Institutional investors tend to be especially wary of first-time funds, and rightly so by at least two measures.
Since 1976, investors in first-time buyout and mezzanine funds have generally experienced lower net IRRs and investment multiples than have investors in follow-on funds, according to the latest edition of Investment Benchmarks Report, an annual study of private equity returns by Thomson Reuters, publisher of Buyouts. The study includes 708 of the estimated 1,758 U.S.-based buyout and mezzanine partnerships raised from 1976 through 2008, representing $542.9 billion of the $892.3 billion raised.
Consider the 17 vintage years (with 1976 to 1983 counting as a single vintage) for which the study had adequate data to make a comparison. First-time funds generated an average investment multiple of 1.6x across those vintages, and a median investment multiple of 1.4x. That was measurably lower than the 1.7x average investment multiple and 1.6x median investment multiple generated by follow-on funds. The story was similar for pooled IRRs for those 17 vintage years: The average and median pooled IRRs for first-time funds of 10.0 percent and 7.8 percent, respectively, fell short of the 13.1 percent and 13.2 percent average and median pooled IRRs achieved by follow-on funds. (The study produces pooled IRRs by combining all funds in a particular sample and using their collective monthly cash flows to calculate a return.)
But by one significant measure, investors can actually count first-time to be less risky than follow-on funds. That measure is standard deviation, a figure that shows how far numbers in a sample deviate from the average.
The net IRRs achieved by first-time funds in any given year tend to be more tightly clustered around the average than for follow-on funds. Across the 17 vintage years in the IBR study, the average and median standard deviations are 14.0 percent and 8.8 percent, respectively, for first-time funds, well under the 16.8 percent and 17.0 percent for follow-on funds. For vintage 2001, for example, the lower-quartile benchmark of 5.7 percent for first-time funds isn’t all that far below the 13.4 percent upper-quartile mark; by comparison, the span for follow-on funds is 0.0 percent to 20.3 percent.
Any attempt at explanation would be conjecture, and our relatively small sample size of 104 first-time funds across those 17 vintage years doesn’t allow for certainty. Still, it’s tempting to suggest that buyout and mezzanine firms on their first funds invest more conservatively than their more established counterparts.
Blow up your first limited partnership and your days as a private-equity fund manager are numbered. Do so on a follow-on fund and investors may give you a get-out-of-jail-free card if, over a series of prior funds, you’ve generated consistently strong returns. Subconsciously or not, partners on their first funds may try to avoid losses, even if it means taking a few less home-run swings at the plate.
New buyout and mezzanine firms of course draw their share of dollars, if more weighted toward friend-and-family money than your typical fund. If they didn’t, an industry that has grown to upwards of 1,000 U.S. fund managers wouldn’t exist. Investors like the stand-out-from-the-crowd strategies that many first-time funds offer; they know a track record is no guarantee of success; they appreciate that successful fund managers will remember their early backers kindly when it comes to assigning slots in subsequent limited partnerships. But return data suggests that investors have another reason to like first-time efforts. Such funds can provide a safe harbor in the choppy sea of returns achieved by the larger asset class.
Investors shouldn’t expect to score huge IRRs or investment multiples with first-time funds. But neither do they have to worry as much about big losses. From there they can decide whether backing the second fund is worth the risk.