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Pension funds missing out on private equity performance

04 Dec 2014


Investments in more diversified private equity fund advisers yield weaker returns

 

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Institutional investors are missing out on outperformance if they allocate more capital to managers with lesser PE focus, according to new research conducted by Private Equity at LBS and supported by Adveq, the private equity investor.

The study, based on US data collected from the U.S. Securities and Exchange Commission (SEC) filings for over 3,800 advisors of private equity funds, and supplemented with private equity performance data from Preqin, shows that pension funds in particular tend to focus on larger managers who have typically diversified away from private equity assets. For private equity advisors with more than $5bn in AUM, the average proportion of assets in private equity is just 36%, while for advisors with assets of between $500m and $1bn the proportion stands significantly higher at 63%.

This has a substantial impact on the performance of US pension funds. As the research shows, those managers that hold a greater percentage of their AUM in private equity generate better absolute returns and superior internal rate of return (IRR) performance relative to their peers.

The research also demonstrates the correlation between reported regulatory violations and underperformance. Larger managers tend to be more complex and this leads to higher potential for mistakes, as shown by the fact that 12% of US private equity firms with over $5bn in AUM report violations of regulations compared to 5% for those with between $500m and $1bn.

In addition, the filings reveal that as fund managers increase in size, alignment of interests with investors tends to decrease. For managers with AUM between $500mn and $1bn, 25% of employees have significant management stakes in the firm, but this decreases to 14% for those with AUM above $5bn. The evidence suggests that this also has a negative impact on returns.

Further, the study finds that a lower proportion of investment professionals relative to overall AUM, a characteristic of large private equity advisors, has a negative impact on returns.

Florin Vasvari, Associate Professor of Accounting London Business School and a Fellow of Private Equity at LBS, said:
“Many of the largest US private equity fund managers have been moving away from private equity assets for some time. This has been driven in part by pension funds looking to add more diversification to their portfolios, while simultaneously reducing the number of private equity managers they commit capital to.

“If this trend continues, the logical conclusion will be that larger private equity managers in the US will play more of a traditional asset manager role. This in turn will create opportunities for the smaller, more specialised private equity firms.”

Sven Lidén, Managing Director and CEO, Adveq, said:
“The study supports our observation that those smaller private equity managers who are dedicated to their asset class outperform the established brand names. It may be surprising to some that smaller manager size and focus actually translate into stronger alignment of interests and better governance. For institutional investors this means that picking true alpha providers from the large universe of smaller managers is well worth the effort.”