U.S. small-cap leveraged buyout funds are outperforming their mega counterparts, but the predictability and size of larger-cap funds are attracting investors toward the larger end of the private equity market.
Small-cap leveraged buyout funds are more profitable than funds focused on acquiring larger targets, according to a report released in June from alternative investment technology provider eFront. The research examined U.S. leveraged buyout funds with vintage years up to 2009, which are fully or largely realized.
It also found that small-cap funds deploy capital at a faster rate and reinvest a "significantly higher proportion" of their fund size than funds further up the market.
The fact that smaller funds can deploy capital faster "makes sense" because it is often quicker to execute a deal for a smaller target than a larger one, eFront Chief Strategy and Marketing Officer Thibaut de Laval said in an interview.
Small-cap managers can also develop and resell the companies they acquire more quickly, which leads to increased ability of smaller funds to recycle capital, de Laval added. In most limited partnership agreements, a fund's key legal document, funds are able to recycle some of their distributions in cases where investments have been realized across an agreed-upon time period, usually between 18 and 24 months of the acquisition.
This helps explain eFront's finding that small-cap funds continue to invest until year eight of their cycle, compared with an average of five years across all funds. "This is because they can precisely recycle capital and therefore dispose of assets later on in the funds life cycle," de Laval said. The report also found that small-cap funds distribute capital much earlier than medium, large and mega LBO funds.
But there are attributes that can make larger-cap funds appear less risky. Contributions from investors are limited to the first five years of activity, and distributions are largely done by year 10, providing a predictable stream of cash flows for investors, eFront found. In terms of spreads between the best- and the worst-performing funds at the lower and the top end of the private equity market, mega funds tend to be much more consistent in performance, de Laval said. An important measure for any investor is not only the performance but also the risk, he added.
Ropes & Gray LLP private investment funds partner Peter Laybourn said the findings were broadly in line with what he has seen in the market. Investors such as pension plans, which may not have an outsized planned allocation to private equity, may elect to spread their allocations in a bid for diversification as well as a way to potentially boost their returns. "If you have one or two home runs in a smaller fund, that can have very meaningful impact on the overall return profile for the fund," Laybourn said. "Some of the earlier venture capital funds on Facebook, they're getting 100x their return, but that just doesn't happen in the larger funds."
But for some investors with large pools of capital that they need to deploy and invest, an allocation to a small-cap manager "simply isn't practical," Laybourn said. He added that the amount some investors want to commit in a single vehicle could make up half the size of a small-cap fund, and some investors have limitations on how much of the fund their commitment equates to. Larger investors could get access to small-cap funds via commitments to fund-of-funds that actively seek out new private equity managers with promising return prospects.
While smaller-cap funds are outperforming larger vehicles, competition and the rapid fundraising pace could change the market dynamics. The accumulation of dry powder can lead to more competition at the lower end of the market, and fund managers potentially paying higher multiples for smaller-sized targets. This could make returns for smaller cap funds "a little bit more complicated over time, at least," eFront's de Laval said.