This article originally appeared on Forbes.com.
It's hard to view the unprecedented flow of capital into private equity funds over the past five years as anything but positive. Buyout funds alone have raised a stunning $1.1 trillion since 2012, and last year's record fund-raising of $301 billion in buyout capital signaled that investor enthusiasm is only increasing.
At the same time, the industry's inability to put money to work as fast as it's coming in is generating annual records in a more problematic metric—dry powder. The number of individual deals has dropped 19% since 2014, and while a steady rise in the average deal size is buttressing value, the industry still isn't putting money to work as fast as it's coming in. At the end of 2017, buyout funds were sitting on an all-time high of $633 billion in uncalled capital. The total has been rising at a rate of 12% compounded annually for the past five years, and 45% of it sits with the expanding population of megafunds, those with more than $5 billion in capital.
This structural imbalance is, without doubt, the industry's biggest challenge. It stems from heavy competition for deals, which has driven multiples for around half of all buyout transactions to more than 11 times earnings before interest, taxes, depreciation and amortization, according to Cambridge Associates.
That's clearly getting in the way of closing more transactions, despite robust global M&A activity generally. In 2017, 38,479 companies were bought and sold around the world, at an estimated value of $3.3 trillion. But private equity's share of this vibrant market was just 13% by value and 8% by deal count.
If the industry could carve out a bigger slice of the M&A market, as it did in 2006–07 when its share hit 20%, the dry powder numbers would begin to turn around. That, however, would require some significant changes in how most PE funds approach the market.
What would those changes look like? The biggest impediment to grabbing a larger share of the M&A market in recent years has been corporate buyers' voracious appetite for assets. These are often upper-midsize to very large businesses buying other businesses of around the same size to increase scale and, frequently, expand scope. At auction, their advantages can be decisive. The long-term synergies and strategic benefits that can come from building scale and scope through large-scale M&A help them justify higher prices.
This suggests that one way megafunds could win more deals is to act more like large corporations—namely, by making a fundamental shift in strategy to buy platform assets and execute M&A as a primary source of business growth. PE funds, of course, bring many of their own strengths to the table at auction. Capturing some of the advantage that makes corporate buyers so competitive would allow general partners to use skills honed over decades of managing complex deals to beat corporations at their own game.
Examples of funds using bold M&A strategies to build very large companies aren't plentiful, but they have been increasing in recent years. The latest headline deal came in January, when JAB Holding Company announced a $21 billion deal to merge Dr Pepper Snapple with its Keurig Green Mountain platform, creating a new beverage giant called Keurig Dr Pepper with $11 billion in revenues. Other examples are less splashy: In 2017, Advent International partnered with Bpifrance to merge its Oberthur Technologies with Safran Identity & Security (Morpho), creating a company called IDEMIA that has combined revenues of €2.9 billion. Vista Equity Partners created a large competitor in the global meeting and event planning business by acquiring Cvent for $1.65 billion and merging it with its Lanyon Solutions. Stone Canyon Industries spent $2.3 billion to acquire Mauser Group and merge it with its BWAY Corp. to create a global leader in containers and packaging.
That M&A-driven deals like these are the exception in the PE universe owes to a number of factors. First, a buyout fund's standard holding period of three to five years isn't calibrated to M&A strategies that can take twice that long to bear fruit. Larger deals, by their nature, can also involve greater risk. They require substantially more capital and tend to create more concentration in a portfolio. Building scope means moving beyond the core into new customer segments, geographies or business adjacencies. It may require developing new capabilities or learning new markets. The bet is on turbocharging growth, not necessarily cutting costs, a tactic that has played to private equity's strength historically.
These challenges will take many buyout funds out of their comfort zone. But they also represent a ripe opportunity to put large amounts of capital to work. Success will require getting even better at complex, large-scale balance sheet management and developing differentiated investment theses to create transformative growth. It will involve better talent management, rapid operational execution and a full understanding of how to use digital innovation to best advantage. Many large PE funds have some of these skill sets, but few have all or enough of them to make "beating corporate buyers at their own game" a centerpiece strategy. That means most will have to rise to the next level of professionalization and operational sophistication.
Bain & Company's latest Global Private Equity Report is devoted to exploring the ways in which funds can raise their game to meet the industry challenges in 2018 and beyond. There's no reason private equity shouldn't claim a bigger share of the M&A market. Beating corporate rivals to the punch may be a powerful way to gain some ground.
Hugh MacArthur, Graham Elton, Daniel Haas and Suvir Varma are leaders of Bain & Company's Private Equity practice.