Why smaller funds are not always the best choice

Research from TorreyCove shows a ‘tenuous link’ between fund size and performance.

Investors with limited resources are better off investing in funds at the larger end of the market where the risk-reward profile is more attractive, according to research from consulting firm TorreyCove.

The paper, which looks into the significance of the relationship between fund size and performance, analyses 870 buyout funds with vintage years between 2000 and 2013 and a minimum fund size of $250 million to rule out unseasoned funds and those often considered sub-scale for institutional investors.

TorreyCove’s analysis finds the link is “tenuous”; the average net internal rate of return for a fund below $500 million is 14.7 percent, while those between $1 billion and $3 billion deliver an average of 14 percent and those between $3 billion and $5 billion an average of 14.3 percent.

While the larger funds perform marginally less well than the smaller, the dispersion of returns among funds greater than $1 billion is a much lower.

“From a rate of return perspective, size matters in private equity,” TorreyCove chief executive David Fann told Private Equity International. “Smaller deals can generate higher returns, but people forget the risk side of the equation.”

The standard deviation of net IRR for funds of less than $500 million is 17.1 percent – significantly higher than the 11.3 percent for those between $1 billion and $3 billion and the 10.7 percent for those between $3 billion and $5 billion.

This means LPs investing at the lower end of the market must work “much harder” to find the right managers, said Fann.

“Manager selection becomes extremely critical [at the lower end] because your outcomes could potentially be so wide. You could have great performance or really bad performance. The dispersion of returns is much wider,” he said.

“It turns out it’s easier to pick managers with funds that are over $1 billion in size. Standard deviation is much tighter. Returns tend to be more clustered”

How LPs should interpret and act on this information depends on several factors, including team size, manager selection capabilitie, and what the investor is looking to achieve with their private equity programme.

“If you have a big team and you believe you’re really good at picking managers, then the small funds can make sense,” Fann said.

“If you have a smaller-sized staff and you’re looking for greater consistency in performance, you would focus on funds over $1 billion in size because the risk-reward profile is more attractive. You don’t have to be an exceptional selector of managers, you just have to be reasonably good, and you still have a good shot at a positive outcome.”