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Do good things come in small packages?

With huge sums of capital to deploy but limited resources dedicated to private equity, many larger institutions feel that their only choice is to commit to the established mega-funds. But there are ways of reaching the smaller end of the market, as some US public pension plans are currently discovering.

‘Sorry, you're too small.' It's a phrase that many managers raising sub-$250m funds must have heard time and time again from large investors. Frustrating as it may be for those managers, especially at a time when fundraising is so tough, investing in smaller funds just isn't practical for a lot of big-scale investors. Many of them, with billions to deploy but only a handful of people (if that) to put the money to work, have found that the only efficient way to invest their capital in private equity has been to commit to big funds.

‘We don't commit to smaller funds,' explains the investment officer of a multi-billion dollar US public pension plan. ‘A function of being a large investor is that we have a hard time investing in them. The resources required to monitor a $25m investment are really no smaller than those required to monitor a $150m investment. Practically speaking, it's much easier to invest in larger funds.'

Yet that's not to say the desire to commit to smaller funds isn't there - quite the reverse, in fact. ‘I realise that we are probably missing out on a whole sector of the market, especially in some of the smaller to middle market buy-outs, early-stage and seed-stage venture capital,' says the investment officer.

It's precisely this feeling of missing out on some potentially great opportunities at the smaller end that has prompted a handful of large US state institutions to do something about it. The $27bn Massachusetts Pension Reserves Investment Management (MassPRIM), for example, recently decided to set up a programme to invest in emerging managers and funds under the $250m mark. The plan is currently seeking an advisor to help it source opportunities and monitor the programme. The $95bn California State Teachers' Retirement System (CalSTRS) has also opted to set up a programme targeted at smaller funds - this time aimed specifically at new and next generation managers.

‘It's a good time to go after experienced investors that start new funds,' explains CalSTRS director of alternative investments Real Desrochers. This is partly to do with the succession issues some of the more established firms are facing. It's also related to the fact that many funds of recent vintage years may not reach the stage at which carried interest is paid to general partners, leading some of the more talented professionals to strike out on their own. The programme's RFP hints at the timeliness of the move. ‘For various reasons, an upcoming generation of senior investors at many funds may seek to develop their own funds as they outgrow their current roles at their existing general partnerships,' it says. ‘From this pool of experienced private equity investment professionals will come a new generation of successful private equity investment partnerships.'

CalSTRS is currently on the hunt for one or two funds of funds to manage a $100m portfolio, as it's an area the pension fund feels is better outsourced. ‘We are expert at managing outside specialised, focused resources,' says Desrochers. ‘It is a better use of our time to manage a manager rather than do it ourselves.' The fund has also made a specific further $250m allocation to invest in ‘underserved urban and rural markets'.

The $25bn Public Employees' Retirement Association of Colorado (CoPERA) is a little further down the line. It established its Targeted Opportunities Program a little over a year ago to invest in funds of under $250m and chose Alignment Capital Group to act as non-discretionary manager. So far, the programme is running well, according to CoPERA director of private equity Kevin Kester. He and his team have looked at 200 funds since July 2002 and invested in two. ‘We also have a number in the pipeline, so we should have made at least another couple of investments by the end of this year,' he says.

The impetus behind the programme was a simple one. ‘We looked at our private equity portfolio and noticed that most of our exposure was to larger funds,' explains Kester. ‘That wasn't always the case. We used to have investments in smaller funds when we, as an investor, were smaller. We just found that as we grew, we had to find more efficient ways of committing our capital - and that usually meant investing in larger funds.' Unsurprisingly, its average commitment hovered around the $40m mark until recently. But the Targeted Opportunities Program, set up as it is in conjunction with an adviser, allows CoPERA to put smaller amounts of capital to work in smaller funds but without putting too much strain on the Colorado staff. Between them, the plan's four private equity investment professionals already manage 125 partnership investments spread across 45 separate general partners, all without the aid of a gatekeeper or fund of funds. Adding another series of smaller partnerships to the equation without hiring an adviser just wasn't going to be feasible, says Kester.

So what's the attraction of this area of the market? Colorado conducted research into different segments of the market and came to the conclusion that the sub-$250m area (including both buy-out and venture capital funds) should not be missed out simply on the grounds of administrative burden. ‘Our feeling is that the smaller end of the market has some very attractive characteristics,' says Kester. ‘These funds often specialise in a particular niche or sector and the GPs generally have a better alignment of interest with their investors because they are not making a substantial profit on their management fees. Their wealth is much more dependent on generating profits and so in general, these managers are hungry and motivated.'

But unlike both the MassPRIM and CalSTRS programmes, Colorado's is not targeted specifically at emerging managers. It won't exclude the up and coming generation of funds, but neither will it single them out for special treatment. It's a point that Kester is keen to emphasise. ‘This is not an emerging managers programme, although many people appear to think that it is,' he says. ‘There are some newer funds out there that we could back. But actually, over the last year we have come across many small funds that are a firm's fourth or fifth offering. The GPs have simply decided to remain small because they are niche players and have been disciplined about the amount of money they raise. These are the really interesting opportunities and they are ones that we would never have seen 18 months ago or would not have been able to back.'

So for now, at least, the opportunities are coming through. But the programme has been set up in a way that does not force CoPERA to put out money if it does not see funds that it likes. The plan is to commit between $40m and $50m a year to smaller funds. ‘We have established this to be flexible,' says Kester. ‘We didn't want to lock ourselves into the programme if our thesis about the smaller market didn't hold true.' Kester is well aware of the fact that other larger investors are also starting to eye this area of the industry. ‘If every large investor starts piling into smaller funds and too much capital floods into the market, it may not be as attractive as it appears to be right now,' he adds.

Programmes such as those at CalSTRS and MassPRIM certainly suggest that interest at the smaller end of the market is on the rise. As fund sizes have crept up and their area of the market has become more efficient, there is a degree of concern among investors that returns will be affected. There is also some disquiet about how motivated managers of larger funds are to generate outperformance. ‘I think there is some disappointment about the larger funds,' says Kester. ‘In the US, many of those with 1997 and 1998 vintages have struggled to achieve the returns investors had been expecting. Some of them are also being increasingly viewed as being asset-gatherers rather than principal investors.'

Yet Kester will probably be able to sleep easy for a while yet. It's unlikely that we will see a wide-scale shift among larger institutions to the smaller market precisely because of the resource issues we've already discussed. And anyway, most institutions are too risk-averse, certainly in the current market, to take a punt on funds that few of their investment committee will have heard of. Large funds will always be an important part of institutions' portfolios (including those of MassPRIM, CalSTRS and CoPERA); it is simply an interesting trend that some of these institutions have started looking for new and different pools of talent to help them boost their overall returns.

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