A forced focus on larger companies, it turns out, makes generating impressive returns more challenging
As yields remain stubbornly low and stock-picking proves to be a foolhardy pursuit, large institutional investors have increasingly looked to alternatives as a way to put hundreds of millions of dollars in dry powder to work. That’s meant increased demand for access to private-equity megafunds with assets in the billions — which, unfortunately, haven’t necessarily generated impressive returns.
“With interest rates still persistently low, the industry’s historical reputation for 20%-plus returns, is appealing—even if it means paying higher fees and having money locked up for long periods,” reported The Wall Street Journal. “The problem is that the largest funds haven’t always lived up to the hype.”
Citing data from Cambridge Associates, the Journal said PE funds with at least US$10 billion in AUM posted 14.4% in five-year annualized returns net of fees by the end of last September; that’s barely better than the 14.1% logged by the S&P 500. Over a longer timeframe of 12.75 years, such mammoth buyout funds saw 10.2% in returns, just matching the broader index.
The trend of unimpressive results was explained by the fact that bigger funds generally need bigger targets to invest in, which means they’re competing over fewer options. In addition, implementing new operating strategies tends to be harder to do at larger companies than at smaller ones. As a result, megafunds often end up buying the market.
A look at smaller PE funds highlights just how much less their returns tend to be tied to the broader market. Referring again to data from Cambridge, the Journal said that US funds packing less than US$350 million in AUM had a correlation of 0.38 with the S&P 500, compared with 0.62 for those with at least US$10 billion.
That’s not to say that the Goliaths of the PE-fund world are abject failures. Some current megafunds may be more successful than others, and aggregate returns for megafunds compare more favourably against other benchmarks such as the MSCI All Country World Index, which is more global and less tech-heavy than the S&P 500. Large PE funds, PE added, own companies with relatively predictable cash flow streams, so they tend to be less volatile than smaller funds.
Megafund managers also note that they mainly tend to outperform during down markets, in stark contrast to the decade-long bull market that investors have enjoyed following the global financial crisis. Such large funds have also provided one of the few places for large pension and sovereign-wealth funds to deploy massive investments of cash at once, offering them a way to get exposure to the growing piece of the market that major exchanges simply can’t provide.
With limited staff and huge amounts of money to put to work, big institutions such as large US pensions have had to find creative ways to deal with limited returns from megafunds. Many are pushing for opportunities to co-invest in buyouts, allowing them to sidestep fees. California Public Employees’ Retirement System (Calpers) is looking at becoming the sole backer of at least two limited-liability companies, which would be overseen by external managers who would invest directly in companies on Calpers’s behalf.