McKinsey: mid-market inconsistency fuels manager selection risk

Private equity mega-funds have historically delivered more consistent returns than those targeting the mid-market, according to a McKinsey report.

Mid-market fund returns vary more widely than those of mega-funds, meaning the onus is on limited partners to select managers wisely.

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Mega-funds – those with $5 billion or above – have historically recorded a 3.2 percent spread between top- and bottom-quartile returns, according to the McKinsey Global Private Markets Review 2018. This compares with 5 percent, 5.5 percent and 7.3 percent spreads for large-cap, mid-cap and small-cap funds respectively, indicating a reduced likelihood of over- and under-performance in bigger funds.

“The consistency of top-quartile returns has come down,” Bryce Klempner, a partner at McKinsey, told Private Equity International. “Variation gets larger and larger as the funds get smaller and smaller, so the selection risk is greater in smaller funds but the potential for outperformance is also greater.”

The potential for variation in mid-market returns has placed a premium on manager selection, Aly Jeddy, senior partner, added. “The issue that some LPs run into is that they underestimate manager selection risk,” he said.

“In the mid-market that’s the bigger issue; not how a given manager will perform but whether you can pick the high performing manager. What you’re ending up with is a higher manager selection risk, time commitment required and given that it’s a mid-market fund there’s obviously limits to how much capital you can commit to those firms.”