Success pushing some private equity firms into uncharted waters

Updated with clarification

Style drift in private equity is back, and some say it could be a sign that the market is topping out.

Despite a global dip in private equity fundraising overall in recent quarters, the most popular private equity managers are raising ever-larger funds that tend to make ever-larger investments. The highly sought-after, often lower middle-market or middle-market managers are having no trouble closing funds that are 30% to 60% larger than their last funds. Managers are lured — at least in part — by the management fees on larger pools of capital.

Among the new larger funds that have closed in the past 18 months are:

nComvest Partners on Oct. 14 closed its fifth middle-market private equity fund, the $893 million Comvest Investment Partners V, which exceeded its $700 million target and is 53% larger than the prior fund, the $580 million Comvest Investment Partners IV;

nFriedman Fleischer & Lowe closed its fourth fund in June with slightly more than $2 billion, exceeding the $1.5 billion target. The new fund had 33% more capital than its prior fund, the $1.5 billion Friedman Fleischer & Lowe Capital Partners III, which closed in 2008.

nKinderhook Industries LLC last year held a first and final close of its fourth private equity investment fund, the $500 million Kinderhook Capital Fund IV, exceeding its $400 million target, with 67% more capital than its prior fund.

Besides the fundraising, managers' assets are further bolstered by growing sums committed to co-investments, direct investments and separate accounts.

Larger funds need to make larger investments and can send once-upon-a-time middle-market managers further away from the kinds of investments that generated their record returns.

There is voracious demand from limited partners for high-performing middle-market funds, said Jonathan Grabel, chief investment officer for the $14 billion New Mexico Public Employees Retirement Association, Santa Fe.

Private equity funds worldwide raised a total of $385.4 billion in the first three-quarters of this year, down 1% from the first three quarters of 2014, according to data from London-based alternative investment research firm Preqin.

And investors are not just investing in funds any longer, Mr. Grabel noted. “Co-investments are changing the dynamic,” he said. “Co-investment has really taken off in a bull market cycle.”

Some 56% of private equity investors surveyed by Preqin expect to increase their level of co-investment alongside fund managers in the next 12 months.

These ballooning fund sizes are just one indication that the private equity market may be nearing a peak, industry insiders say.

“We are seeing maybe signs of a top,” said David Fann, president and chief executive officer based in the New York office of private equity consulting firm TorreyCove Capital Partners LLC.

Not only are popular smaller firms raising larger and larger funds, but alternative investment managers in general are moving into new strategies, he said. “We see public investors, hedge funds and buyout (firms) all moving into late-stage venture capital deals” at high valuations, he added, though he declined to provide examples.

With more capital to invest, these now-larger managers can no longer invest in the smaller companies that earned the returns investors have come to expect.

“It's the nature of the beast for small- and middle-market firms. ... Firms start in middle market and move to the larger and megabuyout space ... the economics are an enticement,” said Kevin Campbell, managing director and portfolio manager in the private markets group at funds-of-funds manager, DuPont Capital Management, Wilmington, Del. “They raise more money because they can.”

And the management fees a firm earns on a larger fund are also enticing, he said. “It's pretty alluring to raise the larger fund size when you can, but it's a shame when it happens,” Mr. Campbell said.

Investing a $200 million fund in companies with $5 million to $10 million of earnings is a very different business than investing a $5 billion fund in $100 million companies, he said.

“It takes very different skills, which are not appreciated by members of the GP and members of the LP community,” Mr. Campbell said.

The same thing happened in 2006 and 2007 with disastrous results, he noted. “We think there is an inverse relationship between fund size and performance for most groups,” Mr. Campbell said. “We are in an environment today where capital raising is easier than it was in 2009, so there is a temptation to go out and raise larger fund sizes. We don't believe they should do that simply because fund size for a majority of those firms often has a negative impact on their performance.”

In a down market, the larger funds raised this cycle, combined with co-investments, could amplify any negative returns, New Mexico PERA's Mr. Grabel said. “Co-investments make a more concentrated portfolio,” which amplifies returns both up and down, he said.

“It's also always worrisome when firms move outside of their sweet spot whether it's geography, size of transaction or sector orientation,” TorreyCove's Mr. Fann said.

A twin concern is uncertainty around what the condition of the financial markets will be when it is time to exit, said Mr. Campbell.

“Any time a decent amount of capital is being raised, you wonder how that capital is going to be absorbed, and how and when it is deployed, and what is the environment going to look like when it is being deployed,” he said. Frothy public markets combined with large amounts of capital being raised by private equity firms “is a recipe for disaster for private equity.”

The issue of private equity firms raising larger funds is “something that we regularly wrestle with when looking (to invest with) groups,” said Ian Aaker, principal in the San Diego office of alternative investment consulting firm StepStone Group.

It is often much more difficult to generate outsized returns investing in larger companies. “It's easier to change the direction of a destroyer than a battleship,” Mr. Aaker said.

There is stiffer competition for larger transactions, and bigger deals often go through auction processes that increase prices, he explained. What's more, management teams are better in larger companies, so changing its course could be tricky, Mr. Aaker said.

Some middle-market private equity firms are moderating their fund sizes, despite a high degree of investor demand.

Earlier this month, Aberdeen Asset Management PLC closed the $295 million FLAG Private Equity VI LP, $70 million above the fund's target, said Scott Reed, head of U.S. private equity at Aberdeen. This is the first fund closing since the September completion of Aberdeen's acquisition of private equity firm FLAG Capital Management.

The fund reached its hard cap after only five months of fundraising, Mr. Reed noted. But once the limit was reached, Aberdeen executives stopped fundraising and started investing, he added.

“There's been so much capital flooding into the lower middle market recently, leading some managers to raise more and more capital and move up the food chain,” Mr. Reed said. “It's become a meaningful factor in the last 12 months.”