Private equity mega-funds are vehicles with pooled capital of $5 billion or more. These large funds can deploy billion-dollar plus equity checks and make up a significant and growing portion of overall capital raised in private equity.
Mega Buyout Funds
Additionally, an overall shift in LP sentiment has also contributed to the rise in private equity mega-funds. Increasingly, LPs are raising their private market allocations, giving preference to managers that take larger commitments and employ multiple strategies.
From 2019 to 2021, private equity mega-funds raised $407.4 billion. With record-setting deal activity and the quick deployment of capital, firms have experienced smooth fundraising cycles and GPs have been able to return distributions to their LPs faster, with many LPs then recycling these distributions into new funds.
GPs managing mega-funds are often large private equity firms, like Blackstone Group, Goldman Sachs and Kohlberg Kravis Roberts. These larger, diversified firms with deep relationships and expertise in a range of areas are often the go-to source for LPs. Still, smaller, more specialized firms are also increasingly raising mega-funds, including those with tech-focused or niche strategies (including GP stakes).
In fact, the current environment of easy fundraising for GPs, has allowed emerging PE mega-fund managers to break into the space. This year, smaller private equity firms like Summit Partners and Veritas have seen quick growth, easily surpassing the $5 billion mega-fund mark for their flagship funds.
Private equity mega-funds offer GPs a (relatively) less competitive avenue in which to do business as middle-market strategies become more crowded. For larger firms, the sheer amount of capital involved acts as an advantage, creating a buffer that is difficult for smaller firms to overcome. In recent years, the lifecycle of a mega-fund has also proven advantageous for LPs, as the quick turnaround of these vehicles has allowed them to deploy capital quickly and return to market.
For GPs, the massive amount of capital in a mega-fund means that fulfilling their expected commitment becomes difficult for more junior partners. For example, for a $20 billion fund, an otherwise reasonable 3% commitment becomes a whopping $600 million.
These historically high private equity mega-fund targets are significant in that LPs have traditionally held the sentiment that mega-funds should not surpass the $20-25 billion range. However, despite this traditional perspective, the demand for these vehicles remains.
The current macroeconomic conditions marked by high inflation and interest rates along with market recalibrations on valuations may present some challenges in the private equity mega-fund environment heading into the second half of 2022.
However, there are some market conditions that favor mega-funds over other middle market alternatives. Currently, the demand of capital by GPs is greater than the amount LPs have to allocate, which favors large private equity firms who are better positioned to receive LP allocations.
Our library of over 500 GP profiles uses commercially available data to produce our proprietary metrics, which analyse private equity fund performance across performance/benchmarking, strategic differentiation, and risk (including return dispersion). Mega buyout funds in the MJ Hudson Fund performance analytics GP profile library include key players such as:
With most communication still happening through Zoom or Microsoft Teams, investors are handing more money to the funds they already know. That means the average fund size grew by 9 percent as of the third quarter. As a result, smaller funds without well-known brand names need to figure out how to get in front of investors.
There were also surprises along the way. When markets cratered beginning in March, industry observers were concerned that investors would fail to make their capital commitments to private equity funds.
As investors search for returns, capital has continued to pour into private equity. The average size of buyout funds has increased substantially over the past 10 years as private equity has come to account for a meaningful allocation of institutional portfolios.
Despite a turbulent year, in 2022 all mega funds in the US raised $179B1, representing 52%1 of all private equity capital raised. These include tech specialists such as Francisco Partners closing on $13.5B3 for its latest flagship fund and Thoma Bravo announcing it raised $24.3B1 for its latest flagship fund.
Within technology, outsized returns are actually most acute within the small-cap segment. Over a 10-year investment horizon ending in 2021, small-cap, technology-focused buyouts have outperformed the private equity industry as a whole by a whopping 700 basis points5. Further, small-cap, technology-focused firms outperformed all other size segments within technology buyout.
We believe that small tech buyout funds are well-positioned to continue to outperform at an ever-increasing rate, driven by 1) valuation advantages on the buy, 2) attractive growth potential during the hold and 3) efficient and well-capitalized exit markets, leading it to be one of the most attractive segments within the buyout ecosystem.
Small-cap tech buyout funds seek exposure to compelling, lower-middle-market software and tech-enabled services companies. Often these companies generate $10-$50M of revenue, are growing, and are at break-even or profitable. There are an estimated 85K software and software-enabled services companies generating less than $50M of revenue6.
With limited private equity capital chasing this massive market opportunity, less competition creates notable valuation advantages, allowing small-cap managers to access deals at much more attractive entry values vs. their larger peers. When looking at the median software and services multiples over the past 15 years, there is a remarkable 5.4x turn delta between the small-cap deals ($50-$200M equity investments) and the mega-fund deals ($1B+ equity investments).
These smaller companies can be attractive to upstream buyout funds as new standalone platforms, or as add-ons to existing platforms, as larger buyout firms execute on their own buy-and-build strategies to scale their existing platform investments or to create synergies that can reduce costs or add revenue. In 2022, the number of add-ons as a share of buyout deals reached a record high of 78%1.
We believe that small tech buyout funds are the best kept secret in private equity and will produce outsized returns for investors. This outperformance is driven by several key dynamics, including 1) lower entry valuations, 2) attractive inorganic and organic growth potential during the hold period and 3) efficient and well-capitalized exit markets. As a result, top quartile managers in the small end of the market have generated the highest MOICs of nearly 4x7 on transactions compared to their larger peers, ranging from 2x7 to 3x7 MOIC. In Part II, Industry Ventures will discuss the importance of the small buyout manager selection process and the ability to gain access to top quartile performance in small tech buyouts.
This evolving landscape represents a significant opportunity for investors. By our estimate, there are more than 1,000 venture-backed software companies that have not raised capital in more than eight years and are ripe for a private equity (PE) exit. Because many of the buyout behemoths are focused on opportunities elsewhere, this has created openings for specialized funds targeting smaller tech companies.
Indeed, there are a number of emerging managers seeking to capitalize on these developments who are well positioned to succeed. Experienced software investors have tended to outperform peers with broader mandates, and it is this profile of investor behind many of the small tech buyout firm launches. Furthermore, emerging managers in the space have historically produced greater total-value-to-paid-in (TVPI) multiples in initial funds than in follow-on efforts. We believe these funds together with the prospect of being able to co-invest alongside these emerging managers as they raise capital, provides a compelling opportunity to generate attractive returns for LPs.
We have seen this trend unfold first-hand across our universe of portfolio companies, as well as through those held by the venture funds where we are LPs. In aggregate, our funds have seen 20+ exits to buyout firms over the past three years. Many of the exits to-date have been in SaaS companies, as the business model lends itself well to private equity, and the history of venture investment in that model has created a number of attractive targets. We explore the SaaS dynamic further here, but anticipate many other venture segments to experience a similar exit trend going forward.
In response to these favorable market dynamics, new tech buyout funds are emerging, targeting companies that have not (yet) achieved critical mass. Indeed, the larger buyout specialists in this segment have experienced remarkable growth in a relatively short period of time. After raising $822.5 million for its Fund IX in 2009, for instance, Thoma Bravo closed Fund XIII seven years later at $7.6 billion. Others that have achieved similar successes include Vista Equity, which has garnered $11 billion in commitments for its seventh fund, Francisco Partners, Accel-KKR, Marlin Equity and Vector Capital. We have watched these firms grow over time, and believe the small end of the market defined as sub $100M tech buyout deals is a very compelling part of the market to focus on for new emerging funds. Not only can these funds roll-up smaller companies into a larger entity, generating synergies in operations, finance, sales and development, they can also acquire and sell these smaller companies to large buyout fund portfolio companies as add-on acquisitions.
Many of the emerging managers are employing opportunistic approaches that heighten the potential for accelerated paybacks and larger returns on capital. We have seen, for example, small tech buyout funds reaccelerate growth at older, formerly venture-backed businesses and then execute dividend recap strategies that enabled them to cover their acquisition costs and produce incremental returns. In doing so, we believe, they also provide liquidity to their owners that is somewhat immune to the vagaries of the stock market.
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