Perhaps the most interesting finding in Gupta’s research is a positive correlation between fund size and performance – that larger funds outperform smaller ones. Yet Sabrina, your research finds the exact opposite. What do you think is going on here?
Sabrina Howell: “It is vital to isolate causation when analysing the impact of fund size on performance. That’s because high-quality GPs inevitably enjoy more LP demand. Fees calculated as a share of AUM create a strong incentive to raise more capital. Therefore, we expect that holding all else equal, high-quality GPs will raise larger funds. “However, our research shows that when a manager raises a larger fund, there will be a cost to LPs’ returns. Specifically, our results imply, with causal interpretation, that if an average fund grows beyond around US$2.6bn, holding all else constant, the size increase would drive the net present value below zero.”
Josh Lerner: “I completely agree. One of the reasons that a fund gets big is that the manager is doing well. It’s a feedback cycle whereby the better your performance, the more people want to invest with you. “In an ideal world, an experiment that involved handing random funds of different sizes half a billion dollars each, irrespective of past performance, would determine the correlation between fund size and performance. That’s not possible in the real world, of course. This paper has identified the next best thing by looking at situations where someone has given a big gift to a university endowment. The hypothesis is that the endowment will continue investing in the same way that it did before, the only difference being that it makes bigger commitments, but to the same managers.
“With respect to the question of whether getting really big negatively impacts performance, the answer from this natural experiment is a resounding yes. The results suggest that if a fund increases in size by 10%, which is not an unreasonable shift, the IRR will drop by 1%.”
William Megginson: “Both of these pieces of research can’t be right, but I am most persuaded by the idea that returns diminish with size. There are network industries where the opposite appears to be the case, for example with Google and Microsoft, and they see increasing returns as they scale. But finance has exhibited diseconomies of scale throughout history, with returns diminishing with size, at least beyond a certain point.”
Reji Vettasseri: “I am also more inclined to go with the historic consensus, which is that the larger the fund is, the harder it is to deliver outperformance. Even if you are able to find a way to add value, intense competition for a relatively limited number of companies of a certain scale means that valuations are frequently high when compared with smaller deals.
“The performance differential between the large and smaller deal markets was diluted by leverage over much of the past decade, when finance was cheap. That’s because larger deals can sustain more debt, which boosts returns. So size drag and the competition effect were temporarily offset by cheap leverage. That is no longer true, however. There is less debt available and what remains is more expensive, so I think outperformance of the small-cap and mid-market will only become more pronounced.”
