(January 24, 2013) – When it comes to private equity investments, a major study has found that size really does matter.
Pension funds with at least $6 billion in private equity return 10.8% more on their portfolios than funds with allocations of $27 million or less, according to researchers Alexander Dyck and Lukasz Pomorski.
Dyck and Pomorski, both faculty members of the University of Toronto’s Rotman School of Management, based their study on a data set covering 874 defined benefit pension funds’ private equity holdings, fee costs, and returns between 1990 and 2009. Economic theory holds that in a competitive and frictionless market, there ought to be no relationship between investment size and performance, but the data said otherwise.
“Our first finding is that investors with large PE investments perform substantially better in PE than investors with small PE investments,” the authors wrote. “This relationship between investor scale in PE and PE performance is monotonic in PE holdings, robust, and consistent across time and geographies.” Pomorski and Dyck found that asset owners making large investments share three powerful advantages over those with modest allocations.
Foremost, the study found that larger investors have a superior ability to bridge information asymmetries between themselves and private equity firms. More assets afford more thorough and sophisticated due diligence practices, as well as the ability to attract and retain talent. Small funds also have fewer channels by which to receive market information, the authors noted. In total, the more level informational playing field accounted for three-quarters of the return premium large investors in private equity posted over small ones.
Cost savings made up the remaining quarter of the return spread. Of that, regression analysis showed roughly half (22 basis points) was due to large investors’ ability to better negotiate with external managers. Major asset owners are free to take their vast capital to almost any private equity firm around, and can select and bargain based on favorable fee arrangements.
The authors did point out that negotiating power boosts returns by lowering fees, not necessarily by granting big investors access to better performing funds. Many asset owners would argue that money—lots of money—can buy admission to top managers and funds. But conversely, the most popular managers often have their pick of investors, giving access to those with good timing or generous fee offers.
“There are funds we would like to be in, but showed up too late,” remarked Tim Walsh, head of New Jersey’s pension fund and a pioneer of huge-scale private equity investments, in a recent interview with aiCIO.
A pension fund of any size might spot a high-performing fund early on, but the authors argue that larger funds can be more active in pursuit of profits. Lower-cost approaches to private equity are the third factor Pomorski and Dyck identified, accounting for the balance of large plans’ cost savings. The lowest-cost approach, direct investing, made up a small but burgeoning portion of the data set’s total private equity deal flow. Virtually all in-sourcing occurred within the top quintile of investor size.
“With these patterns in performance, we predict that plans that have the capacity to become large PE investors will do so,” the authors conclude. “The growing importance of larger investors in PE that we document likely contributes to recent indications of increased bargaining power for investors with general partnerships.”
Read the entire paper here.