But RJR Nabisco is remembered both for its size and its disappointing performance. The company languished for several years despite KKR’s attempts to energize it. After spinning off its tobacco business, KKR disposed of the remaining bits in 2005. Whether the large LBOs being arranged today will perform any better is an open question, especially since they have an additional element of risk: The largest transactions today are typically backed by consortia of private equity firms.

TOP VIEW: Many of the leveraged buyouts of extremely large companies such as SunGard, Hertz and GMAC in the United States and Europe have been sponsored by consortia of private equity firms. These transactions carry the novel risk that a consortium’s members–who otherwise face off in heated competitions for the best assets–may have a falling out over strategic or administrative aspects of a deal. But specialists say the real problem with these transactions is the difficulty their sponsors face getting large, often mature companies to grow at the rapid clip their investors expect.

In 2005, a group of eight leading private equity houses, including Silver Lake Partners and The Blackstone Group, purchased SunGard Data Systems, a financial technology company, for $11.3 billion. The deal was topped shortly thereafter by a consortium consisting of The Carlyle Group, Clayton, Dubilier & Rice and Merrill Lynch Global Private Equity, which bought Hertz for $15 billion. A host of similar, though often smaller, deals has closed in the past two years.

The investment guidelines of most private equity funds prohibit them from putting more than a predetermined percentage of their assets in any one transaction, primarily to avoid exposing investors to the risk of overconcentration. For transactions measured in the billions of dollars, even the largest funds may be forced to ally themselves with rivals in order to aggregate enough equity capital.

These Brobdingnagian private equity deals are leading private investors and family offices into uncharted territory. Those that have channeled money into the popular private equity funds of funds may already have exposure to megadeals, or will as the transactions proliferate. Investors need to weigh how their risk-and-reward landscape differs from more traditional, smaller private equity fund exposures (and from direct exposure to particular buyouts). They must determine the return potential of these leviathans–essentially, whether such large and established companies can be substantially improved within private equity investment timeframes.

"Just as there will be failures of smaller transactions that no one will ever hear about, there are going to be some failures of these mega transactions, but they will be highly publicized," says Tony Rickert, Washington-based chair of the U.S. private equity practice group at DLA Piper Rudnick Gray Cary. He adds that the failures of large and small deals will arise for the same reasons: "Overpaying for a company; not anticipating its problems; borrowing too much money; and not having enough cushion between the amount of debt you borrow and what you pay for the company to be able to work your way out of a problem."

Small Triumphs
The risk of actual loss, versus the risk of underperformance, may differ from smaller transactions, Rickert says. "I think the risk of losing your principal is either the same or slightly less with these mega transactions, but I think the jury is still out on the risk that you will not make as much upside as you had hoped. I believe it is more difficult with the mega companies to create additional growth, which is the basis for profitability and increasing the value of your investment."

This, Rickert argues, is because larger companies generally have more stable cash flows than their smaller counterparts. Their big balance sheets, along with their generally more diversified operations, mean they can weather economic imbalances more easily than the smaller businesses. "The large-cap companies can withstand the bumps in the road. Losing a major customer, for instance, could have a large impact on a smaller company, but a larger company can withstand the volatility," says James McGovern, managing director at private equity investment advisory firm Franklin Park, based in Philadelphia.

McGovern says investors should naturally expect lower returns on these transactions than can be reaped on smaller deals, because they have lower risk. "For the mega buyout deals, we tend to look for funds that can generate at least 2-times return on capital over a five- or six-year holding period, which is about 20 percent internal rate of return. Whether they can do that is the question. Most of them will end up in the 1.5- to 2-times range. In the smaller and middle end of the market, our return bogey is higher, say 2.5, close to 3-times return on capital," he says.

Robert Friedman is the New York-based senior managing director, chief administrative officer and chief legal officer of The Blackstone Group, one of the largest and most successful private equity firms. He says that large transactions’ stability is an advantage, in part because it makes the debt-raising process easier. "You get more competitive financing," he notes. The exit strategy is also more efficient with larger deals, he argues. "Bigger initial public offerings tend to be more successful because they give the market the greater liquidity that it wants."

Expanding the Expansive
Despite this, size can bring its own problems. It is easier to create value by buying, say, a chain of restaurants in the Midwest with a view to increasing its advertising budget to gain market share than it is to grow a multinational company like SunGard or Hertz. "There is no doubt it is harder to grow a $5 billion company 10 percent a year than a $200 million company 50 percent a year," notes Paul Deninger, Boston-based vice chairman of investment bank Jefferies, which provides financing for private equity deals. McGovern adds, "When we meet with the bigger buyout fund managers, we talk a lot about competitive dynamics, and we try to figure out whether they are just competing based on price, or whether they have some kind of factor that differentiates them from their peers in the market. That’s what investors need to look for."

Gaining a sense of the probability of success when no two transactions are the same may be best left to the professionals, either fund of fund managers or specialist private equity advisors. "Each deal has its own investment thesis and its own strategy," Friedman says. Take General Motors’ $7.4 billion sale of a 51 percent stake in its GMAC financing business to a private investor group led by Cerberus Capital Management in April. GMAC itself is a healthy company and is very profitable. By detaching it from its struggling parent, the aim of the new owners seems to be to reduce its cost of capital and eventually secure credit rating upgrades. If they succeed, they will make GMAC an even more profitable business. However, it looks as if GMAC’s core business, financing GM’s sales, will remain unchanged. Here, investors have to weigh the probability of those credit upgrades against the risk that their main customer may go bust.

And, despite the fact that a driver of these deals is the need to avoid concentrated risk, investors in funds involved in these mega transactions may find themselves exposed to risk in another way. "You may have put money in various different funds to spread your risk out, and now these funds are all clubbing together and making one investment," explains Malcolm Wright, a partner in the New York office of KPMG, an international network of financial firms.

The viability of deals done by consortia depends, crucially, on the ability of these rival firms to set aside their differences and work together effectively. "Each one of these firms has a different point of view on almost every issue, I suspect, and I think it’s the nature of the beast that you add more layers of complexity the more people you add," says Charley Jacobs, who heads the private equity practice area at Boston-based law firm Nixon Peabody.

Even so, many of these firms partner again and again. And, as an October 2005 analysis from the Private Equity Leadership Network, an industry group, noted, classic game theory holds that while one-time partnerships are fraught with distrust, the value of cooperation increases dramatically for those who anticipate working on a series of deals together.

"So far we have not had a single problem," Blackstone’s Friedman reports. "We try to choose our consortium partners based on firms we know that generally have the same views that we do. Will we experience significant disagreements among some consortium members in the future? Most probably. But it hasn’t happened to us yet in any of our consortium deals done in the past few years." Friedman says different parts of the process can be farmed out to individual partners–one partner is more responsible for the "100-day plan," the strategy immediately put in action once control is acquired, while another might be responsible for asset divestiture plans, and so on.

Because the club megadeal is a new phenomenon, it may be several years until sponsoring consortia engineer liquidity events and observers can see just how successful they have been. Until then, potential investors in the funds that pursue them should scrutinize the value-creation rationale behind every deal, while keeping in mind that the safety element that a big balance sheet introduces can also stifle returns. And, as with any transaction type, there is always the chance that a deal will sour. As Jacobs says, "There is no question that there is going to be some fallout from some bad deal down the road."