Back in the 1990’s, while conducting research for University College London, a middle-aged British anthropologist named Robin Dunbar began to notice an interesting connection between primate brain size and the size of the social groups they formed.
The correlation he observed was strikingly simple: the bigger the brains, the larger the social groups. The explanation he came up with was equally simple: animals with larger brains should be able to remember more individuals and thus, better manage more relationships.
This hypothesis ultimately led Dunbar to his now famous prediction, the eponymously titled Dunbar’s number. By plotting the neocortex ratio, or the size of the neocortex relative to the overall brain, for 38 different species of primates, Dunbar found a regression equation that was highly correlated with troop size. Extrapolating this function to the size of the human brain generated 148, which he rounded to 150.
That’s Dunbar’s number.
The famous anthropologist reasoned that humans could have no more than 150 meaningful social relationships. Above that, he predicted our ability to successfully manage all the nuances of close relationships would break down, and groups would splinter as a result of social discord.
Interestingly, anecdotal research seems to support this.
Malcolm Gladwell discusses the Dunbar number in his wildly popular book The Tipping Point. In one story, Gladwell describes the company W. L. Gore and Associates, well known for its Gore-Tex brand. Through trial and error, the leadership in the company discovered that if more than 150 employees were working together in one building, personnel disputes and disagreements would invariably soar. As a result, the firm started constructing office buildings with a limit of 150 employees and only 150 parking spaces. When the units were filled, the company would move on to build another 150-employee building.
Dunbar himself documented multiple other communal size tendencies that provided support for his number. 150 people is the rough average size of Neolithic farming villages; Hutterite settlements (Germanic farming communities similar to the Amish) have typically divided into new settlements around 150 people for centuries; and the average size of a company, the basic unit of western armies, has been roughly 150 soldiers for hundreds of years.
Personally, I once worked for an investment firm that grew from nearly a hundred employees to more than 150 by the time I left, and without a doubt cliquishness and inter-departmental bickering erupted over that period. In fact — similar to the Gore-Tex story — the firm quite literally split in half, moving people into two entirely separate office buildings several miles apart. (Performance, it should be noted, has never been the same, however.)
Speaking of performance, there is quite of bit of research showing that smaller asset managers consistently outperform larger ones. It holds for mutual funds, hedge funds, and private equity funds, too. Our own internal research suggests that since 1997, PE funds under $2 billion have generated internal rates of return of 13.1 percent, as opposed to 11.9 percent for funds managing more than $5 billion. The weaker returns of larger funds are usually blamed on diseconomies of scale — or rising costs resulting from increased output — and problems of limited alpha capacity.
There’s also plenty of evidence that independent of fund size, emerging hedge funds and first-time private equity funds reliably outperform older, more established shops. So, asset size can’t be the only challenge.
To be clear, research suggests that larger, older funds tend to underperform, but maybe part of this diseconomy of scale is not merely the challenge of squeezing more dollars into a limited alpha pool. Perhaps there is another related factor that is not as well researched — namely team size.
Manager selection professionals typically believe that all else being equal, bigger teams mean better results. With additional people to source more ideas, provide deeper research, and execute transactions faster, it certainly seems like a safe assumption. But what if larger teams aren’t unilaterally a good thing?
At some point, the human capital challenges of managing progressively larger teams, and more importantly ensuring they continue to pull in the same direction, outweigh the benefits. Gladwell referred to this concept as the tipping point, and for most organizations, it’s 150 people. Why wouldn’t the same hold true for alternative asset managers?
Some research suggests it just might. Economist Jeremy Stein published an article in the Journal of Finance in 2002 called “Information Production and Capital Allocation: Decentralized versus Hierarchical Firms,” which argued that in large, bureaucratic financial organizations, diseconomies of scale and inefficient decision making emerge where “the authority to allocate capital is separated from expertise, which tends to dilute the incentives to become an expert.” Smaller, decentralized teams were shown to be more effective.
Ensuring that a team of 20 professionals (the average number of employees in our small buyout and growth portfolio) is performing better than the sum of its parts is a markedly different exercise than managing 1,385 people dispersed around the globe (the average employee count of the top five publicly traded private equity firms).
While I’ve not seen any research specifically on employee count at alternative investment firms, I think it may be prudent for due diligence professionals to keep a tally on Dunbar’s number.
