Figure 1: Annualised return by asset class (%)¹.

This strong return profile has helped the market to attract more capital over the last few decades. Given this shift in market allocation, an important question emerges: if private equity has received so much capital in recent years, why is it still difficult for LPs to access the fund managers of this industry?

To fully understand the dynamics behind this question, it is important to start by taking a step back. Looking at the different segments of private equity, we see that this increase in funds raised has not been distributed evenly across the industry, but has been concentrated in specific segments of the industry, particularly in the high end of the market as seen below.

Figure 2: Capital raised by fund size over the last XNUMX years ($ BN)².

While all segments (distinguished in the figure above by fund size) have increased overall fundraising over the last ten years, this effect more pronounced in the larger funds, especially for those of over $5BN. These large cap funds have gone from representing approximately 20% of total fundraising in 2012 to over 40% in 2021, a notable increase that accounts for a significant portion of the new capital coming into the broader private equity market.

In contrast, the lowest segment analysed, funds of less than $500MM in size, has decreased in relative scale, having dropped from about 20% of total capital raised in 2011 to around 10% in 2021- despite the + 50% growth in absolute value of capital raised over the last decade

There are several explanations for the concentration of new capital into higher market segments, including the need to put increased dry powder to work efficiently in large cap funds, as discussed in previous editions of our newsletter.

Another crucial factor at play is the tendency for smaller managers to drift into higher market segments. As managers at the lower end of the market generate returns in line with investor expectations and gain traction with a loyal LP base, many opt for increased fund sizes to capture management fees. As a result, GPs join the growing number of managers raising capital in the higher end of the market.

If the natural trend for small funds is to evolve towards the higher market segments with larger funds, what managers remain in this segment to raise the nearly 10% of industry capital allocated to the lower end of the market? There are three main typologies of lower mid market funds, which we profile below.

Firstly, there are what we might call “underperforming” managers, including those that have not generated sufficiently attractive returns to raise funds large enough for a category jump. This may also be caused by factors unrelated to the manager’s historical performance, such as succession issues, team turnover, changes in strategy, or other circumstances.

Secondly, many category-jumping GPs are replaced every year by newly launched “emerging managers”. Emerging managers tend to raise smaller funds at the lower end of the market given the reduced fundraising requirements that allow these managers to start investing as soon as possible.

Figure 3: Return (measured as multiple of investment net of fees) according to fund number³.

Our market analysis concludes that managers’ first and second vintage funds have the potential to generate more alpha than funds launched by more mature managers. This effect may be partially explained by the high motivation of new managers at the beginning of their career to deliver exceptional returns to early investors, since the continuity of the manager itself depends on the success of early funds. Moreover, whereas mature managers are typically led by seasoned industry professionals who have amassed considerable wealth over their careers, emerging managers tend to be led by highly incentivised younger professionals who have yet to enter their prime earning years.

On the other hand, investing in this class of manager assumes a number of associated risks that one may avoid by investing with mature managers, including the lack of an established firm track record and limited experience as a cohesive team.

Finally, the third major group of smaller funds would be made up of managers that we could call “disciplined”, since, despite their past success, they decide to keep the size of their vehicles constant (or at least increase it slowly over time) to ensure that they maintain a similar strategy to the one they have pursued in the past.

These managers often forgo a significant fund size increase with an increase in fund frequency. Allocation within the investor base of such managers is almost exclusively reserved for LPs who supported the manager in early vehicles, making these disciplined managers unavailable to new investors. The scarcity of available allocation in such managers highlights the value offered to investors who identify the right emerging managers: some of the market’s best managers are reserved for LPs who partnered with the GP from its earliest years.

The landscape of lower mid market managers described above explains the central question raised earlier regarding the difficult access to private equity. While this difficulty is accentuated in larger funds due to higher capital requirements and greater demand, access to smaller funds is not without its complexities.

Furthermore, given the reduced fund sizes in the lower end of the market, there is less “space” available in each vehicle, forcing investors to compete for allocation in the most attractive emerging and disciplined managers. In order to effectively execute an investment strategy in such a competitive market, investors must be able to identify promising managers and establish strong relationships with them, for which industry experience and reputation are crucial competitive advantages.

Notes:

1. Global fund performance by asset class, net IRR as of Q3 2021, funds of vintages 2008-2018. Source: Burgiss as reported in McKinsey Global Private Markets Review 2022.
2. Capital raised globally in buyout funds. Source: Preqin as reported in Bain & Company Global Private Equity Report 2022.
3. Source: internal analysis based on information on liquidated funds (1997-2018 series) in Preqin.