Buyout Funds: Large Versus Small. What to Consider Beyond Size. | 1

Mega funds are considerably

less “mega” these days,

returns and exits don’t

come nearly so easily as in

the past . . . and they don’t

have the same cache with

investors.

BUYOUT FUNDS: LARGE VERSUS SMALL. WHAT TO CONSIDER BEYOND SIZE.

Once upon a time, not that long ago, mega buyout funds were the undisputed kings of

the private equity world. They rolled up one blockbuster deal after another, had access to

enormous amounts of cheap credit with easy terms, distributed record amounts back to

investors after relatively short holds, and just as quickly asked those investors to commit even

more to their next fund, which was of course significantly larger than the last. Everyone was

happy, returns were good, and fundraising was easy (and short). With the Lehman collapse

and subsequent events, this perfect picture has drastically changed: fundraising now takes

twice as long and mega funds are considerably less “mega” these days, returns and exits don’t

come nearly so easily as in the past, and while not exactly out of favor, mega funds simply

don’t have the cache with investors that they had prior to the crisis. The arguments against

them are by now well known: they loaded their portfolio companies with excessive leverage,

chased monster club deals, paid too much for trophy deals, and generally benefited not so

much from improving the companies in which they invested but from a lucky alignment

with the euphoric pre-crisis market. Whether or not these are entirely accurate criticisms is a

subject that could be discussed at length, and certainly not all funds in the mega space were

equally implicated in all of these shortcomings; however, in the eyes of most investors, at least

PERSPECTIVETorreyCove CapiTal parTners

Source: Preqin. Note: Respondents were not prompted to give their opinions on each fund type/country/region individually; therefore the results display the fund types, countries and regions at the forefront of investors’ minds at the time of the survey.

Figure 1: Investor Attitudes to Different Fund Types at Present

0

10

20

30

40

50 Areas of the Market Investors are Seeking to Invest in Over the Next 12 Months

Mezzan

ine

Othe

r

Large

to Meg

aBu

yout

Fund

-of-fu

nds

Distr

essed

Pri va

te Eq

uity

Grow

th

Seco

ndari

es Fu

nds

Ventu

re Ca

pital

Small

to Mid

M

arket

Buyo

ut

2 | TorreyCove Capital Partners O C T O B E R 2 0 1 2

some of these will ring true to varying degrees, and this is what has caused the relative decline in

sentiment toward mega funds. Given this outlook, it would be useful – and refreshing – to take a

step back and look at the entire buyout space with a more balanced, objective eye. In this light, a

good question is: just how have bubble era mega/large cap buyout funds fared? In this piece, we

will try to answer that question, and then use it as a springboard into a larger discussion about the

role of various buyout size cohorts in an investor portfolio.

The Bubble Vintages: Performance from 2006 & 2007

Just how poorly did buyout firms raised in the years immediately preceding the crash fare? As seen

in the below chart, unsurprisingly, buyout funds did indeed underperform, both on a historical

basis within the buyout strategy and in comparison to most other strategies within the private

equity world. A couple of things are notable:

• While disappointing, the performance of buyout funds of all sizes from problematic vintage

years has improved in recent years, and the large losses that were expected a few years ago have

not materialized in the aggregate. In fact, buyout funds have outperformed most other asset

classes over five and ten years, as seen in the below chart.

• So far, larger buyout funds of 2006 vintage have underperformed by a meaningful margin,

but the 2007 vintage has effectively held its own with the smaller fund groups. Any advantage

that might have accrued to the latter has proved short lived.

Why have buyout funds performed better than expected so far? Much of this can be attributed to

the extremely generous debt terms granted to buyout-backed companies prior to the crisis, the

accommodative Federal Reserve policy maintained since the crisis erupted, and the willingness

of banks to “amend and extend” debt held by buyout-backed companies. But the actions of

Source: Preqin Source: Thompson Reuters 5-, 10-year Pooled Horizon Returns as of 6/30/12 (All Buyouts); NCREIF Property Index 5-, 10-year return as of 6/30/12 HFRI RV: Fixed Income-Corporate Index total 5-, 10-year return as of 6/30/12; Russell 3000 Total Return Index, 5-, 10-year return as of 6/30/12; USD Total Return Money Market Index as of 3/31/12 and 6/30/12

Figure 2: Buyout Pooled IRRs Figure 3: Returns Over the Past 5 and 10 Years

0

2

4

6

8

10

10-Year Returns

5-Year Returns

Cash & Equivalents

Public Equity

Fixed Income

Real Estate

All Buyouts

0

2

4

6

8

10SmallMediumLarge

20072006

Buyout Funds: Large Versus Small. What to Consider Beyond Size. | 3

the managers in terms of rationalizing capacity, reducing workforces, and cutting expenses in

anticipation of a difficult macroeconomic environment have also contributed.

The brief outperformance of middle/small buyout funds is not too surprising, given the large and

mega firms’ heavy exposure to over-levered and over-priced bubble era deals that have acted as

a drag on performance.

Longer-Term Performance

Clearly, buyout fund performance in what could arguably be their worst vintage years has been

uninspiring, but not disastrous. But what does performance look like going back over multiple

market cycles and what conclusions regarding strategy can be drawn from those results? In order

to evaluate this question, we reviewed performance data for various holding periods (20-year, 10-

year, etc.) for large/mega, middle, and small buyout funds, in order to determine if there is in fact

a meaningful performance differential depending on fund size (and by extension, the size of the

companies in which the fund invests).

The performance data relating to median returns for horizon periods ranging from 3 months out to

20 years for each size cohort of buyout funds appears to indicate a moderate inverse relationship

between performance and fund size over certain time horizons.1 However, this relationship is a bit

dubious, primarily as a result of two important factors:

• The relationship is not linear, as demonstrated by the outperformance of middle market funds

versus both large/mega market and small market funds in certain periods, most notably in the

15- and 20-year horizons. This weakens the argument that smaller fund sizes will on average

correlate with higher returns; in fact, in both the 15- and 20-year horizons, large/mega funds

outperformed the smaller group.

1. Thomson Reuters

Figure 4: Median Pooled IRRs Figure 5: Top Quartile Returns Pooled IRRs

Source: Thomson Reuters Source: Thomson Reuters

0

3

6

9

12

15

Large

Medium

Small

20-year15-year10-year5-year3-year0

5

10

15

20

25

30

35

Large

Medium

Small

20-year15-year10-year5-year3-year

Clearly, buyout fund

performance in what could

arguably be their worst years

has been uninspiring,

but not disastrous.

4 | TorreyCove Capital Partners O C T O B E R 2 0 1 2

• The average return data is inconsistent. Leadership appears to shift between the large/

mega and middle market groups for the more meaningful periods under review, with the

preponderance of the evidence pointing to a slight edge by the middle market cohort (throwing

some cold water on the oft-heard refrain, “just another middle market buyout fund.”). This

suggests that, at least in terms of median returns, any inverse relationship of returns to fund

size would be limited to the comparison between middle market and large/mega market funds.

However, in the private equity world, median performance is not a particularly useful benchmark,

since it rarely compensates investors for the additional risk of the asset class. So is there any fund

size/performance connection using top quartile performance as the benchmark? Indeed, top

quartile data, using the same time horizons and size ranges, makes a stronger case for such a

relationship. Looking at the same time horizons, the small and middle market funds outperformed

the large/mega funds in each period. Some reasonable inferences to draw:

• For top quartile funds, there appears to be an inverse relationship between fund size and

performance to some degree, at least between the large/mega funds and the middle/small

funds (taken as two distinct groups).

• The data do not support drawing the same conclusion regarding the performance differential

between middle market and small market funds.

Source: Thomson Reuters

Figure 6: Performance Differential

-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0

2.5 Medium vs. LargeSmall vs. Large

20-Year15-Year10-Year

Median

0

3

6

9

12

15 Medium vs. LargeSmall vs. Large

20-Year15-Year10-Year

Buyout Funds: Large Versus Small. What to Consider Beyond Size. | 5

• The inverse relationship between large/mega and small/middle segments is not too

surprising, given that larger funds typically invest in more efficient markets populated by more

established companies.

A key characteristic of the data is the larger average dispersion between the top quartile and

median return for the small and middle market segments when compared to the large/mega

segments. This simply supports what informed practitioners in the private equity world have

observed for some time: the difference between a solid manager and a mediocre manager tends

to increase with smaller fund sizes. One of the most important reasons is that nearly all of the

large and mega cap managers are established, and have some measure of past success. The small

and middle market universes, by contrast, have a much higher percentage of first-time and less-

established managers in their ranks, which leads to more underperforming funds and failed funds,

thereby increasing the range between top and bottom. This contention is also supported by our

analysis of data from Preqin over ten vintage years ending in 2009 (see below chart). For nearly

all periods under review, the range of returns was greater for small and middle market firms in

comparison to the large and mega funds, suggesting a higher level of risk relating to the former.

Figure 7: Difference in IRR Percent Between Top and Bottom Quartile Performance by Size in Each Vintage Year

Source: Preqin

Small Buyouts

Large Buyouts

Medium Buyouts

4 Period Moving AverageLarge Buyouts

4 Period Moving AverageMedium Buyouts

4 Period Moving AverageSmall Buyouts

0%

5%

10%

15%

20%

25%

30%

The difference between a

solid manager and a mediocre

manager tends to increase

with smaller fund sizes.

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

6 | TorreyCove Capital Partners O C T O B E R 2 0 1 2

Relative Advantages and Risks of Buyout Strategies

Large and Mega Market

So the numbers point to a higher risk profile for small and middle market funds. How does this jibe

with the qualitative and anecdotal information relating to the various size segments in the buyout

universe? In this respect, our assessment of large/mega buyout funds as exhibiting somewhat

lower risk than their smaller peers rests in part on the following reasons:

• Established franchises, many of which extend back to the 1980s and early 1990s

• Substantial track records, demonstrating success over multiple market cycles

• Large institutional infrastructure, primarily in terms of critical investment talent

• Lower key person risk, due to breadth and depth of investment team

• “Brand value” fosters credibility with sellers, purchasers, lenders, and other intermediaries

• Due to the size of their typical investee companies and their established networks, large/

mega funds are often able to attract superior C-level management to run portfolio companies

• Increased ability to assist portfolio companies with strategic initiatives related to sourcing

and selling on a global basis

• Leverage with financial institutions such as commercial and investment banks

• Access to a large pool of patient, reliable limited partners

• Advantage in attraction and retention of investment talent

• Typically, the larger companies in which large/mega funds invest have several advantages in

relation to smaller companies, namely:

▪ Dominant or substantial market share

▪ Known brand name

▪ Better access to capital markets

▪ More diverse business lines, which provide some measure of protection from cyclicality in

any one product or service

▪ More rounded and professional management teams

▪ More institutionalized processes, governance, and decision making

▪ Generally higher level of public scrutiny

Large/mega funds have some

powerful advantages in terms

of stability, market position, and

access to capital and investment

talent.

Buyout Funds: Large Versus Small. What to Consider Beyond Size. | 7

Clearly, large/mega funds have some powerful advantages in terms of stability, market position,

and access to capital and investment talent. Combined with the characteristics of many of the

companies in which they invest, these factors provide a greater insurance against loss, all else

equal.

The fact that most large/mega investment funds are today quite diversified in terms of business

lines and dramatically larger than they were (AUM) even ten to fifteen years ago confers many of

the advantages noted above, but also some problems from the investor point of view. The most

important are:

• Substantial degradation in alignment of interest that occurs as large/mega funds branch

into new strategies and materially increase AUM. The shift from an investment management

to an asset-gathering focus is nearly guaranteed to weaken the alignment of the firm with any

particular investor in any particular strategy.

• Most of the preeminent funds in the mega fund space have gone public in one way or another

over the past several years. The difference between an organization managing a single (even

very large) fund focused on a fairly well defined strategy with an employee base and limited

partners that are financially and philosophically committed to that strategy is quite marked in

comparison to an organization characterized by a “multi-strategy” fund menu, assets under

management several orders of magnitude greater than for a single fund strategy, a diverse

employee base, different limited partner constituencies, and at least some accountability to

public investors.

• Use of leverage as a key return driver and higher reliance on financial market and credit cycles

to generate target returns.

• Sourcing investments in markets that are relatively more efficient in comparison to small and

middle market funds, which generally indicates less potential upside.

8 | TorreyCove Capital Partners O C T O B E R 2 0 1 2

Small and Middle Market

The advantages of the small and middle market buyout space are perhaps not as numerous, but

their strength is substantial. Chief amongst these are the following:

• Less capital under management allows a disciplined fund to be highly selective, concentrating

its investments on the most attractive opportunities.

• Greater ability to develop focused strategies (often around particular sector expertise) that

enhances market presence, preferred deal flow, and execution.

• Though often overstated, purchase multiples are usually somewhat lower in comparison with

the large/mega sectors (especially for smaller deals), indicating more downside protection and

less need for leverage to amplify returns.

• The use of leverage as a major return driver is less important in comparison to the larger end

of the buyout universe, which lowers risk, all else equal.

• Substantially larger target universe of potential investee companies in relation to number of

funds, which further enhances selectivity.

• The value proposition pertaining to small and middle market companies is considerably clearer

than that for larger companies (absent leverage and market timing) and its potential payoff

is also higher. Most smaller enterprises, though they may have a strong market position and

some real brand value, are in need of “institutionalization” with respect to systems, processes,

governance, and C-level depth, as well as growth capital and strategic direction. These value

levers are not usually present to the same degree for larger, more established companies.

• Generally, the practice of improving operations as a value-added technique will find more

fruitful ground in the small and middle market space, for the reasons cited above.

• Entrepreneurial, aligned, and motivated professional team. The most successful middle

and small market funds are built around a core team of seasoned professionals that are

still hungry - not only in the strictly financial sense but in the sense of building an enduring

enterprise. Smaller funds usually have only one major investment strategy and their principals

often have a large amount of their financial resources (as well as reputation) invested in that

strategy, all of which creates strong alignment.

The disadvantages associated with small and middle market buyout shops principally relate to the

organizational environment attendant with less substantial assets under management. Essentially,

what they gain in terms of alignment of interest, increased focus, and increased specialization due to

smaller fund sizes, comes at a cost in terms of stability, some of the key aspects of which are as follows:

• Increased susceptibility to shocks (particularly for small funds). Smaller funds are usually more

concentrated due to financial and organizational constraints.

• In terms of risk within the portfolio, smaller enterprises are more likely to suffer impacts from

customer revenue concentration, key person losses, and even such things as financial reporting

This higher overall business

risk, when added to the higher

portfolio concentration of smaller

funds, points to an increased

likelihood of “blowups”.

Buyout Funds: Large Versus Small. What to Consider Beyond Size. | 9

irregularities. This higher overall business risk, when added to the higher portfolio concentration of

smaller funds, points to an increased likelihood of “blowups” and a larger impact of these on overall

performance.

• Lower assets under management and a higher reliance on profitable investments is a strong

aligner of interests with investors, but can also create the environment for increased organizational

instability for smaller investment firms. These stresses can manifest in several ways, but most often

emanate from key person considerations, such as:

▪ One or two dominant investors, leading to potential instability at the firm.

▪ Concentration of fund economics as well as decision making with one or a few key persons,

which eventually may lead to turnover of other important professionals.

▪ Decision making is not institutionalized, but is overly reliant on one person’s (or a small group of

people’s) judgment, which over time will often lead to major missteps.

• Finally, poaching of talented mid- and senior-level professionals, along with normal entrepreneurial

spinouts of such individuals, can be counted on to take a toll on the smaller firm’s stability from a

professional standpoint.

Portfolio Implications

The performance data and qualitative factors described above point to two main conclusions.

First, experience and evidence (imperfect though it is) suggests that returns from the buyout

asset class can be maximized over time by deploying more capital to managers that purchase

small and middle market companies. The major caveat here is that this supposition holds only

for top quartile funds. Second, large and mega buyout funds, on average, are lower risk than

middle and small market funds. Taken together, these findings have certain implications for the

strategic management of the buyout strategy within the context of an institutional portfolio.

Tactical

A few thoughts on the appropriate tactical position for a buyout allocation given the current market

environment are in order. As noted, there has been a clear bias for the past few years (continuing

today) in favor of the middle and small market buyout sectors over the large and mega sectors. While

consensus opinion is often wrong, the case for this bias looks to be on pretty firm ground. The more

limited deal flow in the large/mega space, relatively higher reliance on leverage to generate returns,

and unreliable IPO markets should impact recent vintages of the large/mega space more heavily than

their counterparts in the middle/small spaces. To the extent that large/mega funds have relied on

leverage and strong exit markets to enhance returns, they will be at a slight disadvantage until some

sense of stability returns to exit markets and there is more visibility on growth. Conversely, small and

middle market funds’ emphasis on operational improvements, along with less reliance on leverage,

should work to their benefit.

1 0 | TorreyCove Capital Partners O C T O B E R 2 0 1 2

Strategic

Given what can reasonably be concluded regarding buyout fund risk and return, how should an

investor approach the buyout asset class over the longer term? As a beginning, we would suggest

viewing buyouts in a somewhat different light than what might be the norm:

• The allocation between large and small buyouts is less a tactical decision than a strategic one.

• The difference between mega/large buyouts and middle/small (and even within those

groups) is not simply a matter of quantity, but a difference in kind – the characteristics and value

drivers relating to large buyout deals are substantively different from those relating to smaller

deals (in much the same way that earlier stage venture capital is different from growth stage

capital).

• Investing in the small and middle market sectors of the buyout universe is comparatively

more labor intensive in regards to, due diligence, and risk control.

• The critical nature of manager selection with respect to the small and middle market funds

is clear, due to the higher dispersion of returns and implication of higher inefficiency in those

segments. Median returns are not acceptable within those spaces. Because they are less able

to rely on inexpensive credit and strong public markets to generate attractive exits, small and

middle market funds must rely more intensively on operational and strategic levers to increase

value. For this reason, the due diligence on a small or middle market manager must be equally

intense, establishing the validity and differentiation of the funds’ strategies assessing/quantifying

the ability of a fund to execute a plan that includes extensive operational improvements.

• The tradeoff between the size cohorts is more accurately viewed as one between risk and

potential return rather than as absolute outperformance by one or the other group.

• The important elements for determining an appropriate strategic allocation between the two

are return goals, risk tolerance, and the lifecycle of an investor’s private equity program.

When viewed in this light, the “right” allocation between large and small buyouts becomes a

function of an investor’s return and risk profile: those with more conservative return targets and

less appetite for risk will skew toward the larger buyout funds while those on the other side of the

spectrum will skew toward the smaller buyout funds. Just as importantly, organizations with larger

private equity allocations (usually more established programs) will generally have more capacity

Buyout Funds: Large Versus Small. What to Consider Beyond Size. | 1 1

for risk, as well as more organizational resources with which to manage that risk – be it dedicated

staff, qualified consultants/advisors, leverage with general partners, or some combination thereof.

As noted above, the higher dispersion of returns within the small and middle market buyout

spaces, combined with the much larger number of managers operating in those spaces, means

that institutions desiring substantial exposure in the lower end of the market must possess

strong organizational resources and expertise. If these factors are in place, it follows that such

organizations would be better served by a substantial bias toward the middle/small portion of

the buyout sector. In a practical sense, then, new private equity programs should generally opt

for more safety over incremental potential return by investing in the larger, more established

funds. In the case that such investors have higher risk toleration but few organizational resources,

a fund of funds focused on small/middle buyouts may be a viable option; however, the danger

of over-diversification and the substantial additional fee drag often make these less attractive.

A better option, if available, would be a separate account, with a defined investment program,

more concentrated investments, and a reasonable fee structure. For more mature private equity

programs that are appropriately diversified, more experienced, and possessing superior resources,

the potential of higher returns makes direct investments in a portfolio of small and middle market

managers the better option.

For instance, possible allocations for investors at the extremes of lifestyle stages may look

something like this:

Figure 8: Possible Allocation

0

20

40

60

80

100

Large and Mega Market Buyouts

Small and Middle Market Buyouts

0

20

40

60

80

100

Large and mega market buyouts

Small and middle market buyouts

LOW

HIGH

75-85%

25-35%

0-25%

65-75%

Risk Tolerance

Return Target

1 2 | TorreyCove Capital Partners O C T O B E R 2 0 1 2

TorreyCove Capital Partners is a global alternative investments specialist, currently overseeing approximately

$19.5 billion of private equity assets. As a client-oriented firm, we create value through a combination of private

equity market intelligence, objective advice, insightful investment guidance and selection, and innovative

investment products. To find out more about our firm, please visit:

W W W . T O R R E Y C O V E . C O M

Conclusion

The news from the front regarding the performance of the large and mega buyout funds is actually

much better than expected. In spite of this, a real case can be made for a tactical shift in favor of

the middle market in today’s environment. However, any tactical shift should always be seen as an

overlay on a thoughtful, defined, and disciplined strategic program. For buyouts, such a program

should focus primarily on the risk/return tradeoff inherent within the buyout space, and how that fits

within an institution’s risk tolerance, its ability to absorb additional risk, its stage of development, and

resources that can be dedicated to managing the risk of investments in the buyout asset class.

This TorreyCove Perspective has been prepared by TorreyCove Capital Partners LLC for informational purposes only. It does not

constitute legal, securities, tax or investment advice or an opinion regarding whether investment is appropriate. Readers should not

act upon this information without first seeking advice from professional advisers.