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As Private Equity Funds Get Bigger, They May Be Less Likely to Deliver

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As Private Equity Funds Get Bigger, They May Be Less Likely to Deliver

By John McDonald

Private equity funds are getting bigger and bigger, capable of raising larger and large amounts of capital. Unfortunately, just because a fund is setting records for equity raises does not mean it is going to be a successful venture for investors. 

According to the Wall Street Journal, “megafunds” of $10 billion or more have performed only “roughly in line with the S&P 500” rather than exceeding that market’s performance, as one would expect.

Private equity funds have a historical reputation for returns closer to 20 percent and higher rather than just barely over 14 percent, as the S&P posts. However, at the end of last September, investment firm data and analytics company Cambridge Associates released information indicating private-equity funds of $10 billion or more had posted five-year annualized returns that were also just over 14 percent, and many of them looked even worse when analysts examined a longer timeframe. 

Over a span of nearly 13 years, returns for large funds fell to 10 percent, again nearly the same as the S&P 500.

Does this mean that all private equity raises are really no more likely to bring you big returns than a traditional Wall Street stock portfolio? 

Not necessarily. Smaller funds are less tied to broader market performance, Cambridge analysts wrote. “U.S. funds of less than $350 million had a correlation of 0.38 with the S&P 500,” they said. The larger funds’ correlation was nearly double that.

Of course, working with a megafund does have some advantages. Megafund managers tout their funds’ outperformance of the competition when the market is down, saying there is little room for valid comparison at present, when the market has been in a 10-year bull run.

Outsized funds also are among the few venues in which large pension and sovereign-wealth funds can invest massive amounts of cash outside of the major exchanges. Andrea Auerbach, head of Cambridge global private-investment groups, said of megafunds, “They are definitely serving a role in your portfolio, but it may not be the role you think they are serving.”

Steve Mosely, who heads the Alaska Permanent Fund’s department of alternative investments, reported his fund has benefited from putting about $1.6 billion annually toward private equity investments. 

Mosely targets funds between $500 million and $1 billion, writing proportionally large checks to these funds in order to gain access to more co-investment opportunities. 

The results: 5-year annualized returns of 22.6 percent at the end of 2018. Mosely noted the strategy is much more labor-intensive because he oversees more investments and must maintain relationships with more general managers. However, he believes it is worth it.

“We discovered by having more robust relationships with mid-sized and smaller [general partners], we could deliver better returns,” Mosely concluded. 

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