Why Smaller Is Better When It Comes to Private Equity

Private equity has long been a darling of investors and the media, heralded for boosting returns for both institutions and endowments. But recently, it’s been under fire for lackluster returns, persistent delays in returning capital, and a tougher deal-making environment. These criticisms are valid—if you’re looking at the megafunds that tend to dominate the market. But disciplined managers can steer clear of that crowded space. Instead, they can intentionally focus on the road less traveled, where they can buy companies at lower multiples, enhance their operations, and enjoy multiple exit strategies, making them less dependent on the whims of stock market multiples.

The Rise of Megafunds: A Double-Edged Sword

You see, in private markets, smaller size often gives investors an edge.

Yet recently, this dynamic is being tested as private asset classes have attracted the spotlight for their potential to enhance long-term performance. That interest has led to a massive influx of capital, primarily concentrated in the largest funds. As a result, large private alternative investment managers have expanded their assets and ventured beyond their traditional focus areas. This trend has created a towering wave of megafunds, which now dominate private market capital. For instance, private equity funds with $10 billion or more now make up nearly 40% of private equity fundraising, up from just 5% in 2011.

That scale, to be sure, has its advantages. Megafunds can pool resources from across a broad spectrum of capabilities while leveraging sizable, established relationships to source opportunities. However, scale also brings significant limitations that can undermine the very factors that have historically driven private investments’ outperformance.

The Limitations of Scale

Private investment managers have long thrived by uncovering unique opportunities, tapping into their expertise to enhance value, and strategically exiting investments for profit. However, the rise of megafunds presents challenges at every stage, potentially constraining both long-term returns and manager flexibility.

Take sourcing, where larger PE funds must find opportunities that materially impact their returns, pushing them toward bigger deal sizes and effectively narrowing their investable universe. The focus on bigger transactions introduces inherent challenges. First, there are simply fewer large opportunities compared to smaller ones. What’s more, the swelling pool of capital targeting this limited space is intensifying competition and driving up entry valuations (Display). In private equity investments, deal multiples for larger transactions far exceed those of smaller deals, capping potential returns from the outset. 

 

 

Then there’s the ownership phase, where sizable deals also restrict an investor’s ability to add value through operational improvements. For instance, compared to middle-market transactions, large deals tend to exhibit lower average improvements in both revenues and EBITDA during the period from sponsor entry to exit (Display).

Why the gap? In many cases, larger deals stem from previous investors’ attempts to enhance value, such as through roll-ups or tuck-in acquisitions. This is particularly true in the increasingly common sponsor-to-sponsor transactions, where one private equity sponsor sells to another fund. In fact, smaller funds frequently exit by selling to larger ones, leaving less room for further value creation since much of the low-hanging fruit has already been picked. For that reason, larger funds tend to rely more heavily on other strategies, such as increased leverage, to drive returns. And while this use of debt was advantageous during the era of ultra-low interest rates, today’s higher rates diminish the benefits—without limiting the associated risks.

Exit opportunities for larger funds are also less plentiful. While investors in smaller deals can target multiple buyer types—strategic acquirers, private equity sponsors, or public market investors via IPOs—larger transactions face a narrower pool. There are only so many strategic buyers (if any) with the willingness and financial firepower to acquire larger companies or projects. And sales to private equity above a certain size require a “club” or consortium of buyers. As a result, megafunds depend more heavily on the IPO market, which not only limits potential buyers but also poses potential challenges when market conditions effectively render the IPO window “closed.”

These exit challenges have led private funds to hold assets for longer periods, reducing near-term distributions (Display). The result? As megafunds increasingly dominate the landscape, private investors encounter even lower levels of liquidity in this already illiquid asset class. 

 

The Downside of Big: Valuations, Leverage, and Risk

The combination of high valuations, substantial leverage, and little room for operational improvements elevates the downside risk, too. Historically, default rates on the debt of larger deals have significantly exceeded that of smaller deals. Together, these factors have contributed to a stark performance gap between larger and smaller funds. In aggregate, both internal rates of return (IRRs) and multiples of invested capital have been higher for smaller funds—a disparity that’s especially notable among top-performing managers, with top quartile funds under $10 billion materially outpacing larger funds across various metrics.

Ultimately, private market alternatives offer the allure of enhanced return potential and lower volatility through diversification. Yet, the private market landscape has undergone a major shift, with large funds now commanding the fundraising arena. While their size has certain advantages, it tends to come with significant drawbacks. Megafunds often find themselves buying at higher valuations, using more leverage, facing constraints when trying to add value, and shouldering more downside risk. Amid this evolving environment, investors stand to gain by aligning with disciplined managers who remain true to their investment strategies, keeping fund sizes moderate, and focusing on areas of the market where they can create the most value.