Earlier this year, Hamilton Lane’s research team released a report entitled Does Fund Size Matter? Comparing the Performance of Large and Small Buyout Funds. We tackled this question by analyzing the historical performance of both large and small funds, consequently debunking the myth that mega funds consistently underperform and should be avoided by investors in a post-Global Financial Crisis world. Rather, we reached the conclusion that there remains a place for both SMID and Mega/Large (M/L) funds in LP portfolios, and the allocation to each becomes a question of portfolio construction and risk management.
Yet, the topic of whether fund size matters is still hotly debated among LPs, and something about which we are continually asked for our opinion. Luckily, we have more than a few of those – not to mention more than one way to dissect the argument. So, we’ll dig into the Hamilton Lane Fund Investment Database once again in an attempt to offer an updated analysis and a fresh perspective of this ongoing debate.
Why Are LPs Still Debating Fund Size?
It sounds simplistic to say that there are risks and rewards involved with both SMID and M/L strategies, and yet the available data needed to determine exactly what those risks and rewards are can be sparse and misleading. Institutional investors around the world continue to maintain or increase their allocations to private equity, presumably striving to generate the attractive returns that the private equity asset class advertises. One reasonable assumption many investors make, is that in order to create a high-quality PE portfolio, they need to select top-quartile funds. And, when LPs look at the composition of the top quartile of the buyout strategy, they see that the majority of those funds are SMID, whereas Mega/Large funds represent less than a quarter of top quartile funds (Chart 1). From that viewpoint, SMID appears to be the more attractive space for those seeking to build a high-performing portfolio.
But what if we were to make the assertion that that’s not the only, nor even the most appropriate, lens through which to view SMID vs. Mega/Large performance? Consider the fact that there are roughly 10-15 times as many SMID funds in any given vintage year than there are M/L funds. Wouldn’t simple math suggest that SMID funds would be overrepresented in each of the quartiles? That is true and, as it turns out, the quartile where SMID is most overrepresented is the bottom quartile (Chart 2).
But, recall that we said there are both risks and rewards involved with SMID and M/L strategies. Analyzing the data this way underscores the fact that, while SMID returns are compelling (the rewards), the risk factors should not be overlooked, and a bigger picture outlook is needed when deciding to invest in SMID or Mega/Large funds.
What Does the Data Actually Show?
A better way to evaluate SMID vs. M/L fund performance is to look at the returns of those two strategies over time. As we observed in our first SMID vs. M/L piece, in which we compared rolling one-year time-weighted returns to rolling five-year time-weighted returns, it appears that neither strategy always outperforms: there are periods when SMID outperforms, such as from 2000-2003, and in the years coming out of the GFC of 2008; and there are periods when M/L outperforms, such as from 2003-2008 and over the past couple of years (Chart 3).
Another (and we think more interesting) analysis is to look at the return potential for both strategies (Chart 4). What stands out is that the SMID space consistently has a wider dispersion of returns – typically a higher top-quartile return, but a lower bottom-quartile return – meaning that the reward for selecting the very best SMID managers is greater than the reward for picking the very best M/L managers. Conversely, the penalty for getting SMID wrong is more severe. In other words, the risk profile of SMID is quite different than that of the Mega/Large space.
Digging deeper into SMID’s dispersion of returns, we compared the portfolio holdings of five of the largest SMID managers (some of the more sophisticated and institutionalized managers in the space) to the holdings of five of the largest M/L funds (Chart 5).
The difference in portfolio construction is stark. The M/L funds in our case study were more diversified in terms of number of holdings and the geographies in which they invested. Additionally, they took a more generalist approach when targeting different sectors. The SMID funds held fewer investments and were more concentrated in their largest investments. If those concentrated bets underperform, they have a greater ability to negatively affect the fund; and if they outperform, the upside potential could be great.
How else can we measure risk? Let’s next analyze loss ratios. At the fund level, we see that the SMID sub-strategy has a much higher loss ratio than the Mega/Large sub-strategy (Chart 6); not surprising, given the more concentrated bets that SMID managers are making.
This begs the question: do the deals done within SMID funds also lose money more frequently than those within M/L funds? According to our data, deals done by SMID managers do in fact lose money at a higher rate than deals done by M/L managers. Additionally, SMID deals are more likely to result in total write-offs than M/L deals.
Again, this is not terribly surprising considering that SMID investments are often in smaller companies, which are more likely to operate in niche industries and which likely have fewer product lines and customers than larger companies. These types of companies are inherently riskier than their larger, more diversified counterparts that are more likely to be acquired by M/L funds.
To be clear, we’re not saying that SMID is a bad bet. Despite higher deal loss ratios, SMID managers (as a whole) have proven capable of achieving similar returns to M/L managers. Why? Because SMID managers can make up for higher loss ratios with potentially higher deal returns (Chart 7).
Which Strategy Is Best?
Our diligence team reviews more than 800 managers each year, so we’re able to take an in-depth look at how managers are creating value. What we’ve seen is that SMID and Mega/ Large managers each tend to draw upon their unique, inherent advantages to create value in different ways.
|SMID Fund Advantages||Mega/Large Fund Advantages|
• Often able to purchase companies as lower multiples
• Resources to do more complex transactions – corporate carve-outs, debt for control acquisition
|Operations||• Professionalizing management teams and systems|
• Dedicated operating partners
|Exit||• Option for sale to strategic or larger sponsor||• Public exits – can create an asset to which public markets will assign a high multiple, could list on a global exchange|
So, what strategy should LPs favor? When developing an allocation plan, LPs should consider the risk/return profile of each strategy, including the type of manager they’re selecting with each. We’ve established that the long-term returns of SMID and Mega/Large are similar, and that no single strategy always outperforms. Thus, LPs should focus more on the risk portion of the equation when deciding how to allocate between SMID and M/L.
Larger managers offer LPs attractive returns with less risk of loss, smaller underperformance risk, a diversified investment portfolio, and the opportunity to deploy a meaningful amount of capital in a single commitment. Smaller managers offer LPs higher return potential, along with greater access to niche industries and companies. Thus, the answer of which strategy is “best” will be different for every LP and will come down to an understanding of the risk profile inherent in both SMID and Mega/Large strategies and how that lines up with the risk tolerance and investment objectives of an individual LP’s portfolio.
- All Private Equity:
- The “All PE” sample is inclusive of all funds classified as buyout, growth equity, venture capital, distressed debt, mezzanine, and real assets (excluding real estate) in addition to other miscellaneous strategies. Sample excludes real estate, secondary, and fund-of-fund strategies.
- The “Credit” sample includes mezzanine and distressed debt strategies. Sample excludes secondary and fund-of-fund strategies.
- US & EU Venture/Growth:
- The “US & EU Venture/Growth” sample includes North American and Western European venture capital and growth equity strategies. Sample excludes secondary and fund-of-fund strategies.
- Real Assets:
- Real Assets is inclusive of all funds classified as natural resources, commodities, and infrastructure. Sample excludes real estate, secondary, and fund-of-fund strategies.
- Industry Level:
- All data labeled as “Industry Level” is extrapolated up to the industry level based on Hamilton Lane’s known sample.
- PME (Public Market Equivalent):
- Calculated by taking the fund cash flows and investing them in a relevant index. The fund cash flows are pooled such that capital calls are simulated as index share purchases and distributions as index share sales. Contributions are scaled by a factor such that the ending portfolio balance is equal to the private equity net asset value (equal ending exposures for both portfolios). This seeks to prevent shorting of the public market equivalent portfolio. Distributions are not scaled by this factor. The IRR is calculated based off of these adjusted cash flows.
- MSCI World Net Total Return Index:
- The MSCI World Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity performance of developed markets with net dividends reinvested.
- Time-Weighted Return:
Time Weighted Return calculates the return that an investor achieves over some period of time. The single-period return is calculated using the Simple Dietz method:
R = (EMV - BMV - C) / (BMV + C/2)
BMV = starting portfolio value
EMV = ending portfolio value
R = the portfolio rate of return, and
C = period contributions - period distributions
Returns are linked together and annualized to calculate a longer term horizon return, such as 5 year, 10 year, etc. The Simple Dietz method assumes that cash flows are spread evenly throughout the quarter.
- Liquidity Ratio:
- Liquidity Ratio = (Amount of Distributions Received) / (Amount of Capital Called)
- Pooled IRR:
- Internal Rate of Return (“IRR”) of investments at the ‘LP level’, inclusive of fees such as management fees and carried interest paid to the General Partner. Cashflows are pooled at the vintage year level and then an IRR is calculated.
- Net IRR:
- The Internal Rate of Return (“IRR”) of investments at the ‘LP level’, net of fees, such as management fees and carried interest, paid to the General Partner.
- Remaining Value-to-Paid In = (Current Net Asset Value) / (Total Amount of Capital Paid-In)
- Total Value-to-Paid In = (Amount of Distributions Received + Current Net Asset Value) / (Total Amount of Capital Paid-In)
- Distributed-to-Paid In = (Amount of Distributions Received) / (Total Amount of Capital Paid-In)
A mathematical process to remove serial autocorrelation in the return stream of assets that experience infrequent appraisal pricing, such as private equity. Desmoothed returns may more accurately capture volatility than reported returns. The formula used here for demsoothing is:
rD(t) = (r(t) - r(t-1) * p) / (1- p)
rD(t) = the desmoothed return for period t
r(t) = the return for period t
p = the autocorrelation
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As of July 21, 2016