A major study of the returns from private equity firms over the past 40 years has produced some unusual insights into their performance, not the least of which is that the largest firms have produced the worst results.

The study, undertaken by the Edhec-Risk Institute, part of France’s Edhec Business School, looked at 75,000 investments worldwide and concluded that the scale of private equity firms was a significant and consistent driver of returns, with small investments significantly out-performing large ones.

For the 10% of cases where the fewest investments were held simultaneously, the median annual internal rate of return (IRR) was 36%. For firms with the largest portfolios of companies, the annual IRR fell to 16%. The large portfolios also tend to have almost twice the proportion of their companies collapse and more than three times as many that lose money.

Edhec says that the number of simultaneous investments held by the firm over the life of a deal is a better predictor of negative returns than other proxies.

That’s not necessarily counter-intuitive as it is an axiom in funds management generally that the greater the funds under management the more difficult it is to generate above median returns, partly because individual investment decisions have less impact on overall returns as the portfolio becomes larger. For private equity, however, the authors of the Edhec report conclude that communication is the reason for the lower returns within large portfolios.

As the firms get larger the communication over individual investments suffers and less time can be devoted to individual investments, they say. The study also shows that most private equity investments are small, with a median equity investment of only $US10 million and that only about 10% of the investments analysed involved more than $100 million of equity.

Another possible strand of the explanation for the divergence of the returns between small and large firms is that the big firms tend to need to make big individual investments to deploy the funds they attract.

Their targets tend to be large listed companies or divisions of big companies where the vendors are likely to have a good understanding of the value of what they are selling and significant negotiating leverage, given that private equity generally wants and needs to own 100% of its investments.

Smaller investments are likely to be cheaper and easier to manage and add value to and the capital structures supporting that investment simpler and involving less leverage. Pre-crisis, when credit was exceptionally and unsustainably cheap, leverage would presumably have worked for the big firms with big portfolios; post-crisis it has worked against them.

Overall, private equity does tend to generate superior returns, with a median IRR of 21%. One in 10 investments ends in bankruptcy but one in four has an IRR above 50%.

Interestingly, “quick flips” — investments held for less than two years — grossly out-perform long-term investments, with the quick flips generating a median IRR of 85% but investments held more than six years producing a median IRR of only 8%.

Also of note in the study is that investments in emerging economies substantially under-perform, delivering a median annual return of only 13% against the 20%-plus returns in developed economies. Less leverage, poorer legal environments and greater difficulty in exiting the investments were cited as explanations for the weaker performance.

The negative correlation between size and returns ought to encourage the emergence of more boutique managers and the continuation of the evolution of the industry giants such as Blackstone, KKR and TPG into something more akin to investment banks, with funds management, advisory and securities trading businesses alongside their traditional private equity portfolios.

*This article originally appeared on Business Spectator.

Peter Fray

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