EDHEC: A closer look at alpha across private equity fund size
By Evan Clark, Senior Private Market Analyst at, EDHEC Infra & Private Assets (EIPA)
Bigger isn’t always better — at least not in private equity. That’s one of the striking takeaways from a recent report by Scientific Infra & Private Assets.
The report entitled Does Size Matter? A Closer Look at Alpha across Fund Size, analysed the performance of 586 buyout funds in North America, spanning vintages from 2013 to 2023.
The performance of the upper mid-market and large segment (excluding mega funds) was the most surprising. While many champion these segments as the higher potential parts of the market in terms of ‘alpha’ (risk-adjusted outperformance), our analysis finds that they underperformed the small, lower middle market and mega cap space.
Small and mega private equity funds outperform
Using privateMetrics® indices and the Excel plug-in tool, we calculated alpha performance across the fund universe. By segmenting funds into size buckets, we observe that smaller and lower mid-market funds achieved higher median internal rates of return (IRRs) and alpha. In the smallest bucket (< $ 500 million fund size), median alpha observed was +5.6%. At the top end of the market, mega buyout funds also produced positive alpha. Funds with greater than $ 5 billion of committed capital showed median positive alpha of 1.77%, displaying the benefits of scale at the very high end of the market.
The upper middle market delivered the poorest results in our analysis for the Americas. For Europe we had a smaller sample (129 funds), and the performance was more mixed. Small and mid-market funds had higher median IRRs and alpha, while the mega buyout segment underperformed.
Dispersion narrows with size
More extreme positive alpha is observed in smaller funds. As fund sizes increase to $ 5 billion and beyond, extreme outperformance is less frequently observed but the overall return dispersion profile is narrower. Fewer outsized returns but also fewer major negative alpha funds. This is also true on the downside, where more pronounced negative returns are observed in smaller funds. Median market return (beta) also declined as we moved from the smallest to the largest size quartile, potentially indicating a difference in riskiness of the assets in small vs very large funds.
Systematic risk factors explanation
Mega buyout funds pursue the largest transactions, which are generally less liquid and thus warrant a higher risk premium. This is balanced against the higher quality of businesses and greater leverage employed in very large transactions, signalling a lower risk asset. Small buyouts tend to be value-oriented investments with lower quality earnings, as evidenced by the significantly lower leverage levels employed in small buyout transactions. These characteristics would suggest higher risk premiums in this segment. The high dispersion in alpha also supports the idea of it being a riskier segment of the market.
Manager incentives
The fee model in the private equity industry encourages managers to capitalise on success and scale by raising ever larger funds. Rather than executing more deals of the same size, the model encourages doing a similar number of deals of larger size to benefit from the increased scale.
This leads to the most successful long-standing managers ending up in the mega cap space, after managing many funds of increasing size over time. It may also indicate that the mega cap universe is disproportionately represented by strong managers, partially explaining the performance at the top end of the market. Further, delivering alpha at scale is valuable as many institutions may not have the resources to comb the small cap market.
Conclusion
Using privateMetrics indices as benchmarks, we find that smaller US buyout funds exhibit greater potential to generate outsized alpha, but they also carry a higher risk of delivering significantly negative alpha. This heightened volatility is influenced by systematic risk exposures and manager incentives that shape both asset selection and strategy. At the other end of the spectrum, mega-cap US buyout managers have also demonstrated an ability to generate alpha—albeit at lower levels—though doing so at scale still translates into substantial dollar value for limited partners (LPs).
Consistent with prior research, we observe a negative relationship between fund size and performance, along with a narrowing of return dispersion. This may reflect a shift towards lower-risk assets and strategies as fund size increases. The difference in alpha may partly stem from greater inefficiencies in the smaller end of the market, where there are more companies and untapped opportunities to augment value. In contrast, LPs investing mainly in mega funds will likely track the broader private equity market, with less over/under performance.