Intro: So… what do we even mean by “top tier” Private Equity?

So you’ve decided you want to start investing some of your capital into private equity funds.

We’ve talked before about how you can integrate private equity into your portfolio and build diversified exposure to private equity (see our newsletter here).

But where do we go from here?

What exactly are the types of funds we to invest in?

What do we even mean by “top tier” private equity funds?

And how do we find them?

All of these questions we hope to answer in this weeks newsletter.

Context: Brand ≠ “Best”

There’s a lot of noise in private equity land about “top” funds…

Gone are the days where we can blindly associate “brand” with performance.

As we’ve covered in previous newsletters (see here), historical returns data shows that deal performance at the 1st quartile level decreases as the deal size increases.

Said another way, the best small deals outperform the best large deals… on average.

Of course… this all presupposes that we end up in the 1st quartile deals… which of course, is no guarantee.

And its important to flag that the smaller deals also have the greatest downside risk (e.g. 4th quartile small deals underperform 4th quartile larger deals).

This is all to say that there is greater dispersion in smallcap deals.

But dispersion = an opportunity for alpha generated through manager selection and finding the best funds. Hence what we’re discussing today.

So how has larger deals and larger fund sizes translated into performance?

The brand named PE funds earned their stripes with outstanding performance in their heyday, when deals and fund sizes were smaller and “leveraged buyouts” were a cottage industry… when “private equity” wasn’t even a term.

As fund sizes have increased, returns have compressed (the general trend… of course with some exceptions).

Its not to say that the megafunds don’t have tremendous talent and resources…

…which they do…

As I’ve always said — many of the best investors at the world work at the megafunds, and they are rewarded handsomely for deploying large amounts of capital.

The key point is that comparing lower middle market / smallcap buyouts to megacap deals is just an entirely different sandbox and ballgame.

Megafunds solve a different type of problem for mega-LPs, like sovereign wealth funds and giant pension funds that need to deploy billions of dollars at a time…

and simply can’t do that at scale to invest piecemeal into dozens of $500mm smallcap funds.

Writing one massive check to Blackstone is easier than writing 50 checks to smaller managers that require much more work to get comfortable and that have more dispersion in outcomes (upside and downside).

As many institutional investors like to say — “no one was ever fired for investing in Blackstone”. 

You can see many of these trends (fund size increases accompanied by performance decreases) at play looking at the earnings reports from the Big 4 private equity firms Apollo, Blackstone, Carlyle, KKR.

As their buyout fund sizes have crept up into the high-teens billion to over $20 billion in size, returns have generally trended downwards (with some exceptions, of course).

OK, OK, I Get It… I Shouldn’t Just Invest into the “Brand Name” Funds… then where do I even start?

Manager selection can get complicated and nuanced very fast… so today, we’ll keep it fairly high level and focus on the key principles and frameworks to think about.

Got it… so how do I think about their historical track record and signs of outperformance?

Benchmarking by Vintage / Sector / Deal Size vs. Peers

Private equity performance is impacted by fund vintage (e.g. the year the fund was launched) given investments are being made in different market and economic environments.

So firstly, this is why its important for us as investors / LPs to deploy across multiple vintages (more on this in our piece here).

But secondly, this is why its important to compare a fund’s performance against other funds of the same vintage.

The chart below with Preqin data shows how PE (and public market) performance fluctuates by vintage:

So, I get it… I want to compare performance within each vintage.

What else?

Its also important to get even more nuanced to truly try to uncover any “alpha" at the manager level.

If we are considering investing into a lower middle market healthcare buyout firm… then we want to understand:

How did other smallcap healthcare buyouts perform for that vintage… and did this fund outperform those?

So we benchmark against sector and deal size within vintages as well.

We also look across a number of key metrics (which we dig into much more deeply in our newsletter here) such as IRR, DPI and TVPI (MOIC).

As we discuss in the newsletter linked above, its not as simple as comparing performance metrics directly.

For metrics like IRR and TVPI — these factor in both realized and unrealized returns, which means that the GP essentially gets performance credit for the “fair” market value that they assign to their un-exited portfolio companies.

As we always love to say… returns aren’t real… until they are real-ized… and the cash is in your pocket.

This was especially true in 2023 and 2024 when private equity exits dropped significantly and starved LPs from distributions (see our piece on this here).

We also want to consider how the funds performed vs. public markets.

One of the most popular comparisons in the “Public Market Equivalent” which seeks to create an apples-to-apples comparison of cash flows for a private equity investment vs. an equivalent benchmark of public markets stocks.

More on PME here from Preqin if you’re curious.

Understanding Returns Composition

Lastly — we also want to dig into the underlying composition of returns drivers.

Check out this chart from McKinsey:

The key here is to understand how the GP is actually driving value in their investments and to look for any consistent trends or themes.

Are they growing companies and making them more profitable due to concrete value they are adding? Or are they riding the “beta” wave as market multiples increase.

Finding the “Secret Sauce”

Got it… so we’ve figured out signs of outperformance in the fund’s track record. Now what?

So now we hopefully pulled together a picture of a fund’s outperformance vs. peers.

Its not as simple as just saying “oh they outperformed and hit 1st quartile in their earlier funds, so I should invest in them going forward”.

At the end of the day, a couple of important things to remember:

1. Past performance is not indicative of future results.

   • Obviously this is always in disclaimers and risk disclosures… but its also true. We can’t just rest on our laurels and assume history will repeat itself. It rarely does

2. Private equity is ultimately about the people making investments and the team’s “secret sauce” — and how sustainable and repeatable their “edge” is.

   • Uncovering the secret sauce that enables an investment team to generate outperformance is part of the equation

   • But then we need to determine how sustainable the team’s competitive advantages are and ensure that the firm is setting itself up to maintain their edge

So we want to figure out what the “secret sauce” is and how sustainable it is… what do we look for?

There’s no magic bullet to look for… its a mix of art and science.

Ultimately, we want to figure out if the fund has a playbook, process and differentiated expertise that is repeatable and can be relied upon to create alpha.

The secret sauce can come from a number of areas:

1. Sector specialist expertise

   1. Do they have true, differentiated understanding, perspectives and expertise in a sector that yield differentiated opportunities to create value?

   2. Or are they a generalist firm that pinballs between opportunities that fall into their lap across different spaces without any deep domain expertise

2. Deal sourcing capabilities

   1. Are they building proprietary relationships and buying directly from founders and family business owners?

   2. Or are they buying companies in large-scale, highly competitive auction processes where prices are bid up

   3. Are they first time private equity owners?

   4. Or are they the 4th PE fund to own the asset… all the juice has been squeezed out… and the armies of consultants from BCG/Bain/McKinsey have already uncovered all the value creation opportunities

3. Value Creation Capabilities

   1. How does the fund actually drive value in the portfolio companies?

   2. Are returns being driven by revenue growth and EBITDA margin expansion?

   3. Are companies being sold at higher multiples due to value creation / alpha generation (in excess of market “beta” expansion) due to actually making the company more valuable, dollar for dollar?

4. Firm Value Creation Resources / Deep Network of Operating Executives

   1. Does the firm drive the value creation above through its in-house capabilities and network of external operating partner relationships?

   2. Does the firm leverage in-house value creation resources (revenue / growth / operations / procurement / M&A / capital markets expertise)?

5. Repeatable investment strategy and playbook

   1. Does the firm follow a rigorous investment and execution playbook that generates alpha in the portfolio companies?

   2. For example — if the firm does buy-and-build M&A platform “roll-ups” — is there a clear track record of how the firm has executed on this playbook repeatedly and succeeded in generating value in the portfolio companies?

Cool… so that’s a long list of “stuff” to look for to find the “secret sauce” — how do I actually answer all of these questions?

Ok… so that’s kind of vague. How do I answer that?

We triangulate on an answer to this looking at the firm’s investment process from a few different angles:

1. Investment committee memos

   1. How did the historical deals perform vs. the PE fund’s plan?

   2. Did they do what they said they would do?

   3. Did they get lucky?

2. Reference checks / interviews with existing limited partners

   1. Existing LPs are a wealth of information when they have multi-fund, multi-year relationships with a GP… they can give you color on how the GP has evolved their “story telling”, where their strengths and weaknesses are… what their best guess at the “secret sauce” is

3. Reference checks / interviews with portfolio company CEOs

   1. where better to hear how the PE firm “added value” than from the CEO who had to lead the portfolio company through thick and thin

   2. the operators can speak to what the PE firm actually did to add value

   3. Did the PE GP sit on the board and do a lot of talking?

   4. Or did the PE GP go above and beyond to provide in-house value creation resources, leverage the GP’s network to bring on talent and expertise, make connections to industry partners / M&A targets / partners / potential buyers?

   5. Did the GP leverage their expertise from prior investments to add value to the portco?

Our goal here is to figure out the tangible actions that the GP takes over the ~3-7 year “investment” period while a PE fund holds a company that actually drive value.

Many of these things can be “intangible”, but by having enough conversations with the PE GP investors, LPs, PortCo operators, we can start to piece together the story.

Determining “Secret Sauce” Sustainability

So we’ve determined that a fund has generated alpha due to its “secret sauce”… how do we figure out how sustainable this is for future funds?

This is ultimately where we piece everything together.

We’re focused on things like:

1. Discipline — “sticking to their knitting”, doing what they do best

   1. Critical: is the fund size and target deal size consistent with the GPs area of expertise and track record?

      1. Or are they moving up market and risk damaging their returns?

   2. Is the firm going to keep implementing the same investing and value creation playbook and “secret sauce” they’ve followed in prior funds?

   3. E.g. if they are experts at smallcap healthcare rollups… is that what they will continue doing?

   4. Or all of a sudden are they doing larger deals, different deals, different sectors, different strategies?

2. Alignment of incentives between GP & LP

   1. Is the GP commit meaningful enough for them to have “skin in the game”?

   2. Is the fund size large so big that the GP can “get rich” off management fees alone?

      1. (E.g. 2% on $20 billion = $400mm of management fees per year… not bad!!!)

   3. Or will the GP be hungry to maximize performance (and therefore their carry?)

3. Human Capital — its all about the people and the investors…

   1. Are the right incentives in place to keep the key people who generated alpha historically both motivated and part of the team?

   2. Retention is critical… some GPs hoard carry amongst a handful of founders who are about to retire… this can be demotivating and push away high performing, up-and-coming investors.

   3. Will the right firm resources / operating execs / network and key deal partners be part of the next fund to continue doing what they do best?

We’ll leave it here for this week.

Obviously, there’s lots to think through and both art & science to navigate when choosing which funds to invest in.

This is what we love doing at Gather Capital — we’re always excited to chat about any of these topics.

Give us a shout if you want to discuss investing into top tier lower middle market private equity funds.

At Gather Capital, we curate a set of world class private equity opportunities enabling our clients to invest alongside elite family office limited partners.

If you’re interested in learning more about what we do, feel free to:

• swing by our website & create an account (if you haven’t already)

• grab some time on our calendar here

• shoot us an email

We’re looking forward to Talking Shop with you soon.

Sincerely,