The Impact of Fund Size on Private Equity Performance: Navigating the Trade-offs Between Small and Large Funds

In the intricate world of private equity (PE), fund size is more than just a number—it's a critical factor that influences performance, strategy, and risk. While larger funds offer the allure of scale and access to marquee deals, smaller funds often present greater potential for excess returns. Understanding the trade-offs between different fund sizes is essential for investors aiming to optimize their portfolios in today's dynamic market.

The Law of Large Numbers in Private Equity

As PE funds grow, the challenge of delivering outsized returns intensifies—a concept rooted in the law of large numbers. Large funds, managing substantial capital pools, tend to invest in sizable deals where competition is fierce and valuations are high. This environment can limit the potential for extraordinary returns, causing performance to cluster around the industry median.

Studies have shown that smaller PE funds (those with less than $1 billion in assets under management) have historically outperformed larger funds. According to data from Cambridge Associates, small and mid-sized buyout funds have generated higher net internal rates of return (IRR) compared to their larger counterparts over multiple vintage years.¹

On the flip side, smaller funds generally possess the agility to pursue niche markets and undervalued opportunities. Their ability to navigate less-trodden paths allows them to capitalize on inefficiencies and generate higher excess returns. However, this approach comes with increased idiosyncratic risk, necessitating robust sourcing, thorough vetting, and meticulous management.

Key Drivers Influencing Fund Performance

1. Competition Dynamics

Large deals often attract attention from numerous PE firms, investment banks, and institutional investors. This heightened competition can inflate valuations, reducing the attractiveness of entry points and compressing future returns. In 2023, funds larger than $1 billion raised approximately 71% of all private capital inflows, despite representing only 9% of total funds in the market.²

In contrast, smaller deals typically operate under the radar, allowing smaller funds to negotiate better terms and acquire assets at more reasonable valuations. With less competition, these funds can focus on unlocking value and driving performance, provided they have the expertise to identify and execute on these opportunities.

According to PitchBook, the median entry EBITDA multiple for U.S. buyouts in 2022 was 11.5x, but smaller deals (enterprise value under $500 million) had lower multiples, averaging around 9.0x.³ This suggests that smaller funds can acquire companies at more attractive valuations compared to larger funds.

2. Resourcing and Value Creation

Large funds often employ a standardized playbook across investments—a rinse and repeat strategy that can yield consistent but unremarkable results. The sheer number of portfolio companies can dilute the attention and resources dedicated to each, potentially overlooking unique value creation avenues.

Smaller funds, however, usually have a concentrated portfolio, enabling them to dedicate significant resources to each investment. This focused approach can unearth untapped potential through operational improvements, strategic repositioning, and market expansion. Research from McKinsey & Company indicates that small and mid-cap buyouts can outperform their large-cap counterparts by up to 4 percentage points in IRR.⁴ This performance differential underscores the value potential in smaller-scale transactions.

3. Alignment of Interests

The incentives driving fund managers can vary markedly with fund size. Large funds often prioritize asset gathering to maximize management fees, which may shift focus away from investment performance. For instance, a $10 billion fund earning a 2% management fee collects $200 million annually, creating a substantial revenue stream irrespective of performance.

In contrast, smaller funds typically rely more on carried interest—the share of profits from successful investments—aligning their success directly with that of their investors. This alignment encourages smaller fund managers to pursue strategies that enhance returns rather than merely increasing assets under management. A study by Preqin found that emerging managers (often managing smaller funds) outperformed established firms by an average of 3 percentage points in net IRR.⁵

Balancing Risk and Access in Fund Selection

Choosing between large and small PE funds isn't a binary decision but a reflection of an investor's risk tolerance, resources, and access to opportunities. Smaller funds can offer the allure of higher returns but come with increased risk and the need for extensive due diligence. Larger funds provide stability and access to high-profile deals but may offer more modest returns.

Investors with robust due diligence capabilities and a higher risk appetite might lean toward smaller funds. Those preferring steadier performance and institutional infrastructure might opt for larger funds. Ultimately, a diversified approach that includes both can help balance potential returns with acceptable risk levels.

The Consolidation of Capital Among Top Brands

The PE industry has seen a consolidation of capital among leading firms, driven by institutional investors seeking efficiency and perceived safety in established brands. In 2023, the top 25 PE firms accounted for nearly 50% of the total capital raised globally.⁶ While this trend benefits large funds in capital raising, it intensifies competition for sizable deals, potentially impacting returns.

This concentration raises questions about market saturation and whether large funds can continue to deploy capital effectively without compromising investment quality. It also underscores the importance of exploring opportunities beyond the industry's giants.

Not Mutually Exclusive Strategies

Investors don't have to choose exclusively between large and small funds. Incorporating a mix of fund sizes can provide exposure to the unique benefits of each. Allocating a portion of a portfolio to smaller funds can tap into higher return potentials, while investments in larger funds can offer stability and risk mitigation.

Conclusion

Fund size is a pivotal factor in private equity performance, influencing everything from competition and value creation to alignment of interests. Smaller funds can offer greater excess return potential through less competitive deals and focused strategies but come with higher risks that require diligent management. Larger funds provide scale and access but may see returns gravitate toward the median due to intensified competition and deployment challenges.

Investors should align their fund size preferences with their risk tolerance, resources, and investment objectives. By appreciating the strengths and limitations associated with different fund sizes, they can make more informed decisions and potentially enhance their portfolio's overall performance.

Why Investors Should Pay Attention

Understanding the impact of fund size on performance is crucial for navigating the private equity landscape effectively. Investors should consider:

● Assess Risk Tolerance: Determining acceptable risk levels and select funds that align with this profile.

● Utilize Resources: Leveraging due diligence capabilities to identify promising smaller funds and manage associated risks.

● Diversify Holdings: Building a balanced portfolio that includes both small and large funds to optimize returns and mitigate risks.

● Stay Informed: Keeping abreast of industry trends, fundraising patterns, and performance data to make timely, informed decisions.

By carefully taking into account fund size dynamics, investors can position themselves to capitalize on opportunities that align with their goals and enhance potential returns in a competitive market.

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1. Cambridge Associates, Global Private Equity & Venture Capital Index and Selected Benchmark Statistics, Q4 2022.

2. Preqin, Global Private Equity Report 2023, published January 2023.

3. PitchBook, Annual U.S. PE Breakdown, 2022.

4. McKinsey & Company, Global Private Markets Review 2023, March 2023.

5. Preqin, The Outperformance of Emerging Private Equity Managers, August 2022.

6. Bain & Company, Global Private Equity Report 2023, published February 2023.

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