I read with interest your letter from the editor titled “Smaller Funds Don’t Often Outperform, Study Finds” in your December 14, 2009 issue (page 56). You state that “the argument behind why small buyout shops should theoretically outperform their larger counterparts is persuasive.” But you conclude by stating that “An analysis of return data tracked by Thomson Reuters IBR from 1987 to 2004 undermines the theory that small funds outperform large funds in general, although you can probably find periods of time where smaller categories have outperformed.”
As a partner in a lower middle-market mezzanine fund that supports lower middle-market equity funds, I realize that I am biased. However, I am a firm believer that experienced managers of lower middle-market funds can expect to out-perform the larger market as a whole during most time periods. I think your conclusion may be a little hasty given the following:
Date of data: The data you are interpreting (vintage years 1987 to 2004) is a little dated. The vintage years only go through 2004, which is understandable due to lack of final numbers to judge post-2004 vintage year funds. However, the misalignment of interests prevalent in larger funds (e.g. mega-funds) probably became more of an issue in recent years. The proliferation of large mega-funds with management fees that incent the raising of a fund more than the prudent investment of that fund really gained steam in more recent years. Institutional investors have recognized that, even though the complete data to confirm the results of that misalignment of interests may not yet be available.
Cycles: The IBR report itself shows that smaller funds outperformed larger funds for a large time frame (1987 to 1996). However, larger funds (on a median basis) outperformed smaller funds for the following period to 2004. This probably runs in cycles. The fact that smaller funds significantly outperformed larger funds for such a large period makes it hard to conclude that larger funds usually outperform smaller funds.
Median vs. top-quartile: One of my biggest concerns is the use of median numbers. I would think top-quartile numbers might tell a different story. There are numerous advantages to the lower middle market, many of which you cite in your piece (e.g. lower purchase price multiples, lower leverage multiples, etc). However, smaller companies can also imply higher business risk (lower market share, thinner management teams, higher customer concentrations, etc.). That is why it is important for investors to invest in experienced and successful management teams in the lower middle market. There are simply less barriers to entry to get into the lower market, so the universe as a whole may reflect less experienced management teams “at the median”. However, if you look at top-quartile performers, you most likely are comparing highly experienced management teams in each market (more of an apples-to-apples comparison). In that case, I would think that the advantages of the lower middle market will be reflected in the returns comparison.
Industry comparisons: To compare apples to apples, you probably need to make sure the investment make-up is the same for the markets being compared (i.e. basic industry vs basic industry; tech-oriented investments vs tech-oriented investments, etc.). I wouldn’t be surprised if a lot of small tech funds were included in the late 1990s database that did very poorly and could have skewed the results.
Public exits: I expect that the larger funds with 2002 to 2004 vintage years benefited from public exits (taking advantage of the exuberant public markets) more than did smaller funds. Larger funds do have the advantage of shifting the focus of their exits between public IPOs and selling privately to other funds or strategic buyers given the relative strength of the public market. Smaller funds don’t usually have that flexibility. Thus, returns for some vintage years for public funds might be bolstered by this fact. But in other years that advantage doesn’t exist and hence the advantages of the smaller market may dominate in those periods.
We all wish our industry had more complete data to make these sorts of questions easier to analyze. But then we wouldn’t have the fun of arguing about it!! I would be interested to know what other readers may think of this issue.
Michael D. McHugh, Managing Principal
GMB Mezzanine Capital