Private Equity Capital Overhang from a Middle Market Perspective (part II)

Statistics: The only science that enables different experts using the same figures to draw different conclusions.” – Evan Esar, American Humorist (1899-1995)


As I have suggested before, the Private Equity market place is not monolithic and most attempts to describe the market in generalities, be it performance or otherwise, fall flat – especially if one is trying to use the information to make ground-level decisions related to investing in a specific segment or sector like the middle market.


  • “How does a macro figure like $432B of capital overhang translate to the middle market?”
  • “How does it impact my decisions on investing partners?”
  • “Is the sky really falling?”


201304_overhand_silloetteAs an illustration of how data can be skewed: In 2011 deals greater than $1B accounted for 55% of capital invested across the year; however, deals less than or equal to $1B accounted for approximately 92% of deal volume (count)[1]. If you take data (e.g. debt multiples, relative equity contribution, etc.) that are typically very different in mega deals as compared to middle market transactions and then weight the averages by capital invested and then by number of deals – you would have very different results. In this example, the global number would not tell a meaningful story of variance in key metrics between the market segments – this weakens the power of the descriptive statistic considerably.


Getting back to the question of capital overhang, I find the error in using global statistics to describe the sub-sectors of the private equity market equally present in the discussion about dry powder in the market. As outlined in the July 1, 2012 post, there are three important questions about the capital overhang debate that impact the middle market investor:


  • Is the urgency implied by the capital overhang balanced across fund vintages?
  • Do the challenges of the capital overhang impact all sectors (e.g. mega buyout vs. middle market) in the same way?
  • How does this impact investing with private equity funds in the middle market?


We tackled the first question in an earlier post. In this second of three installments, we’ll look into the second question:


Do the challenges of the capital overhang impact all sectors
(e.g. mega buyout vs. middle market)?


In a word, the answer is no. It is very difficult to suggest that the middle market funds face the same challenges as their larger cousins.  Let’s take a look at this across two dimensions:
First, of the overall market overhang of $432B, more than $122B (28% of the total) resides in funds greater than $5B in size, $196B (45%) are in funds $1B to $5B in size, while just $114B (27%) of dry powder is located in funds targeted squarely at the middle market with fund sizes less than $1B. Figure 1 illustrates the distribution across vintages (with relative contribution represented by the width of the respective columns) and by fund sizes (represented by relative stacking within columns). As we noted in the previous post, about 45% of overall capital overhang is in the older vintages (2006 -2008) – while the majority was attributable to funds raised post-crisis.


On the second dimension, I find it compelling that a relatively marginal amount of dry powder relates to the smaller funds
[2]. The dry powder in older vintages (2006 to 2008) attributed to funds with less than $1B in size accounts for less than 10% of the total capital overhang of $432B. This suggests that these smaller funds as a class have a less urgent challenge than the larger funds.


The larger funds had raised a lot of capital in the boom and have nearly 50% of their total dry powder in the older funds (2006-2008). Conversely, smaller funds (those <$1B) have less than 37% of their total dry powder in similar vintages. If the volume of middle market deals can be sustained, the smaller funds appear to have a clearer runway to working down capital overhang than do their larger cousins.


Across the last two posts, we’ve peeled the onion on the capital overhang data to argue that the challenge is more subtle due to weighting of the dry powder across vintage years and across fund sizes. With respect to the middle market investor, it gets even more interesting as we have to be smart about potential entrants (e.g. the $1B funds moving more aggressively down-market) and the performance of specific legacy middle market funds.


For example, there are most certainly more small funds – especially freshman and sophomore funds raised in boom years – in the older vintages that may well have stalled out in their investment activities and are now in de facto run off mode. These funds, which are likely to be running with weak investment multiples and IRR’s below return thresholds in Limited Partnership Agreements would be very challenging funds with which to invest as their interests may not align with others in a potential capital structure.
More on that in the next post…


[1] Pitchbook Annual Private Equity Breakdown 2012 (Presented by Merrill Datasite)
[2] Pitchbook The 2012 Pitchbook Capital Overhang and Fund Cashflow Report

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