Buyout Funds: Large Versus Small. What to Consider Beyond Size.

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Mega funds are considerably
less mega these days,
returns and exits dont
come nearly so easily as in
the past . . . and they dont
have the same cache with
investors.
BUYOUT FUNDS: LARGE VERSUS SMALL.
WHAT TO CONSIDER BEYOND SIZE.
Once upon a time, not that long ago, mega buyout funds were the undisputed kings of
the private equity world. They rolled up one blockbuster deal after another, had access to
enormous amounts of cheap credit with easy terms, distributed record amounts back to
investors after relatively short holds, and just as quickly asked those investors to commit even
more to their next fund, which was of course signifcantly larger than the last. Everyone was
happy, returns were good, and fundraising was easy (and short). With the Lehman collapse
and subsequent events, this perfect picture has drastically changed: fundraising now takes
twice as long and mega funds are considerably less mega these days, returns and exits dont
come nearly so easily as in the past, and while not exactly out of favor, mega funds simply
dont have the cache with investors that they had prior to the crisis. The arguments against
them are by now well known: they loaded their portfolio companies with excessive leverage,
chased monster club deals, paid too much for trophy deals, and generally benefted not so
much from improving the companies in which they invested but from a lucky alignment
with the euphoric pre-crisis market. Whether or not these are entirely accurate criticisms is a
subject that could be discussed at length, and certainly not all funds in the mega space were
equally implicated in all of these shortcomings; however, in the eyes of most investors, at least
PERSPECTIVE
TORREYCOVE CAPITAL PARTNERS
Source: Preqin. Note: Respondents were not prompted to give their opinions on each fund type/country/region individually; therefore
the results display the fund types, countries and regions at the forefront of investors minds at the tme of the survey.
Figure 1: Investor Attitudes to Different Fund Types at Present
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some of these will ring true to varying degrees, and this is what has caused the relative decline in
sentiment toward mega funds. Given this outlook, it would be useful and refreshing to take a
step back and look at the entire buyout space with a more balanced, objective eye. In this light, a
good question is: just how have bubble era mega/large cap buyout funds fared? In this piece, we
will try to answer that question, and then use it as a springboard into a larger discussion about the
role of various buyout size cohorts in an investor portfolio.
The Bubble Vintages: Performance from 2006 & 2007
Just how poorly did buyout frms raised in the years immediately preceding the crash fare? As seen
in the below chart, unsurprisingly, buyout funds did indeed underperform, both on a historical
basis within the buyout strategy and in comparison to most other strategies within the private
equity world. A couple of things are notable:
While disappointing, the performance of buyout funds of all sizes from problematic vintage
years has improved in recent years, and the large losses that were expected a few years ago have
not materialized in the aggregate. In fact, buyout funds have outperformed most other asset
classes over fve and ten years, as seen in the below chart.
So far, larger buyout funds of 2006 vintage have underperformed by a meaningful margin,
but the 2007 vintage has efectively held its own with the smaller fund groups. Any advantage
that might have accrued to the latter has proved short lived.
Why have buyout funds performed better than expected so far? Much of this can be attributed to
the extremely generous debt terms granted to buyout-backed companies prior to the crisis, the
accommodative Federal Reserve policy maintained since the crisis erupted, and the willingness
of banks to amend and extend debt held by buyout-backed companies. But the actions of
Source: Preqin Source: Thompson Reuters 5-, 10-year Pooled Horizon Returns as of 6/30/12 (All Buyouts);
NCREIF Property Index 5-, 10-year return as of 6/30/12 HFRI RV: Fixed Income-Corporate
Index total 5-, 10-year return as of 6/30/12; Russell 3000 Total Return Index, 5-, 10-year
return as of 6/30/12; USD Total Return Money Market Index as of 3/31/12 and 6/30/12
Figure 2: Buyout Pooled IRRs Figure 3: Returns Over the Past 5 and 10 Years
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5-Year Returns

Cash &
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Buyouts
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2007 2006
Buyout Funds: Large Versus Small. What to Consider Beyond Size. | 3
the managers in terms of rationalizing capacity, reducing workforces, and cutting expenses in
anticipation of a difcult macroeconomic environment have also contributed.
The brief outperformance of middle/small buyout funds is not too surprising, given the large and
mega frms heavy exposure to over-levered and over-priced bubble era deals that have acted as
a drag on performance.
Longer-Term Performance
Clearly, buyout fund performance in what could arguably be their worst vintage years has been
uninspiring, but not disastrous. But what does performance look like going back over multiple
market cycles and what conclusions regarding strategy can be drawn from those results? In order
to evaluate this question, we reviewed performance data for various holding periods (20-year, 10-
year, etc.) for large/mega, middle, and small buyout funds, in order to determine if there is in fact
a meaningful performance diferential depending on fund size (and by extension, the size of the
companies in which the fund invests).
The performance data relating to median returns for horizon periods ranging from 3 months out to
20 years for each size cohort of buyout funds appears to indicate a moderate inverse relationship
between performance and fund size over certain time horizons.
1
However, this relationship is a bit
dubious, primarily as a result of two important factors:
The relationship is not linear, as demonstrated by the outperformance of middle market funds
versus both large/mega market and small market funds in certain periods, most notably in the
15- and 20-year horizons. This weakens the argument that smaller fund sizes will on average
correlate with higher returns; in fact, in both the 15- and 20-year horizons, large/mega funds
outperformed the smaller group.
1. Thomson Reuters
Figure 4: Median Pooled IRRs Figure 5: Top Quartile Returns Pooled IRRs
Source: Thomson Reuters Source: Thomson Reuters
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Medium

Small
20-year 15-year 10-year 5-year 3-year
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Medium
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20-year 15-year 10-year 5-year 3-year
Clearly, buyout fund
performance in what could
arguably be their worst years
has been uninspiring,
but not disastrous.
4 | TorreyCove Capital Partners O C T O B E R 2 0 12
The average return data is inconsistent. Leadership appears to shift between the large/
mega and middle market groups for the more meaningful periods under review, with the
preponderance of the evidence pointing to a slight edge by the middle market cohort (throwing
some cold water on the oft-heard refrain, just another middle market buyout fund.). This
suggests that, at least in terms of median returns, any inverse relationship of returns to fund
size would be limited to the comparison between middle market and large/mega market funds.
However, in the private equity world, median performance is not a particularly useful benchmark,
since it rarely compensates investors for the additional risk of the asset class. So is there any fund
size/performance connection using top quartile performance as the benchmark? Indeed, top
quartile data, using the same time horizons and size ranges, makes a stronger case for such a
relationship. Looking at the same time horizons, the small and middle market funds outperformed
the large/mega funds in each period. Some reasonable inferences to draw:
For top quartile funds, there appears to be an inverse relationship between fund size and
performance to some degree, at least between the large/mega funds and the middle/small
funds (taken as two distinct groups).
The data do not support drawing the same conclusion regarding the performance diferential
between middle market and small market funds.
Source: Thomson Reuters
Figure 6: Performance Differential
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20-Year 15-Year 10-Year
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20-Year 15-Year 10-Year
Buyout Funds: Large Versus Small. What to Consider Beyond Size. | 5
The inverse relationship between large/mega and small/middle segments is not too
surprising, given that larger funds typically invest in more efcient markets populated by more
established companies.
A key characteristic of the data is the larger average dispersion between the top quartile and
median return for the small and middle market segments when compared to the large/mega
segments. This simply supports what informed practitioners in the private equity world have
observed for some time: the diference between a solid manager and a mediocre manager tends
to increase with smaller fund sizes. One of the most important reasons is that nearly all of the
large and mega cap managers are established, and have some measure of past success. The small
and middle market universes, by contrast, have a much higher percentage of frst-time and less-
established managers in their ranks, which leads to more underperforming funds and failed funds,
thereby increasing the range between top and bottom. This contention is also supported by our
analysis of data from Preqin over ten vintage years ending in 2009 (see below chart). For nearly
all periods under review, the range of returns was greater for small and middle market frms in
comparison to the large and mega funds, suggesting a higher level of risk relating to the former.
Figure 7: Difference in IRR Percent Between Top and Bottom Quartile Performance by Size in Each Vintage Year
Source: Preqin
Small Buyouts
Large Buyouts
Medium Buyouts
4 Period Moving Average
Large Buyouts
4 Period Moving Average
Medium Buyouts
4 Period Moving Average
Small Buyouts
0%
5%
10%
15%
20%
25%
30%
The diference between a
solid manager and a mediocre
manager tends to increase
with smaller fund sizes.
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
6 | TorreyCove Capital Partners O C T O B E R 2 0 12
Relative Advantages and Risks of Buyout Strategies
Large and Mega Market
So the numbers point to a higher risk profle for small and middle market funds. How does this jibe
with the qualitative and anecdotal information relating to the various size segments in the buyout
universe? In this respect, our assessment of large/mega buyout funds as exhibiting somewhat
lower risk than their smaller peers rests in part on the following reasons:
Established franchises, many of which extend back to the 1980s and early 1990s
Substantial track records, demonstrating success over multiple market cycles
Large institutional infrastructure, primarily in terms of critical investment talent
Lower key person risk, due to breadth and depth of investment team
Brand value fosters credibility with sellers, purchasers, lenders, and other intermediaries
Due to the size of their typical investee companies and their established networks, large/
mega funds are often able to attract superior C-level management to run portfolio companies
Increased ability to assist portfolio companies with strategic initiatives related to sourcing
and selling on a global basis
Leverage with fnancial institutions such as commercial and investment banks
Access to a large pool of patient, reliable limited partners
Advantage in attraction and retention of investment talent
Typically, the larger companies in which large/mega funds invest have several advantages in
relation to smaller companies, namely:
Dominant or substantial market share
Known brand name
Better access to capital markets
More diverse business lines, which provide some measure of protection from cyclicality in
any one product or service
More rounded and professional management teams
More institutionalized processes, governance, and decision making
Generally higher level of public scrutiny
Large/mega funds have some
powerful advantages in terms
of stability, market position, and
access to capital and investment
talent.
Buyout Funds: Large Versus Small. What to Consider Beyond Size. | 7
Clearly, large/mega funds have some powerful advantages in terms of stability, market position,
and access to capital and investment talent. Combined with the characteristics of many of the
companies in which they invest, these factors provide a greater insurance against loss, all else
equal.
The fact that most large/mega investment funds are today quite diversifed in terms of business
lines and dramatically larger than they were (AUM) even ten to ffteen years ago confers many of
the advantages noted above, but also some problems from the investor point of view. The most
important are:
Substantial degradation in alignment of interest that occurs as large/mega funds branch
into new strategies and materially increase AUM. The shift from an investment management
to an asset-gathering focus is nearly guaranteed to weaken the alignment of the frm with any
particular investor in any particular strategy.
Most of the preeminent funds in the mega fund space have gone public in one way or another
over the past several years. The diference between an organization managing a single (even
very large) fund focused on a fairly well defned strategy with an employee base and limited
partners that are fnancially and philosophically committed to that strategy is quite marked in
comparison to an organization characterized by a multi-strategy fund menu, assets under
management several orders of magnitude greater than for a single fund strategy, a diverse
employee base, diferent limited partner constituencies, and at least some accountability to
public investors.
Use of leverage as a key return driver and higher reliance on fnancial market and credit cycles
to generate target returns.
Sourcing investments in markets that are relatively more efcient in comparison to small and
middle market funds, which generally indicates less potential upside.
8 | TorreyCove Capital Partners O C T O B E R 2 0 12
Small and Middle Market
The advantages of the small and middle market buyout space are perhaps not as numerous, but
their strength is substantial. Chief amongst these are the following:
Less capital under management allows a disciplined fund to be highly selective, concentrating
its investments on the most attractive opportunities.
Greater ability to develop focused strategies (often around particular sector expertise) that
enhances market presence, preferred deal fow, and execution.
Though often overstated, purchase multiples are usually somewhat lower in comparison with
the large/mega sectors (especially for smaller deals), indicating more downside protection and
less need for leverage to amplify returns.
The use of leverage as a major return driver is less important in comparison to the larger end
of the buyout universe, which lowers risk, all else equal.
Substantially larger target universe of potential investee companies in relation to number of
funds, which further enhances selectivity.
The value proposition pertaining to small and middle market companies is considerably clearer
than that for larger companies (absent leverage and market timing) and its potential payof
is also higher. Most smaller enterprises, though they may have a strong market position and
some real brand value, are in need of institutionalization with respect to systems, processes,
governance, and C-level depth, as well as growth capital and strategic direction. These value
levers are not usually present to the same degree for larger, more established companies.
Generally, the practice of improving operations as a value-added technique will fnd more
fruitful ground in the small and middle market space, for the reasons cited above.
Entrepreneurial, aligned, and motivated professional team. The most successful middle
and small market funds are built around a core team of seasoned professionals that are
still hungry - not only in the strictly fnancial sense but in the sense of building an enduring
enterprise. Smaller funds usually have only one major investment strategy and their principals
often have a large amount of their fnancial resources (as well as reputation) invested in that
strategy, all of which creates strong alignment.
The disadvantages associated with small and middle market buyout shops principally relate to the
organizational environment attendant with less substantial assets under management. Essentially,
what they gain in terms of alignment of interest, increased focus, and increased specialization due to
smaller fund sizes, comes at a cost in terms of stability, some of the key aspects of which are as follows:
Increased susceptibility to shocks (particularly for small funds). Smaller funds are usually more
concentrated due to fnancial and organizational constraints.
In terms of risk within the portfolio, smaller enterprises are more likely to sufer impacts from
customer revenue concentration, key person losses, and even such things as fnancial reporting
This higher overall business
risk, when added to the higher
portfolio concentration of smaller
funds, points to an increased
likelihood of blowups.
Buyout Funds: Large Versus Small. What to Consider Beyond Size. | 9
irregularities. This higher overall business risk, when added to the higher portfolio concentration of
smaller funds, points to an increased likelihood of blowups and a larger impact of these on overall
performance.
Lower assets under management and a higher reliance on proftable investments is a strong
aligner of interests with investors, but can also create the environment for increased organizational
instability for smaller investment frms. These stresses can manifest in several ways, but most often
emanate from key person considerations, such as:
One or two dominant investors, leading to potential instability at the frm.
Concentration of fund economics as well as decision making with one or a few key persons,
which eventually may lead to turnover of other important professionals.
Decision making is not institutionalized, but is overly reliant on one persons (or a small group of
peoples) judgment, which over time will often lead to major missteps.
Finally, poaching of talented mid- and senior-level professionals, along with normal entrepreneurial
spinouts of such individuals, can be counted on to take a toll on the smaller frms stability from a
professional standpoint.
Portfolio Implications
The performance data and qualitative factors described above point to two main conclusions.
First, experience and evidence (imperfect though it is) suggests that returns from the buyout
asset class can be maximized over time by deploying more capital to managers that purchase
small and middle market companies. The major caveat here is that this supposition holds only
for top quartile funds. Second, large and mega buyout funds, on average, are lower risk than
middle and small market funds. Taken together, these fndings have certain implications for the
strategic management of the buyout strategy within the context of an institutional portfolio.
Tactical
A few thoughts on the appropriate tactical position for a buyout allocation given the current market
environment are in order. As noted, there has been a clear bias for the past few years (continuing
today) in favor of the middle and small market buyout sectors over the large and mega sectors. While
consensus opinion is often wrong, the case for this bias looks to be on pretty frm ground. The more
limited deal fow in the large/mega space, relatively higher reliance on leverage to generate returns,
and unreliable IPO markets should impact recent vintages of the large/mega space more heavily than
their counterparts in the middle/small spaces. To the extent that large/mega funds have relied on
leverage and strong exit markets to enhance returns, they will be at a slight disadvantage until some
sense of stability returns to exit markets and there is more visibility on growth. Conversely, small and
middle market funds emphasis on operational improvements, along with less reliance on leverage,
should work to their beneft.
1 0 | TorreyCove Capital Partners O C T O B E R 2 0 12
Strategic
Given what can reasonably be concluded regarding buyout fund risk and return, how should an
investor approach the buyout asset class over the longer term? As a beginning, we would suggest
viewing buyouts in a somewhat diferent light than what might be the norm:
The allocation between large and small buyouts is less a tactical decision than a strategic one.
The diference between mega/large buyouts and middle/small (and even within those
groups) is not simply a matter of quantity, but a diference in kind the characteristics and value
drivers relating to large buyout deals are substantively diferent from those relating to smaller
deals (in much the same way that earlier stage venture capital is diferent from growth stage
capital).
Investing in the small and middle market sectors of the buyout universe is comparatively
more labor intensive in regards to, due diligence, and risk control.
The critical nature of manager selection with respect to the small and middle market funds
is clear, due to the higher dispersion of returns and implication of higher inefciency in those
segments. Median returns are not acceptable within those spaces. Because they are less able
to rely on inexpensive credit and strong public markets to generate attractive exits, small and
middle market funds must rely more intensively on operational and strategic levers to increase
value. For this reason, the due diligence on a small or middle market manager must be equally
intense, establishing the validity and diferentiation of the funds strategies assessing/quantifying
the ability of a fund to execute a plan that includes extensive operational improvements.
The tradeof between the size cohorts is more accurately viewed as one between risk and
potential return rather than as absolute outperformance by one or the other group.
The important elements for determining an appropriate strategic allocation between the two
are return goals, risk tolerance, and the lifecycle of an investors private equity program.
When viewed in this light, the right allocation between large and small buyouts becomes a
function of an investors return and risk profle: those with more conservative return targets and
less appetite for risk will skew toward the larger buyout funds while those on the other side of the
spectrum will skew toward the smaller buyout funds. Just as importantly, organizations with larger
private equity allocations (usually more established programs) will generally have more capacity
Buyout Funds: Large Versus Small. What to Consider Beyond Size. | 1 1
for risk, as well as more organizational resources with which to manage that risk be it dedicated
staf, qualifed consultants/advisors, leverage with general partners, or some combination thereof.
As noted above, the higher dispersion of returns within the small and middle market buyout
spaces, combined with the much larger number of managers operating in those spaces, means
that institutions desiring substantial exposure in the lower end of the market must possess
strong organizational resources and expertise. If these factors are in place, it follows that such
organizations would be better served by a substantial bias toward the middle/small portion of
the buyout sector. In a practical sense, then, new private equity programs should generally opt
for more safety over incremental potential return by investing in the larger, more established
funds. In the case that such investors have higher risk toleration but few organizational resources,
a fund of funds focused on small/middle buyouts may be a viable option; however, the danger
of over-diversifcation and the substantial additional fee drag often make these less attractive.
A better option, if available, would be a separate account, with a defned investment program,
more concentrated investments, and a reasonable fee structure. For more mature private equity
programs that are appropriately diversifed, more experienced, and possessing superior resources,
the potential of higher returns makes direct investments in a portfolio of small and middle market
managers the better option.
For instance, possible allocations for investors at the extremes of lifestyle stages may look
something like this:
Figure 8: Possible Allocation
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Large and Mega Market Buyouts
Small and Middle Market Buyouts
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Large and mega market buyouts
Small and middle market buyouts
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75-85%
25-35%
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Risk Tolerance
Return Target
1 2 | TorreyCove Capital Partners O C T O B E R 2 0 12
TorreyCove Capital Partners is a global alternative investments specialist, currently overseeing approximately
$19.5 billion of private equity assets. As a client-oriented frm, we create value through a combination of private
equity market intelligence, objective advice, insightful investment guidance and selection, and innovative
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Conclusion
The news from the front regarding the performance of the large and mega buyout funds is actually
much better than expected. In spite of this, a real case can be made for a tactical shift in favor of
the middle market in todays environment. However, any tactical shift should always be seen as an
overlay on a thoughtful, defned, and disciplined strategic program. For buyouts, such a program
should focus primarily on the risk/return tradeof inherent within the buyout space, and how that fts
within an institutions risk tolerance, its ability to absorb additional risk, its stage of development, and
resources that can be dedicated to managing the risk of investments in the buyout asset class.
This TorreyCove Perspective has been prepared by TorreyCove Capital Partners LLC for informational purposes only. It does not
constitute legal, securities, tax or investment advice or an opinion regarding whether investment is appropriate. Readers should not
act upon this information without frst seeking advice from professional advisers.