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The Often Overlooked Strengths of Smaller Funds

By: Gridline Team | Published: 07/29/2022
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Est. Reading Time:
5 minutes

The war in Ukraine, China's unending zero-Covid policy, and the global practice of unprecedented quantitative easing led to consistently high inflation rates, forcing The Fed's hand to hike interest rates sooner than later. This has put pressure on public market returns, which were predicted to have "dismal returns" even before the crisis, as reported by The Economist.

In response, investors are increasingly turning to private markets, which historically have been more resilient to public market volatility, have provided higher absolute returns, and have been less correlated to the stock market. The vast majority of this capital is going to larger, more established private equity and venture capital funds. In fact, according to PitchBook data, of the total capital being raised, only 1.4% of it is going to smaller funds.

This is a mistake. Smaller funds have a number of inherent advantages that make them more attractive investments, and this is borne out in their returns.

Smaller Funds Outperform

Research published by the American Economic Association highlights that fund returns decline with fund size. This is due to the diseconomies of scale in the money management industry, where larger funds are burdened by communication and hierarchy costs, management fees, and a lack of cohesion. In contrast, smaller funds have nimbler investment strategies, less bureaucracy, and better alignment between managers and investors.

This study isn't an outlier. A paper from Singapore Management University found that, on average, smaller funds outperformed larger funds by 3.65% per year. Another examination by PerTrac found that, over a 14-year period, the cumulative total return for small funds was 576.91%, compared to 317.74% for large funds.

Performance suffers greatly with particularly large funds. For one, they are forced to make more simultaneous investments, diluting focus. Worse, these large funds find themselves unable to quickly exit, redeploy capital, find strategic buyers, or invest in new growth opportunities. An Invesco study shows that the average IRR for funds under $400 million was 19 to 20%, as compared to funds of $400 million to $1 billion with an IRR of 7.2%, and funds above $1 billion with an IRR of 2.4%.

These are dramatic performance differences that cannot be ignored by any serious investor. Not only do smaller funds outperform, but so do newer and first-time funds. In a comprehensive analysis of PitchBook data, researchers found that almost 18% of first-time funds achieved a 25% IRR, while later funds only exceeded that number 12% of the time.

Smaller Funds Have Less Competition

The trend is clear: smaller is often better when it comes to private market investing, but that's not the only reason to consider smaller funds. They also have less competition.

The investment industry is notoriously competitive. The vacuum of capital allocated to smaller funds relative to their larger counterparts means that there's less competition for the best deals. This allows managers of small funds to cherry-pick the most attractive investments and achieve market-beating returns.

Larger fund managers have the advantage of establishing relationships with LPs, but these relationships often lead to herding behavior and groupthink. This can result in bad decision-making, as managers feel pressure to make investments that will please LPs rather than generate the best returns.

The rise of small funds is a relatively new phenomenon, and it's being driven by the same market forces that are benefiting private markets as a whole: the need for higher returns, less volatility, and diversification. But small funds have an extra edge that makes them even more attractive: less competition. Smaller funds are a clear choice if you're looking for the best returns in private markets.

Smaller Funds Outperform Across Geographies

Diversifying across geographies is another important consideration for private market investors. While emerging markets are often seen as less performant and riskier, the data tells a different story.

According to an analysis by the World Bank, long-term emerging market returns comparable to those in developed markets can be achieved through a global, diversified strategy. Further studies show that funds focused on emerging markets have demonstrated attractive returns. According to Preqin data, top-quartile net IRRs at emerging funds were mostly above 20% for 2011-2015 vintages.

The outperformance of smaller funds holds up even when you consider these different geographies. A LiveMint analysis shows that small-cap funds in India consistently outperformed in the last year, and a MorningStar India analysis of funds over the last 10 years shows that small- and mid-cap funds outperformed large-cap funds by a wide margin.

This year, as venture capital has followed the downturn of public markets, Africa's venture ecosystem has been one of the few bright spots. Africa set deal count and volume records in 2021, and 2022 is set to exceed those figures. The region has recorded three-digit growth in the first quarter of this year, with venture funding up 150%, hitting a record $1.8 billion, compared to $730 million in the same period in 2021.

This growth is largely thanks to early-stage deals, including in crypto. The African Blockchain Report reveals that crypto startups in Africa saw more venture funding in the first quarter of 2022 than in all of 2021.

The outperformance of smaller funds is a global phenomenon. No matter where you look, you'll find that small funds are posting superior returns.

Micro-funds Are On The Rise

There's no doubt that smaller funds are getting a tiny slice of the pie when it comes to private market investing. But one segment of the market is bucking this trend: micro-funds.

Micro-funds are defined as private equity or venture capital funds with less than $50 million in committed capital. According to PitchBook data, "the number of micro-funds closed annually has grown from an average of 75 each year between 2006 and 2011, to an average of 320 each year between 2018 and 2021."

This growth is closely correlated with the rise of seed investing. In the past, it was more difficult for early-stage startups to raise capital, as investors were focused on later-stage companies with more established track records. Smaller funds are the perfect solution for these companies, as they're able to take on more risk and invest smaller sums of money.

The result is that micro-funds are providing an essential source of capital for the most innovative and disruptive companies, which also helps explain their outperformance: A smaller check makes it easier to generate higher returns.

The rise of small funds is good news for the economy as a whole, as it democratizes access to capital and allows more companies to get started. But it's also good news for investors. Consider smaller funds if you're looking to take advantage of the many benefits of private market investing. They're outperforming their larger counterparts and offer a unique opportunity to get in on the ground floor of the next big thing.

With Gridline, you can access these small, high-performing private market funds with low capital minimums and fees. Gridline is the most efficient way to gain diversified exposure to non-public assets, and our mission is to open up access to top-quartile private market alternative investments. Sign up today to learn more about how we can help you achieve your investment goals.

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