Smaller Funds Don’t Often Outperform, Study Finds

Investors in buyout funds need every edge they can get if they’re to avoid generating median returns, which are generally acknowledged to be unspectacular. Results from a recent study of fund returns suggest that the strategy of backing smaller funds as one way to outperform has some holes in it.

The argument behind why small buyout shops should theoretically outperform their larger counterparts is persuasive. Small companies can often be bought on the cheap from unsophisticated sellers who don’t necessarily hire investment bankers and run auctions to maximize price. They may well be under-managed, since talented executives tend to migrate toward more lucrative opportunities at big companies.

Small companies tend to command lower multiples than larger companies; that creates an arbitrage opportunity for the buyout shop, letting it take advantage of higher multiples at exit time if it can grow the company organically or through acquisitions.

But according to the 2009 edition of Investment Benchmarks Report, published by Thomson Reuters (publisher of Buyouts), small U.S. buyout and mezzanine funds haven’t necessarily been the places to be. The study includes enough data with which to make a comparison for 14 vintage years from 1987 to 2004. The median pooled IRR for private equity funds of less than $250 million for those vintages comes in at 7.85 percent, well under the 10.25 percent median pooled IRR for private equity funds of between $250 million and $500 million, and 10.90 for private equity funds of more than $500 million. The story is similar when you look at performance by investment multiples.

The median investment multiple for private equity funds of less than $250 million for those same 14 vintage years comes in at 1.41x. That’s below the median investment multiple of 1.52x achieved by the funds of between $250 million and $500 million and also by the funds of more than $500 million. One big caveat to these results is that the sample sizes are quite small in many cases, especially for the older vintages. Still, it’s not hard to come up with one big advantage that larger funds have in the buyout game. The capital markets are more developed at the higher end of the market, lenders are more comfortable with bigger businesses, and buyout shops can presumably put cheaper leverage on them.

The study provides some evidence that small funds may have outperformed at one time, but that more recently they’ve been losing to large funds. For seven vintage years from 1987 through 1996, for example, the median pooled IRR for private equity funds of $250 million to $500 million in the sample came in at 13.2 percent, 200 bps higher than the median pooled IRR of 11.2 percent for funds of more than $500 million. However, the median investment multiple of 1.66x for private equity funds of $250 million to $500 million for those years still fell short of the median of 1.73x achieved by funds of more than $500 million. Over no significant time period do the funds in the less-than-$250 million category outperform either of the other two size categories.

In response to growing demand for benchmarking data from subscribers, Buyouts has been closely examining fund performance over the last three editions, including as part of a cover story in the Nov. 16 edition. Here’s a summary of our main conclusions:

• 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;

• New funds haven’t generated returns as strong as those of follow-on funds, but they do offer less volatility in an asset class known for an especially large dispersion in performance, according to Thomson Reuters IBR;

• Investors should approach co-mingled and captive funds of funds with extreme caution, knowing that median performance translates to generating an investment multiple of just 1.1x, according to an analysis of fund data published by eight public pensions; and

• Investors building a large, diversified pool of buyout funds should anticipate achieving a median investment multiple of about 1.54x, according to the aforementioned analysis of fund data published by eight public pensions. For the six public pensions in our sample that provide investment multiples (or enable us to calculate them), none fell short of that median by more than 9 bps, and none beat the median by more than 3 bps. That would suggest it’s very difficult for large investors to reach the 2x multiple that equates with achieving top-quartile or better performance.