There Is Something Special about Large Investors

It has been argued that the best private equity partnerships do not increase fund size or fees to market-clearing levels. Instead they have rationed access to their funds to favor their most prestigious investors (e.g. Ivy League university endowments). Further, industry observers (e.g. Swensen (2000)) have often argued that endowments are better equipped to assess and evaluate emerging alternative investments, such as private equity, in which asymmetric information problems are especially severe. Lerner, Schoar, and Wongsunwai (2007) document that improved access as well as experience of investing in the private equity sector led endowments to outperform other institutional investors substantially during the 1990s. However, private equity is no longer an emerging, unfamiliar asset class, and the distribution of private equity fund returns has also changed over time. In particular, venture capital returns fell dramatically after the technology bust of the early 2000s.

Nowadays, investors such as the Canadian CPPIB and the Dutch AlpinInvest have built private equity portfolios worth over $35 billion each in just a decade (both started in 2001). In contrast, both Yale and Harvard endowment, the pioneer investors in that asset class, have private equity portfolios worth around $5 billion. The emergence of very large investors goes hand in hand with the disintermediation of private equity. Large investors either co-invest alongside funds or even bypass funds altogether.

In our paper, There Is Something Special about Large Investors: Evidence from a Survey of Private Equity Limited Partners, which was recently made publicly available on SSRN, we use a large-scale survey and show that institutional investors exhibit considerable heterogeneity in their structure, behavior, and beliefs, and that the amount of capital allocated to private equity is its foremost driver. Other characteristics that broadly capture prestige and long-term relationships (e.g., investor type, tenure, total asset under management, and location) play virtually no role. The rapid concentration in the asset management industry should therefore significantly change the characteristics of the ‘marginal’ investor.

Our findings also have implications for the organizational design of institutional investors. For example, let us evaluate the potential benefit from investing in private equity for the Norwegian or Chinese Sovereign Wealth funds, two of the largest investors in the world, yet private equity novices. On the one hand, one could think that it would be difficult for these investors to enter private equity because they have little experience and lack long standing relationship with funds. On the other hand, one could think that all you need is cash. If you have cash, you can assemble a large team of competent people that will be effective at negotiating, screening and monitoring. From our evidence, the latter is more likely to hold true. That is, the case for private equity investing is stronger for large albeit new investors, all else being equal.

Let us consider a second example. Following the perceived success of large endowment in venture capital (e.g. Yale University), several small endowments have targeted aggressive allocation to private equity. If what explains investor heterogeneity is investors’ type (such as endowment versus pension fund) this move is warranted, but if the source of heterogeneity is size, as we find here, this move cannot be justified on the grounds of just being an endowment.

Our findings show the benefits for investors in pooling resources either directly or via fund-of-funds. They may provide a rationale for the current trend in the consolidation of money management in the pension fund industry. For example, larger pension funds in the Netherlands (e.g., APG and PGGM) obtain mandates from smaller pension funds to invest in certain asset classes, predominantly alternative assets. In Canada, large Canadian pension plans such as Ontario Teachers’ Pension Plan and OMERS are discussing similar moves. Oxford University created a university endowment that is the collection of a number of smaller Oxford colleges’ endowments. This university-wide endowment is targeting a much larger private equity allocation than the colleges were before the merge.

In contrast, Swedish pension funds were split in five independent funds (AP1, AP2, AP3, AP4 and AP6) because the government did not want most of the country’s equity to be concentrated in one hand. If these pension funds invest in private equity independently, they each carry their due diligence, negotiate terms and conditions, monitor independently. There are talks in Sweden about merging them back together and evidence in this paper shows the potential benefits of doing so in an asset class such as private equity.

The full paper is available for download here.