even tougher fundraising environment during the next 3-4 year cycle. If the “mega funds” under-perform, the winners and losers are obviously reversed and a huge demand would likely emerge for investment vehicles offering diversified exposure to the small and mid-market funds, because large pension funds are not equipped to deploy billions of dollars each year using $10 million commitments.

Finally, I can envision the bulge brackets creating and marketing new hedging instruments for pension funds to reduce their value at risk to the mega fund strategy. While I would agree that the volatility in large leveraged buyout deals may be lower than an early stage venture strategy, financial exposure is a measure of the volatility AND amount of capital at risk. Of all the private equity strategies, large cap buyout is the easiest to create equity-linked contracts of comparable companies that could be used to take defensive positions.

Just a few thoughts on the subject, but I am sure the peHUB readers have a variety of opinions / forecasts, so please post your thoughts.