When It Comes to Private Equity, Is Smaller Better?

British charities and endowments are increasing their allocations to private equity. Is that a good thing?


When David Renton was hired by Guy’s and St. Thomas’ Charity (GST Charity) in 2011 to be its finance and development director, the foundation — whose roots go back to the 12th century — was in need of modernization. Renton, who had worked for 15 years in corporate finance at boutique investment bank Hawkpoint Partners, was chosen to review the portfolio and devise an action plan. His background inspired the investment committee, formed just a few years before Renton was selected, to venture outside the usual endowment officer field in its search. “I wasn’t an accountant and hadn’t managed portfolios,” he explains.

With £700 million ($853 million) in gross assets, the charity funds the National Health Service Foundation Trust, which in turn funds health projects that are beyond what the National Health Service can provide. With the new investment committee and finance director in place, GST Charity was ready to formalize its investment policy with a spending rule (4 percent) — a mandated annual donation from the charity’s investment fund — structure the portfolio, and change consultants.

Of particular interest was the private equity portfolio. As it stood, private equity accounted for 10 percent of the total portfolio, with diversified holdings of 30 to 40 managers that were approaching maturity.

Renton initiated an analysis of the private equity portfolio with investment consultant Mercer to determine if that asset class was earning its place, including whether it was getting a premium to justify costs that included leverage. His conclusion: lose the fund-of-funds approach and find another avenue into the asset class.

But how? As a midsize endowment with limited staff and resources, the charity would not be able to select managers on its own. Because most small to midsize institutions like GST Charity cannot access big-name private equity managers that raise multibillion-dollar funds, their investment committees often shun this asset class entirely. More generally, these trustees also often worry about liquidity and scale — specifically, the lack of both.

Such fears are unfounded, argues Stan Miranda, founder, CEO and CIO of Partners Capital in London. In fact, says Miranda — who launched the outsourced CIO (OCIO) firm in 2001 — small institutions like GST Charity should be investing in private equity. The reason: Private equity has the highest long-term expected returns of any major asset class. Adding to his argument is the fact that smaller private funds often have outsized returns when compared to their larger brethren.


“Private equity is the one asset class that can most fundamentally improve the long-term portfolio return potential,” says Miranda, who previously co-founded eVolution Global Partners (a 2000 joint venture between Kleiner Perkins Caufield & Byers, Bain & Co., and Texas Pacific Group) and was a founding partner of Bain & Co.’s private equity practice. “Alpha for hedge fund strategies has dwindled,” he adds. “Everything has come down in terms of beta. The only place it’s most resilient is in private equity.”

According to Cambridge Associates, over the ten years ending March 31, 2016, using a public market equivalent measure, private equity achieved a 10.7 percent return compared with 8.0 percent for the S&P 500 index. The investment consultant also found that institutions with more than 15 percent allocated to private investments produced higher investment performance over the long term.

Small endowments and charities still have some catching up to do, according to the latest data from Preqin. In 2015, those with under $500 million in assets had an average of 8.5 percent allocated to private equity, while those with over $500 million had 11.6 percent. Both Cambridge and Partners Capital recommend a minimum 15 percent allocation for investors of all sizes.

That might be a difficult target given current industry dynamics. Fund managers returned a record $443 billion to investors through 2015, according to Preqin, up from $424 billion the previous year. Moreover, private equity firms made fewer capital calls — that is, they asked for less new money to invest — so private equity investors received record net capital flows of $217 billion.

David Reid Scott also has strong opinions on private equity investing. As chairman of the Eton College Investment Committee, which he helped form in 2007, Scott helps direct investments for his alma mater’s endowment fund. With only £300 million ($370 million) to invest, Scott — based in Ireland and whose day job is chairman of Kazimir Partners, an emerging markets asset manager — has learned the advantages of investing with smaller managers. “We don’t support the Blackstones of the world,” he explains. “Once you get much over $500 million — and certainly at $3 billion to $5 billion — these aren’t places we want to be as investors.”

Cambridge Associates’ U.K.-based investment director Nicolas Schellenberg agrees. “The times are over where you need to be in top funds in venture. You can get value in non–brand names,” he believes. “It’s not about getting access but about finding these funds. It’s the same for private equity.” Schellenberg stresses that even private equity allocations below $20 million can have a meaningful impact on the investment performance of a smaller institution. He adds that between eight and 15 such investments can be enough for good diversification.

Yet despite the general euphoria over private equity, some industry experts urge caution. Elroy Dimson, professor of finance at Cambridge University’s Judge Business School, says small investors need to weigh the benefits of costly asset management. He concedes that “outsourcing CIO roles have been quite big because there are very few CIOs in European countries”; the investment function at smaller institutions, he points out, is often part of the bursar, CFO, or trustee responsibilities. Dimson also espouses the increasingly popular notion that smaller investors who are unable to diversify as well as larger ones “are probably best served by low-cost exposure to listed securities such as passive funds.”

Dimson’s caution is supported by Ludovic Phalippou, associate professor of finance at Saïd Business School at the University of Oxford. He has no quibble with engaging an OCIO but believes that potential clients should “have a close look at fees. You might get good access, but how much are you paying for it?”

Even private investment champion Miranda believes that most active managers fail to justify their fees, as Partners Capital chairman and partner Paul Dimitruk wrote in a letter to senior private equity professionals in 2013. Using a “systematic look-through risk quantification process to separate market risks from manager skill,” writes Dimitruk, the firm allocates capital to those managers who are most likely to generate a positive return after their fees.

Still, there is a plethora of reasons to invest in private equity, says Eli Talmor, founder of the Coller Institute of Private Equity at the London Business School. He points to the decline in the number of publicly traded companies, from 7,322 in 1996 to 3,700 at the end of 2015. At the same time, private equity assets have increased five times over the 12 years from 2003 to 2015, with little slowdown following the global financial crisis.

Schellenberg emphasizes the advantages to the smaller investor, particularly now when, he believes, the large and middle segments of the market are overvalued. “The small allocators have an advantage,” he explains. “They don’t need to go into these [the largest] funds.” New managers are hungry and motivated, he adds, and smaller companies often have lower entry price multiples of earnings before interest, taxes, depreciation and amortization.

Back at GST Charity, Renton was crunching the numbers. After performing the private equity portfolio analysis, he and the trustees determined that the asset class did indeed belong in its portfolio — and that hiring an OCIO was the way to go. In 2013, after jettisoning their fund-of-funds arrangement, they signed on with Partners Capital. The allocation, which had previously been at 10 percent of the portfolio in the terminated fund-of-funds arrangement, was raised to a new target of 14 percent as recommended by the OCIO. It currently stands at 8 percent and is heading toward its goal. •

Follow Frances Denmark on Twitter at @francesdenmark.