Study: Smaller, focused managers deliver better returns

New research shows pension funds are missing out on returns by backing industry giants

When pension funds back the largest players in the private equity space they are cheating themselves out of the best returns, according to a recent study from London Business School’s Coller Institute and Swiss fund of funds manager Adveq.

The study, based on US data collected from the US Securities and Exchange Commission filings for more than 3,800 advisors of private equity funds and paired it with performance data from Preqin to come up with a sample of 407 US-based fund managers. The research shows that larger managers who tend to have diversified away from private equity assets deliver poorer performance relative to their peers.

US-based private equity firms with more than $5 billion in assets under management had, on average, 36 percent of assets dedicated to private equity, while those with assets of between $500 million and $1 billion had 63 percent of assets in private equity.

According to the research, private equity advisors with more than 50 percent of their AUM in private equity delivered a return of more than 9.5 percent per year after fees on average, while those with less than half of their AUM dedicated to the asset class delivered 8.2 percent.

The data show that as assets under management increase, so does the percentage of that AUM provided by pension funds, demonstrating that larger fund managers are more attractive to these investors.

Adveq managing director and CEO Sven Lidén told PEI that one of the reasons pension funds are attracted to these industry behemoths is what he calls “the IBM effect”, referring to the well-known saying that nobody ever got fired for buying IBM. Backing household names such as Blackrock and Blackstone, Lidén said, brings with it a level of comfort.

The most compelling reason, however, is that these larger houses off clients a “one-stop solution” to all of their alternatives needs, helping them invest not only in private equity but also infrastructure, real estate, mezzanine debt and any other assets in clients’ mandates.

“I think many of the smaller pension funds don’t have the in-house capability to actually look at asset allocation decisions within the alternatives, especially if the alternatives are a very small part of their investments,” Lidén said.

There are several factors affecting the performance of these large managers. As AUM increases, there is a decrease in the proportion of investment professionals dealing with that money. The study also shows a decrease in alignment of interest: for managers with AUM between $500 million and $1 billion, 25 percent of employees have “significant management stakes” in the firm, whereas only 14 percent of employees hold such a stake in those with more than $5 billion.

However, as Lidén points out, the market also plays a substantial role. Diversification aside, it is much harder to make good returns at the large-cap end of the market. Big firms often buy companies in auctions, competing against other large buyout houses, and a surplus of capital in the large-cap space has driven up entry prices, Lidén said. 

“That’s the way I see the industry in general, I think that smaller, specialized managers will have better returns than larger, more generalist managers,” he said.

Despite this research, which claims their money could be working harder for them, Lidén doubts many pension funds will change their ways.

“For many, it will not change the allocation strategy, they will stick to one big provider anyway,” Lidén said. “But I think at the margins some people will change their strategy and go away from large providers and focus in on the specialists instead.”