It is widely believed that the number one concern for LPs is the high multiples in today’s private equity investing.  At the same time, LPs continue to pour money into managers with multi-billion dollar funds who are chasing mega-deals to put investor money to work.  What is ironic about this, however, is that these mega-deals are trading at the highest multiples.

Median buyout multiples have hit 10.2x in 2017, which, according to PitchBook, is up from 5.7x in 2009.  There are many theories as to why multiples are rising, but the amount of money that managers have at their disposal is clearly one of them.

  • Since the beginning of 2016, buyout funds have raised $337 billion across 394 vehicles (average fund size of $855 million) – PitchBook
  • 48% of LPs intend to increase allocation amounts to private equity – Preqin
  • 2016 marked the fourth consecutive year PE managers raised more than $300 billion – Preqin
  • PE firms hold $872 billion of dry powder globally – PitchBook

Apollo Group announced this week the closing of a $23.5 billion buyout fund, the largest accumulation of cash ever by a PE Fund.  This comes a month after CVC Capital Partners, a London-based buyout firm, raised $18.14 billion.  Three other North American funds have exceeded $10 billion in 2017, with Silver Lake Partners, KKR, and Vista Equity Partners closing funds totaling $15b, $13.9b, and $11b, respectively.

The concern for LPs is that as fund size increases, so do multiples, resulting in lower returns. In their Exploring Buyout Multiples report released in June 2017, the Pitchbook authors write, “When returns to PE have been the highest, for vintages 2001 through 2003, buyout multiples were some of the lowest we’ve seen in the last two decades- below 8.0x in each of those years.  Similarly, when median returns have been the lowest- for vintages 2005 through 2007- buyout multiples were at record levels, exceeding 10.0x in 2006 and 2007.”  Based on these statistics, we would expect allocations to large funds chasing mega-deals to decrease.

However, a 2017 Preqin LP survey found that managers who have raised funds of $1 billion or more have an easier time raising a follow-on fund.  The survey continues to report that a top 50 manager, on average, raises 2x more capital than a 51 to 100 manager.  This is illustrated in the Preqin chart above, which shows fund size for top 10 managers exceeds $4 billion.  The same chart shows the average fund size for managers ranked 51-100 is $1.7 billion, with these funds surpassing their fundraising goal by 12%.

PE Fundraise Breakdown by Rank

Are All Multiples High?

PwC reports that the private equity sector where multiples are increasing the most is Software.  Acquisitions by Cisco, HP, and the $15.4 billion first quarter acquisition of Mobileye by Intel helped push multiples up across private equity.  Preqin documented that year-to-date venture capital exits are down 9%, yet values are up 17% compared to the first half of 2016, with Software and Health Care representing 48% of all exits.

The good news is, research suggests lower multiples are available in smaller companies.  Per PitchBook, the median multiple for mega-deals, greater than $2.5 billion of revenue, has reached 12.3x.  In comparison, multiples for companies with less than $25 million equal 5.6x.  The PitchBook report goes on to say that multiples for companies with revenues between $25 – $100 million and $100 – $500 million are 7.8x and 9.4x, respectively.Median Global Buyout Multiples by EV

Higher Risk Associated with Smaller Funds

The $23.5 billion Apollo Group fund could not survive with a strategy to invest solely in sub-$100 million deals.  Apollo must look to $1 billion plus opportunities to place investor money in a timely manner.  However, sub-$250 million managers make a living operating in this space.  The concern is, will investors’ risk increase when investing in managers who target smaller companies?  Small companies present more risk because, typically, their management teams are less experienced, the firm’s systems/technology are less sophisticated, and customer/exit networks are smaller.  These factors often make deals riskier.

For those investors willing to take the time to properly perform diligence on a manager, the rewards can be great.  Lower multiples are available to funds chasing smaller companies, which positions investors for greater returns.  Money managers with the ability or resources to research and identify pedigreed managers with the industry experience to direct management teams towards growth will typically outperform the markets by a generous margin.

It is hard to find a money manager who was fired for investing in a name brand fund with billions of dollars under management.  This is even true as the statistics point to lower returns as multiples increase.  For those money managers able to source and diligence smaller funds with pedigreed managers, the reward should be significant.