Private Equity: Bigger Funds Not Necessarily Better

Private equity firms are raising increasingly bigger funds, but they don’t necessarily deliver bigger returns. This according to a recent article in The Wall Street Journal.

“The rise of megafunds reflects the growing demand for private equity from large investors such as sovereign-wealth funds with hundreds of millions of dollars to put to work,” the article explains, adding that persistently low interest rates, private equity’s reputation for double-digit returns is enticing, even if it means paying higher fees and locking up capital.

The problem, however, is that these behemoth funds haven’t always delivered. The article cites data from Cambridge Associates showing that private equity funds of $10 billion or more generated five-year annualized returns of 14.4% (net of fees) as of the end of last September, “barely edging past the 14.1% return for the S&P 500.”

The reason for this, the article explains, is simply that “bigger funds have to find bigger targets to invest their money, which means they have fewer options. It tends to be more difficult to broadly implement new operating strategies at larger companies than at smaller ones. Megafunds, as a result, are often buying the market.” Conversely, it says, the smaller the fund, the less its returns tend to track the broader market.

The article reports that, according to megafund managers, they tend to outperform when the market is down, “not in a decadelong bull market like the current one.” They also provide one of the few options for large pension and sovereign-wealth funds to “invest massive amounts of cash all at once” and therefore get exposure to a growing portion of the market that isn’t traded on the major exchanges.

According to Andrea Auerbach, head of the global private-investments group at Cambridge, “Size is the frenemy of performance.”