In the low rate environment that has followed the financial crisis, big institutional investors have looked to alternative investments like private equity to generate returns large enough to fund promised payouts. The problem is, that once a fund gets big enough, the number of options it has for meaningful investment becomes limited. Dick Young explained this phenomenon in his popular post on the Crisis at Vanguard.
Now, after plaguing the largest mutual funds for years, the problem of getting too big is hitting private equity funds. Miriam Gottfried reports at The Wall Street Journal:
The problem is that the largest funds haven’t always lived up to the hype. Taken together, private-equity funds of $10 billion or more posted 14.4% five-year annualized returns net of fees as of the end of last September, barely edging past the 14.1% return for the S&P 500, according to data from investment firm Cambridge Associates.
Buyout funds’ relative performance doesn’t improve much over a longer time frame. Over a span of 12.75 years—the longest period for which Cambridge has sufficient data on megafunds—returns for these large funds was 10.2%, the same as the broader index, its data show.
The reasons behind the trend are simple: Bigger funds generally 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.
The smaller the fund is, the less its returns tend to be tied to the broader market. U.S. funds of less than $350 million had a correlation of 0.38 with the S&P 500, compared with 0.62 for funds $10 billion or more, according to Cambridge.
Read more here.