Good things in smaller packages

Having worked at both a very large public institution and a specialist investor in small private equity funds, Kevin Kester knows very well the barriers that exist between large LPs forming relationships with small GPs.

Before becoming a managing director in 2004 at Boston and New York-based fund of funds investor Siguler Guff, Kester worked in the asset management office of the Colorado Public Employees' Retirement Association (PERA), a US pension fund with roughly $30 billion in assets under management. Given the limited resources available to his investment staff at PERA, Kester found himself all too frequently passing on good investment opportunities in smaller private equity funds.

Large institutions, explains Kester, often lack the personnel to focus on very discrete categories within private equity. Small funds, which often have a narrower focus and a less refined marketing presence, require more work. In addition, he says, large institutions must commit large amounts of money in order to be efficient investors, predisposing them to invest in larger funds. “Larger pension funds are forced to do larger deals,” he says, noting that these large institutional investors often miss out entirely on the smaller end of the market.

This is a shame, says Kester, because in the small market can be found greater price inefficiency and good opportunities.

Kester's observations will resonate with most private equity portfolio managers at large institutions (and to many hopeful GPs on the fundraising trail who fail to get the attention of elephantine investors). They simply are not set up to perform due diligence on the hundreds of smaller opportunities sent their way.

Added to this is the fact that, for the largest LPs, there is a perception that a small investment to a small fund won't “move the needle” within a multibillion private equity allocation. In other words, a modest return on a billion-dollar commitment to a megafund GP will have an exponentially greater affect on the portfolio than a spectacular return on a $10 million commitment. So why bother doing all the work necessary for the smaller commitment?

According to proponents of small funds in large portfolios, though they may lack in size, they should by no means be short of appeal to large investors. Though the effort to conduct due diligence and build relationships before making a commitment to a small or mid-sized fund may appear to be counterproductive for large limited partners, the benefits of doing so are often substantial. Taking a chance on the little guys can pay off in the long run by contributing to a diversified portfolio and building a solid foundation for future relationships.

Loren Boston, a placement agent at global financial management and advisory services company Merrill Lynch, notes that diversity of investments should be a key goal for all investors, and making commitments to small funds adds to the assortment. “The more investments a group makes, the greater the diversification,” he says.

Peter Flynn of London-based private equity and hedge fund placement agent Candela Capital, agrees. “Even large, geographically focused funds of funds have different regional targets, and as such it makes sense for them to be interested in smaller and different GPs,” he says.

As important as diversification is the argument that, with talented GPs, the smaller end of the market presents the opportunity for comparatively high returns. According to Kester, smaller funds that target smaller companies can offer high rates of risk-adjusted return. Smaller funds do smaller deals, he argues, and the deal market is simply less competitive.

“Over 70 percent of all companies that are for sale in any given year have transaction values of less than $100 million,” says Kester. “Many are owner-operated, and the principal owner is getting older. The Baby Boom demographic is creating a situation where even more of these businesses will be up for sale over the next 15 years.”

And while no one small commitment will have much impact, if the overall allocation to this segment of the market outperforms, it can have a meaningful impact on overall returns.

In addition, investing in small funds allows limited partners in general to build relationships with up-andcoming professionals of the future, says Flynn. “If you want the entrepreneurial winners of tomorrow, you need to support the talent coming through,” he says.

“If you want the entrepreneurial winners of tomorrow, you need to support the talent coming through

Peter Flynn

Deciding that an allocation to smaller funds is a good thing is one challenge, but the execution of the decision is often even more difficult. Planning for and researching smaller funds is, of course, crucial, says Nick Shaw of Gartmore Investment Management, a global independent fund manager with offices in London, Tokyo, Boston, Madrid and Frankfurt. If investing is done in an “ad hoc way”, he says, the result will likely be commitments to insignificant managers who will struggle to deliver.

Shaw's own firm, which has 12 investment professionals, allocates 25 percent to smaller managers. Historically, he says, the small managers had quite high loss rates. More recently, the risk-reward ratios on the small end of the portfolio have moved in Gartmore's favour. Shaw notes that his firm's small GPs have great advantages with regard to transaction prices.

Most large LPs do not – and will never – have the resources necessary in-house to pursue smaller commitments, and so the natural strategy is to outsource the management of this allocation. While at Colorado, Kester created the Targeted Opportunities Programme to invest in “less efficient private equity opportunities in the smaller end of the market”. The pension hired Austin, Texas-based Alignment Capital Group to sift through fund commitment opportunities where the funds are less than $250 million in size.

At Siguler Guff, Kester himself now oversees a business called the Small Buyout Opportunities Fund.

As an example of a large LP with a sophisticated approach to smaller funds, Candela Capital's Flynn points to AP3 in Sweden. The SEK 212 billion ($30 billion; €23 billion) buffer fund, which is part of Sweden's national pension system, has a target allocation to private equity of 6.5 percent – which is high by European standards. While this means nearly $2 billion in capital is available for investment, the managers of AP3 have not seen fit to sink, say, half of that into the next KKR fund. Instead, through advisors like Switzerland-based LGT Capital Partners, AP3 sprinkles its capital across the Nordic region, Europe, the US and Asia in private equity funds and venture capital funds of all types, including quite small funds. The pension's biggest commitments in 2006 were no more than SEK200 million ($28 million; €21 million) each.

One of the biggest private equity backers in the world has also chosen to stick with smaller funds. The California Public Employees' Retirement System with approximately $230 billion in assets under management, despite the fact that it is seeking to place more capital with fewer GPs, has launched a New Investment Vehicles programme that will seek to outsource the management of a suite of niche vehicles that will target small funds, including “emerging” managers, middle-market funds and “cleantech” funds, among others.

Making the decision to invest in smaller funds requires “more work, more efficiency and maybe more skill because not as much capital is flowing in,” Kester says. “We understand that not all investors can take advantage of the opportunity. That's a good thing because there is only so much capital that can be absorbed at this end of the market.”