As the end of the year approaches, institutional investors in private markets are wrapping up work on the last few funds we need to invest in to hit our targeted annual commitment levels.
You see, private equity is sort of like a treadmill. Money is always going out and coming back. Just to just keep your allocation the same, you have to keep committing new capital to more funds. In other words, like a treadmill, you have to keep running just to stay in the same place.
And if you want to actually increase your allocation to private equity – like 47 percent of institutions this year – then you have to run even faster, committing even more capital to more funds to increase exposure to the asset class. As a result of this demand, fund raising has been robust. Private equity managers have returned to market to raise new funds faster than ever before, and they’re seeking bigger funds, too, giving their investors what they are asking for — a place to park their capital.
In the past, managers often would not begin asking for capital for a new fund until the previous one was 75 percent deployed. Often today, the process begins when the previous fund is only 65 percent, or sometimes even 55 percent, invested. And when in-demand managers do return to the fund raising circuit, the time frame for their process is often very compressed — sometimes a mere three months from the marketing announcement to the final closing of the fund.
Aside from the challenges of keeping up with a faster and faster treadmill — particularly problematic for slower, more bureaucratic institutions — or the obvious concerns regarding valuations and the implications of the capital glut on the market cycle, limited partners are also confronted with the task of assessing whether the manager’s new fund size is too big, too little, or just right.
Just because a team was successful investing a $500 million fund — for instance, buying ten fifty-million dollar businesses and turning them into hundred-million dollar businesses — does not mean they will generate the same results on a $1 billion fund. For the larger fund, they would either need to find 20 companies the same size, which would stress the deal capacity of a small team, or they would have to buy ten companies at $100 million, the scale where they used to be a seller, often an entirely different market segment altogether with different dynamics and competitors.
Figuring out just how relevant the earlier track record is, and whether or not the firm has the right team and strategy in place to successfully execute on the larger fund size, requires qualitative judgement. There’s hardly ever a conclusive answer.
Limited partners typically want the fund to stay approximately the same size, believing this will result in returns that look a lot more like the previous track record. Despite needing to put ever more money to work, we want our managers to remain consistent in their approach to the market. At TMRS, we refer to this as fund size discipline.
On the other hand, general partners argue a larger fund provides competitive advantages in a growing market. (It doesn’t hurt that it’s more profitable for them, too.)
Thankfully, new research from consultant StepStone has provided some insight to help address this conundrum. Looking at a sample of over 2,600 funds for which the consultant had mature performance information for both an initial and subsequent fund from the same manager, the firm was able to explicitly quantify the effects of fund size increases.
Their research showed that managers who raised substantially larger funds experienced lower IRRs (internal rates of return) in the subsequent bigger investment vehicles. The worst performance results were observed in those funds that were more than double the prior vintage; such managers posted returns 5.8 percent lower on average.
On the other hand, those managers who raised funds no more than 25 percent larger than their earlier partnerships were actually able to increase returns modestly, and funds that shrunk saw returns jump meaningfully, up by 4.4 percent. Interestingly, private equity funds that were 25 percent to 50 percent bigger than the previous fund produced returns that were virtually unchanged since the last go around.
As I thought about this relationship, I realized it made perfect sense. Most private equity partnerships invest their capital over a three- to five-year investment window. Over the past fifteen years, the private equity industry has surged from roughly $1 trillion in assets in 2004 to nearly $4.5 trillion at the end of last year, a compound annual growth rate of 10.8 percent. Over a four-year period, that represents cumulative 50 percent growth.
Perhaps a manager who raises a fund 50 percent larger than their fund from four years ago, when the market has also grown by 50 percent over that same time, has in effect stayed in place competitively. But if they’ve grown faster than the market they participate in, by definition they have to be less choosy on a relative basis, buying more dollars’ worth of private equity company total market share than they did previously.
Certainly the specifics of each individual manager, additions to the investment team, and improvements to their sourcing or value creation capabilities can change the calculus in each circumstance, but this research conclusively demonstrates the importance of fund size discipline.
And as the fund raising treadmill runs faster and faster, we are using this research to help us identify managers who we think are getting it just right.