For VC and buyout funds, smaller means more

When it comes to buyout and venture capital funds, size matters.

New research by Invesco Private Capital, the private equity funds-of-funds arm of money manager Invesco Ltd., suggests that smaller private equity funds outperform larger ones.

While most of the empirical data focus on venture capital, reviewing its 30-year history of investing in the private equity asset class, Invesco discovered that larger buyout and venture capital funds underperform smaller ones.

“We always had a notion that smaller funds performed better,” said Theresa Boyd, senior associate in the New York office of Invesco Private Capital, who wrote a white paper on the subject.

Reviewing a combination of available research and Invesco's own portfolio, Invesco Private Capital executives discovered that their inkling was accurate. Invesco Private Capital has committed about $4.3 billion to more than 450 limited partnerships over 30 years. More than 70% of its venture capital funds are early-stage funds that hold less than $300 million, and 75% of its leveraged buyout funds are $1 billion or less.

Returns for the smaller venture capital funds in which Invesco invested produced returns of 2.1 times capital over the 30-year history, compared to what the paper called “venture-like returns” of two times capital.

Invesco's return experience is consistent with other research cited by the white paper.

Thomson Venture Economics All Venture Capital Index, reflecting all vintage years as of Sept. 30, indicated that early stage funds with $100 million to $300 million in total committed capital earned an internal rate of return of 22.3%, besting returns of larger funds. Those with $300 million to $500 million in committed capital earned 7.8% IRR; those $500 million to $1 billion, 1.1%; and those with more than $1 billion, 0.9%.

The reason for the difference is that smaller funds are more nimble and efficient, Ms. Boyd said. When they exit their portfolio companies, they generally produce higher returns.

The smaller leveraged buyout funds in Invesco Private Capital's portfolio also outperformed the larger funds, but the difference in performance was not as stunning, Ms. Boyd said.

Its historical buyout investment performance for investments in funds that are $1 billion or less is 1.7 times multiple of cost.

Thomson Venture Economics data for buyout funds of all vintages as of Sept. 30 showed the mega funds — those with more than $1 billion — were by far the worst performing funds with 9.3% pooled average internal rate of return.

The best performing small buyout funds were between $500 million and $1 billion, with a 15.7% return. Small buyout funds, with less than $250 million, had a 15% IRR. Smaller venture capital funds outperform larger funds because “when you start raising larger and larger funds, one home run will not affect the overall returns, (as it will in a small fund),” Ms. Boyd said.

In venture capital, investors know that there will be losers in the portfolio, but the idea is to invest early in companies and hope that one company will be a smash hit, she explained.

”With smaller funds, you get a bigger bang for your buck,” she added. “You can't rely on a Google or a Facebook to come along that often. That's a once-in-a-decade event.”

Buyout fund managers do not rely as much on a home-run investment to make the entire fund's return. Buyout is more stable, with general partners hoping for to earn about the same — roughly between two times and five times the money they invested for each of their portfolio companies, Ms. Boyd said.