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Guest blog: Study reveals Achilles heel of mega private equity funds

US Pension Funds | Study reveals Achilles heel of mega private equity funds All About Alpha

A few weeks ago, we told you about a study of US pension funds showing that smaller funds experienced better performance than their larger peers. This was counter-intuitive to us – and to several readers – given the assumption that larger funds had more resources and therefore could afford to find better investment opportunities.

It looks like small pension funds are not the only Davids than can run circles around their larger Goliath competitors. A recent study of private equity funds found that large funds earn lower returns. The study by Mark Humphrey-Jenner of Columbia University and the University of New South Wales examined the performance of 1550 funds ranging from tiny VC funds to LBO behemoths.

Humphrey-Jenner begins with the intuitive assumption that larger funds should perform better than smaller ones. After all, he surmises that larger funds should have more connections with I-banks and other PE funds (giving it access to deal flow and ideas), they should be better diversified, and should be able to win better financing terms. However, as he goes on to explain, previous research has shown that these common assumptions might be wrong. For example, diversification is difficult when PE fund returns are highly correlated with each other and with the public equity markets. In addition, large PE firms tend to “increase the number of investments faster than they increase the number of staff”, thus stretching existing resources and potentially under-exploiting new opportunities. Furthermore, Humphrey-Jenner says, a requirement to deploy more capital can mean diminishing marginal returns.

He adds to this list of mitigating effects of size by suggesting that large PE funds also lose out when they invest outside their area of expertise, which is often a requisite part of managing a large fund. This is especially endemic amongst large PE funds that invest in small companies. Humphrey-Jenner highlights research that shows small funds have to be specialists in order to compete and that they have smaller fixed overhead costs than the big guys. This handicap faced by larger funds is then amplified by their smaller number of investment professionals per investment.

So do these assumptions stand up to empirical testing? For the most part, they do.

For starters, small funds in Humphrey-Jenner’s sample had higher IRRs. The chart below from his paper shows the IRRs of fund deciles based on fund size (“10″ being the largest 10% of funds in the sample):

Fund IRR by Find Size Decile

In order to determine what other factors were driving this phenomenon, the study regresses fund returns against a set of nearly a dozen factors such as: claimed “expertise”, typical investment size, board seats sought, use of syndicates, and manager compensation.

Although large PE funds tended to under-perform smaller ones, Humphrey-Jenner discovered that large investments, i.e. target investments, produced significant value. He also found that IRRs were higher when fees were lower and when the average experience of its managers was greater (measured as number of funds previously managed). Thankfully for PE managers, diversification was correlated with higher returns (despite the concern that PE funds tended to be highly correlated).

Although larger funds fell short of expectations at investing in smaller firms, they did trump small firms when it came to the biggest PE deals. So the bottom line is that large funds tend to excel at large investments and small funds at small investments. The problem for large funds, of course, is that there simply too few large investments at which to excel.

This guest blog was first published on

Tags: fund irr , fund management , pension funds , Pensions , private equity , risk , us pension funds
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