Institutional investors that want top private equity returns need to find a consultant where they can be a top client.
That means allocators need their private equity mandates to be larger than that of their consultants’ other clients, according to a new study by Jose Vicente Martinez and Yiming Qian from the University of Connecticut. The study found that asset owners with PE mandates that were in the top size quintile of similar mandates at their search consultants ultimately invest in funds with higher internal rates of return.
“When we started the paper, our idea was to [figure out] what sort of consultants should I go to if I were an asset owner,” Martinez said. “Should I go to a large one? Small one? One that specializes in private equity? In the end, the only thing that seems to make a difference is the size of the mandate.”
According to the study, a client whose PE mandate’s size is in the top 20 percent of all of an investment consultants’ mandates invest in funds with significantly higher IRRs than asset owners with smaller tickets. Allocators with large enough mandates to be among their consultants’ most important clients outperform other investors with the firm, even after the authors adjust for funds’ vintage year, investment strategies, and types of asset owners, according to the study. Martinez and Qian based the result on an analysis of public pensions (80 percent), endowments (6 percent), and sovereign wealth funds (2 percent). They studied a sample of more than 10,000 private equity mandates from 1995 to 2020.
The size of asset owners doesn’t matter as much as the size of the PE mandate itself in how consultants choose managers for their clients, according to the paper. However, larger asset owners typically have bigger PE mandates. The very largest allocators, however, typically conduct their manager searches without the help of investment consultants, Martinez added.
As a result, allocators with relatively small private equity investments should avoid using the biggest investment consultants, according to Martinez.
The study also found that there’s little performance difference between funds recommended by large consultants and those identified by small consultants. “Maybe the largest consultants have access to more private equity managers. But maybe they have too many clients and they just can’t accommodate [every client],” he said.
Allocators are not alone in facing discrimination based on size in the consulting industry. Managers are victims, too. Some critics have argued that the consulting model tends to favor the more established asset management firms over the emerging ones because the former have more resources devoted to courting consultants, Institutional Investor previously reported.
Yet for both managers and allocators, it seems impossible to bypass consultants, especially in the private markets where networking is key for dealmaking. Consultants take part in more than 75 percent of private equity manager searches, according to the study. As of September, they advise on 71.2 percent of institutional assets in the United States, according to data provided by Cerulli.
The performance disparity between larger and smaller mandates could be “the result of consultants directly favoring their most important and profitable clients,” according to the paper. It is also possible that consultants don’t want to favor anyone, but they only have access to managers whose terms favor their bigger clients, the paper added.
“It is very difficult to disentangle these two explanations,” Martinez said. “But in both cases, what is true is that it is good to be a top customer for a consultant.”
