Diminishing Returns to Scale in Private Equity (w/ Andrew Akers, PitchBook)

0:00My mom told her financial advisor the one thing she cared about most was that the number never go down. So when she passed a few years ago and I finally got my hands on what he had her in because she was never going to ask me for advice. You know, a stubborn and very smart entrepreneurial Irish woman. She had a lot of private equity, very small allocations to some very big brand names. And guess what? Number never really went down. Podcast is about to begin. So give it up for your hosts, Devin and Jim. My guest today spent five years deciding where LP money goes as an allocator to private equity.

0:45Then he went to PitchBook and trained a neural network on which are the best companies to take private. His conclusion was most of what we call operational alpha really is just sector picking, multiple expansion and debt. Now his team's data says the biggest buyout funds are getting worse as they get bigger. So today on the FunCast, is bigger better? Is anybody better than the public markets? And what's the path forward in a competitive, expensive, consolidating private equity industry? Andrew Akers, Associate Director of Quantitative Research at PitchBook. Welcome to the FunCast. Thanks for having me, Devin.

1:22All right. So what did I get wrong? Yeah, I started Pretty traditionally. Business finance degree out of college, went through the CFA program, started my first role at Vanguard on the retail side, talking to clients. And then, yeah, really started kind of getting into the investment world, working at institutional consultant here in Seattle. Did a few different things, did some stuff on the research side, A lot of strategic asset allocation, capital market assumptions, how do we build portfolios? And then finished on the portfolio management side, on the OCAO side of the house, helping to manage about$2 billion in multi-asset portfolios.

2:11Realized that wanted to be a little bit more in the data side of things. So a bit of a pivot, went back and got a master's in analytics, data science, found myself at PitchBook, which is a great place for the intersection of investing in data. So here we are. Yeah, you've got piles of it. And what was that index project you worked on, kind of, as you said, the foundation for kind of just getting in the weeds of those things? What did you glean out of that? Was my characterization right that there's a lot of beta in the private equity world disguised as alpha? That characterization was correct.

2:50So interestingly, when we set out on that project, we were actually just looking at, can we predict take privates? It's the easiest thing to study for certain deals. A lot of the private deals, we don't know the deal size. We don't get a lot of information on the company financials. But we have kind of an interesting window in security selection when these big GPs take companies private. And we said, can we predict who's next? And what we found is we actually could. And then that begged the next question is, if we can predict who they're going to invest in, that is kind of the idea of systemic or systematic security selection.

3:32Can we build an index off of that? Are there certain characteristics of these public companies that they tend to invest in? And then can we layer in, like you mentioned, the sector bets, right? They've been heavy in tech for the last 10 plus years. That bet, for the most part, has paid off. They've been underweight financials, more so out of regulations, right? P's aren't going to take over mid-market banks, but that bet has also paid off. And then, of course, leverage. you're looking at like two to two and a half times leverage on your average buyout fund versus your public market portfolio embedded in companies is probably more like 1.3 to 1.5 times.

4:13And so all that has kind of helped propel a buyout performance higher. And when you adjust for some of those things, performance does not look as good if you're just comparing it to say like the Russell 2000. Yeah, so let's point this data machine and your big brain on the latest piece of research or a recent piece of research called diminishing returns to scale, right? Which kind of the conclusion, well, what was the thesis going into this? Obviously, private equity is consolidating. We'll show some charts and talk about that. But generally, as you and your team worked on this research project, what was the thesis going in and what were you trying to prove or disprove?

4:52I think the impetus was this, was just that we see the consolidation happening. And what's the justification for it? A lot of times, right, performance drives allocations, whether it should or shouldn't, right? Past performance is not indicative of future results. But if you look at mutual funds and fund flows, funds tend to chase the best performers. So is there a performance element to this? Is that why we're seeing some of the consolidation to some of these top funds that are now raising$15,$20,$30 billion in a single fund? And the answer, which we'll get into a bunch more detail, is not necessarily.

5:37And there's actually been a pretty clear downtrend over time. And so we can't say that there's a causal link, but we'll talk about scaling these strategies and putting$5 billion to work is a lot easier than$10 billion. And I think we're kind of questioning whether this is actually good for investors. Great. So the headline here is last year, almost 60 % of the capital raised in private equity, pretty close, was raised by 10 funds. You know, I think the data is 5 % of the funds are raising two thirds of the capital. 25 years ago, there's maybe a third. The biggest funds raised about a third of the capital in private equity.

6:20And that capital base is growing, right? We're about 6 trillion now, maybe headed to 8 trillion over the next few years. So let's pull up this first chart and just show like the global, you know, forecast you guys have for AUM and private equity. So as we take a look at that, walk through this increasing size and then increasing consolidation stuff you found? Well, I think the first point, which is no surprise, is we're forecasting, this is global, global private equity AUM to be almost$9 trillion by 2030. So this is no longer a small asset class. And so I think some of the consolidation, right, is just the maturation of the industry.

7:06But I think a lot of it, too, has to do with the sophistication on the LP side, and really that they've been demanding more and more allocations to private markets. And I think those seeds were planted well before, I think, our data kind of shows these mega funds taking off, which we saw some of it in 2018, but really where we saw it take off was after 2020, 2021 and 2022 in particular. But if you go back to 2018 and you are trying to build a strategic asset allocation as an LP that roughly hit, you know, it depends on the LP, depends on the LP type, right? But 7 % total portfolio return is kind of the bogey for LPs.

7:56And depending on whose capital market assumptions you look at, and when I was on the consulting side, ours was actually a bit lower than this, but you look at public equities, they were less than 7%. So your riskiest part of your portfolio, right? Public portfolio is not going to hit your total portfolio return. What do you do? I mean, in inter-private markets, and we'll get into whether some of this is justified, but a lot of what happened on the LP side when we model out private equity due to lack of data was this kind of just premium over public equities. And for whatever reason, that premium tended to center around like 3%, 300 basis points.

8:41So So a lot of LPs and consultants were operating off the assumption that private equity just gets you a premium of about 300 basis points. Similar on private credit, although that's more of a recent story. But that started changing the way I think LPs allocate. More LPs are allocating, larger LPs are allocating. And a lot of that means that on the GP side, they just took advantage of the opportunity. You know, if you're going to raise a couple billion dollars and you go out to market and realize you can probably raise double that, you know, you're going to take advantage of that. So I think a lot of it has been on the actual demand side rather than really anything that the, you know, the managers have done themselves.

9:25And this is if you think of like a lot of our listeners would know like the Swenson model and kind of the endowment foundation model, which, you know, some private foundations and, you know, top endowments could be 40, 50 plus percent in privates, you know, rather than a traditional pension fund that may have like a 8 to 12 percent allocation. So you're talking about these allocations from late entrants, maybe say they had huge private group programs going back to the 80s and 90s, increase their allocations to privates. That created this flood of opportunity to raise these bigger funds and consolidate some of that.

10:03Was that what you guys were finding? Yeah, this was more on your traditional LPs, pensions and things of that nature. The foundations were early, which may be a bit of a tangent, right? But the Swenson model worked great when he was kind of the only LP in town. Maybe not the only, right? But he had the kind of pick of the top managers, and there wasn't a ton of money flowing into the space. And so got an incredible first mover advantage, if you will. I think even now people are starting to question that model. I think Yale itself has kind of stripped back a little bit of their allocations to private markets.

10:46And kind of going back to the maturation theme, like the competition has increased on, you know, the LP side. There's more dollars chasing more funds, chasing more deals. And that leads to, you know, pricing decreasing. Yeah. And there are only so many private companies or other things to go by. So, all right. So this chart shows you think it's only going to go up. So$6 trillion-ish today could be$9 trillion down the road. So a 50 % growth still in private equity AUM globally as this trend continues. Let's talk about this. Let's show the next chart around the consolidation. So the share of U.S.

11:25biocapital raised by the top 5 % of the funds continues to grow. So go back to the early, you know, pre-2000 era, you know, the Swenson era, the golden age of private equity, people would call it. about a third of that capital and top 5 % of the funds. Now we're approaching 60%. Is there a limit to this? What do you see happening and what was in the data? And don't worry, we're going to get to performance later. We're just setting you up on what's actually happening here. And where else has this happened? The private equity may be just tracking other industries in the financial services world where this happened.

12:03Well, I think there's a limit. And I think if you kind of talk about the number of private companies out there, and of course, you know, we've already talked about take privates, that's another opportunity. But as these funds reach these enormous sizes, right, like where are they shopping? And how many of these private companies actually exist? And I think that's been one of the things that investors will say about why we should allocate to private markets, right, is this breadth of investment universe, right? There's thousands and thousands of private companies. But how many of those companies are actually worth over a billion dollars, over, you know, over$5 billion?

12:43And as these funds get larger and larger, they're all kind of competing for the same deal. So I do think that puts a limit on how high this can go. And I will also comment we're showing by decade here because I think the trend is a slower, long term structural trend. But it's not been a straight line if you just look at the individual vintage years. Actually, there's quite a bit of concentration in 2006 and 2007. So there is somewhat of a cyclical element to this, I think, as well. Going back to my earlier point is if you go out to market as a fund and you realize you can raise 30, 40, 50 percent more and LPs are demanding it, you're going to take advantage of that.

13:23But I do think the underlying trend, as we'll talk about more and more, is structural. It's on the LP side. And I don't necessarily see this starting to mean revert or trend the other way. Let's go to the next slide, the bubble chart that kind of shows exactly what you were just talking about is like, this has been a little cyclical in terms of when these big funds get raised. And are we talking about an individual fund? We're not talking about a firm goes out and raises three funds at once, the mega fund, the middle market fund and the baby fund. These are individual funds being raised. Is that right?

13:59These are individual funds. Yes. So a very small number, obviously, but becoming increasingly common. And then you see, again, 2018, like I mentioned, kind of was the start of this trend. A bit of a dip in 2019, but right back at it post 2020. And then some of the size of these bubbles at the top, right? These are ordered in terms of size and the bubble represents the size of the fund. And so you see that marker there on the left of what 10 billion represents. The funds at the top end, right, are magnitudes larger than 10 billion. And we're talking 20, 30 billion. And so if you looked at, you know, going back to that last slide, if you even looked at the further top of the market, just a very small number of firms commanding a lot of the capital.

14:54So in this 2020 chart, we're talking about the 60 % based on the top 5%. That's about 150 funds overall in that six years. And that's less than 100 unique investors, right? Because these funds are also raising at a clip of about three to four years right now. So a lot of these funds, investors have raised more than one of these mega funds just in the last six years. Yeah, I wrote a piece on our sub stack just about the kind of history of tech buyouts. Like you couldn't do an LBO in tech in the mid 90s, right? There was no there were no assets, there's nothing to repossess from the lender. So like true software buyouts really didn't start maybe Silver Lake kind of kicked it off and then Endeavor and then obviously Toma gets into the buyout game in the mid aughts vista you know first two deals were more bpo deals than than software deals and then gets into the software deal as we kind of move towards recurring revenue and the gift that salesforce.com gave everybody so you saw on the tech side right uh i mean a lot of these individual 20 billion dollar funds were just sectored funds right just tech right you don't see a lot of health care services 20 billion dollar just health care services funds but maybe beyond like energy, tech, these big, big sectors that could consume a lot of capital, at least for a long time.

16:12And maybe some of these other ones is more generalist, right? Like business services or lots of different things inside these. But the real push post 2000, heading into 2000, 2020, sorry, 2019, 2020, 2021 was these massive sector funds, which we really hadn't seen before either, right? Thus, you show up at PitchBook and build a algorithm to predict which one of these things are going to get taken private. So perfect timing. Yeah, it's probably a topic for another podcast is different type of concentration in but in tech sector sense. We've seen that's actually reached a peak recently where most buyout is tech.

16:50And so part of that is going back to like the take private predictor and building a replication style index is that it's been one massive sector bet over the last 10, 15 years. Yeah, where you could probably just lever the NASDAQ or something. And I'm sure you could run that math to see which one would perform better. But what happened, as you look at this bubble chart, is this just a denominator thing that the stock market was just going up? People had way more capital, and so my program's bigger, and I'm allocating more to private equity. and private equity has more targets because a lot of take privates and other things so they can do bigger and bigger deals they can come back a year later and raise another 20 billion dollar fund like um it didn't just happen by accident like something was going on underneath the surface uh so was it just like i have more capital and now today with markets at at record highs there's even more capital to deploy and do you want to redeploy it in public markets or privates or other esoteric things like what was actually happening then that would drive these massive funds?

17:56I think it's a combination of all of those things. So certainly you have on the LP side, increasing allocations, moving privates from 10 % to 15 % to 20 % of the total portfolio. I think you also have the idea that, and people have started to come around to the idea that manager selections hard. And there was, I think, a sense in private markets that manager selection was, if you had skill, was more valuable. And we'll talk about that later, too, because the dispersion between a good fund and a bad fund is much higher than you get in public markets. But that also that performance was persistent.

18:41And so if you establish these relationships with the top managers, you could re-up and you'd continue to outperform. We've actually done quite a bit of research on this and that the persistence factor is not as high as you would think. Just using past performance to make your manager selection in private markets is certainly not foolproof, if helpful at all. That's changed over time, I think, right? If you went back to like the golden age of private equity in the 90s where you bought a company, you improved it, you grew it at higher margins, you sold it for multiple expansions, and you use leverage, Like you got all of those things, that cornucopia all worked in your favor.

19:23And then you went and raised the same size fund you did, you know, five years before that, rather than double the fund you just raised 12 months before that. So persistence, the lack of persistence has shown up relatively recently in the private equity industry is that, and I will talk about venture later, but like, you know, more persistence in venture, it appears down to the partner, not only the fund, but like, why, what is it? about buyout that if you have a, you have a, what you're saying on this persistence thing for audiences, Hey, we, our last fund was top quartile, very little predictability that your next fund is going to be top quartile, even top, you know, even above the median, um, it's just very hard to do anymore.

20:06Walks walk the audience through at least the data or what you guys have seen and learned about why that is true. And while we're doing that, uh, like what's going on on persistence and why is it so fleeting? Well, I think to your kind of first point about how that was a held belief and has, I think, recently started to change is that there were some academic papers that were missing a key component. They came out and said persistence is very strong. But what they were looking at was finalized performance of the prior fund to the next fund. And the big problem with that is, like we just talked about, with these managers raising every three to four years, you're making that decision of whether to re-up when the prior fund is three, four, five years old.

20:50We actually don't really put any stock in a preliminary IRR of a fund that's younger than five. It's just not very predictive. So I think that was one point on why that belief has changed. On the persistence itself, I think the market as a whole, the operational alpha, if you will, is kind of a less important driver to performance than I think the industry would care to admit. And so what you're left with, right, is a lot of leveraged equity risk and security selection. And just like public markets, right, we've learned that security selection is a hard thing to replicate. Picking stocks, picking companies is very hard.

21:40And, you know, from fund to fund, a lot of it is luck that's actually driving some of the differences in performance. That's not to say that there's not great managers out there. I'm just saying it takes more than just looking at prior performance to have a good manager selection program in private markets. All the value creators listening right now are going to be really bummed out that it's all just beta and leverage disguised as your value creation plan and your 100-day plan and your playbooks and all these things. Well, Apollo came out with a report at the beginning of this year, like back to basics.

22:18Private equity has got to get back to basics and walk through all this. I mean, I think their analysis was more than two-thirds of the returns from 2010 to 2020 or whatever they had in their data set was really beta. It had nothing to do with operational performance. We're going to get to that in this because you guys have absolute stunning data on that piece of it, which I'll hold people back about is Pryvac actually improving businesses. So let's walk through this busy chart here. We've got kind of fund performance scores for marquee buyout managers. One, define what a marquee manager is and why is this, why is the trend line going down to the right rather than up to the right?

23:00So the marquee term is something that we manually created because we didn't want to set a fund size, right? Because as we talked about, fund sizes are getting larger. So we didn't just want to establish, oh, let's look at funds a certain size, like$5 billion, right? Because those didn't really exist in like the 2000s. So your marquee managers are your household names. If in your household, you have someone that works in the industry. Although I did see an advertisement for EQT watching a golf tournament the other day. So maybe there are going to be more household names. But I mean, these are the ones you know, right?

23:36It's your Blackstones. It's your Carlyle. It's your KKR. And what we looked at is this is our manager performance scoring framework. It is based on IRR, but it looks at things on a continuous basis. So we move away from your quartile rankings. We put it on a continuous scale. We look at kind of more specific peer groups across multiple vintages, not single vintage years where you can get some small sample size. Essentially normalize that from zero to 100 and kind of weed out some outliers as well. So pretty simple scale. Your 50 is basically your median. You're close to your average. 100 is basically the best performing, zero is the worst performing.

24:18So what we see in this trend, particularly the line here, is on a capital-weighted basis of all these dots, each bubble represents a fund, is that performance of these managers relative to the rest of the fund universe have performances degraded. And we actually see in recent vintages that performance has fallen below 50 neutral levels. So, and they're actually underperforming. And again, I mentioned - This chart stops at 2021. Is that right? Out of my glasses. It does, which kind of goes back to the point of, we don't really put much stock into preliminary IRRs before a fund reaches the age of five.

24:58So - Yeah, but Andrew, this is before like the massive DPI drought of the last five years where people are, you know, the industry's returning 10 % of the capital every year instead of 20, 25 % of the capital. So this is only going to get worse on the IRR front. Likely. This is a relative measure, though. So depends on how the middle market does as well. So I think the one caveat to the listeners that I'd make on this chart is that these early kind of where you see the line go below median there is going to be subject to change. And I think a lot of these IRs, like you mentioned on the DPI side, we put even less stock in them if they haven't returned any capital yet, because we're all just calculating the IRR off of a NAV, which, as you know, may or may not reflect reality.

25:46Yeah. And we could, you know, for another day, pull up the DPI charts by Vintage and show that going down and down and down. So a lot of what we're hanging on to right now are paper marks that haven't been quite realized yet. All right, so the pitch on bigger funds. So here is the challenge, right? These marquee names, brand names, well, they all raise bigger and bigger funds, more and more products. So are they really private equity or are they just more diversified financial services? But the buyout product is deteriorating in terms of total return opportunity up until 2021. We'll see how it plays out over the next five or six years when we talk, as we keep talking.

26:28The pitch was, yeah, but our outcomes are really tight, right? We don't have blowups. This is a safer place to put your money. So let's go to chart five, which shows that. It's kind of the performance outliers from 1999 to 2021 vintages. So walk everybody through this. I think the conclusion is big buyout funds don't have blowups like middle market funds. Smaller deals are riskier than bigger deals. So give us your money. And yeah, we may not get you a 20 % net like a middle market fund, but those guys might put up 2 % net because we'll have some blowups. will give you a tighter band of outcomes.

27:02Is that the pitch? Is that accurate from what you said? And you were an allocator. Is that the pitch you heard? That's not the pitch that they would pitch. I think part of coming up from the allocator side is that you start to appreciate is career risk is a very real element of how people allocate capital. And whether that's on the LP decision makers themselves on the board or whether that's consultants. The old saying was always right, you don't get fired for buying IBM. Maybe you do now. In the private markets, it's now, you don't get fired for insert your marquee manager here because it's almost a defensible investment decision by brand name alone.

27:50And there is a, I think, a real benefit there on the convenience factor is, as you mentioned, manager selection is hard. It requires a lot of work. For an LP or a consultant, you spend a lot of your resources on manager research teams. And all of a sudden, if we're just going to shorten that down to five to 10 names, we don't have to spend all that time. We can go focus on other things. So I think there is some real benefit to that. But I do think the pitch is that we're not going to invest in a fund that, you know, when the board is looking at our performance goes, what the heck happened with this fund?

28:32Yeah, because again, as this allocation increase has happened largely at big pension funds, big, big allocators, right, increasing their exposure to privates, a small percent, a few hundred basis points is a massive movements in dollars. They need to deploy a lot of capital. These big allocate, these big, uh, GPs can deploy, can, can deploy capital in big chunks so they can bring in capital in big chunks. And it's a nice match of better to have$100 million LP or, you know, uh, uh, then 10, $10 million LPs and vice versa. Right. Uh, they can also invest in a lot of your products. So it's kind of a match made in heaven.

29:16Hey, I need to write a$250 million check or it's not going to make sense for my program or move the needle. Well, hey, I can consume$250 million check from you and a lot of other people because I can go buy these bigger companies. Last chart showed as the funds got bigger. So far, returns have deteriorated. And then this chart is showing that, yeah, we actually don't blow up. Now, the problem is their winners aren't as big. They don't have bigger winners. Their losers are less volatile, but their winners aren't more performative, right? They don't outperform middle markets. So what are we looking here on this kind of fund performance outliers?

29:53And as you think of like, you know, significant outperformers versus significant underperformers, do you remember where you set that line for a return? And this is for an individual investment or for a total fund? This is on the fund level. And this once again, uses our kind of manager scoring framework, which puts funds on a relative basis on a continuous scale as well. So what we're looking at here is for each vintage, we essentially say if you're outside of kind of one standard deviation of the distribution of fund returns, we mark you as an outlier for that particular vintage. And then we bucket it again here by marquee versus other and seeing how many of those funds wind up in those kind of underperformer below a standard deviation on your IRR versus an outperformer.

30:42And so obviously you'll see that the distribution's right skewed, right? So you have more outperformers, but really what we're doing here is comparing the two groups. Like you already mentioned, you're not buying these marquee managers because you think they're going to outperform. you're buying them because they're very unlikely to significantly underperform the rest of the fund universe. So it's very unlikely that you're going to look back and say that that was a bad allocation decision. And sometimes in investing, like avoiding big losses is more important than picking the perfect winner. So that would make intellectually that holds true.

31:25sure it may be the you don't get fired for for investing in kkr but this chart would say like yeah and they don't underperform all that often and the challenge for some allocators you would you know bet this better than me being on that side is well i really need my privates to outperform the public's by by the rest of my program by quite a lot to generate the a blended return here so i can't be in a, I want to be in the middle market or lower middle market where I can get teens, 20s, net IRRs. Again, knowing the manager selection is hard, but they're making that bet because maybe their public program has a different characteristics where they really need to deliver better returns than, you know, the state of Washington or the state of Minnesota or something.

32:12Does that hold true? I think that was, I mean, still is some degree the kind of the promise of private markets. And I think whether that's a false promise is hard to say, right? Because each allocation, each private markets program is so different. And I think we'll get to the whole indexing stuff and can we all treat private markets as this one monolith asset class and we just can't. But when I think LPs are building these strategic asset allocations, the private markets are doing so much work in that modeling. And I think part of that modeling is flawed. And you'll see this all the time. It's one of my pet peeves.

32:56I call it like research marketing, where you'll see these big names come out and be like, oh, here's a 60-40 portfolio. But if you take away 10 % of equity, 10 % of those bonds and add a diversified allocation to privates, and you're on the efficient frontier, look, Like your risk goes down and your returns go up. Those are all just based on kind of the models that we go back to at the beginning of the show of, you know, at a simplest form, yes, they said private equity was public equity plus 300 basis points. It's like, of course, you know, if you add that into a, you know, efficient frontier framework, your expected returns are going to go up.

33:33I think it remains still to be seen, and I call it like the great performance debate, which I think will rage on maybe forever, of whether that promise actually gets fulfilled. And I think you do have a lot of allocators in the recent periods where, like you mentioned, distributions are about half of what they were, are starting to maybe rethink a little bit. and I think that's also why you're starting to see a shift in strategy a little bit on the these large managers to looking at other distribution channels yeah yeah and and our mutual we're both mutual admirers of cliff assness so sometimes allocating to private equity is a is a strategy as well and I'll let you tell the listeners why that is well he has a he has a couple, I think, good quotes that are relevant to private markets.

34:28One, not necessarily for private markets, but a quote I use a lot is that there's no investment good enough that high fees can't make it bad. I think that's more relevant than ever, especially on the retail side. I think we can talk about some of those products that are popping up. Two would be on his kind of concept that he's dubbed volatility laundering, which we've written about as well, which essentially just goes back to, you're talking about that efficient frontier, and now let's focus on the risk side of things, that private equity returns are artificially smooth, which just mathematically speaking will lower your standard deviations and these inputs correlations as well that go into these mean variance frameworks, which allocators still absolutely rely on.

35:18talk about a lot of limitations to those frameworks, but they still are absolutely relied on. And you basically, you get these outcomes where the model pushes you into privates, more so about the assumptions that you make regarding the kind of risk and returns, which may not be accurate. Yeah, my mom told her financial advisor, the one thing she cared about most was that the number never go down. So when she passed a few years ago and I finally got my hands on what he had her in, because she was never going to ask me for advice, you know, a stubborn and very smart entrepreneurial Irish woman. She had a lot of private equity, very small allocations to some very big products with some very big brand names.

36:08And guess what? number never really went down. Didn't go up that fast compared to the public markets. But at her age and stage, maybe that was the place to be. But she got what she asked for 100%. Yeah, I never, never underestimate behavioral biases in investing. They're very real. And I don't think it's just on the retail side. We actually, when I was in the consulting, we had our senior consultant, president of the company, we were talking about an allocation for a particular client, whether it should be public real estate versus private real estate and whether we could, you know, on the merits, what's a better allocation for the client.

36:45And she was talking about, you know, the client is hesitant to put real estate in the portfolio. If you put REITs in and they go down, like it's going to be a problem and they're not gonna be able to stick with it. So it may not be the optimal decision from an investment perspective, but when you start to layer in the behavioral biases, which exist at the institutional level. They absolutely exist at the institutional level. And if that is going to lead to a better outcome, because it leads to investors not shooting themselves in the foot and selling at the wrong time, we're not sticking with a good investment strategy.

37:19I think there is benefit to that. Yeah. Hey, give your clients what they ask for sometimes. It's good for the relationship. All right. So as we move on to the next chart, kind of more on the middle market, which I want to talk about because you guys, we're not just talking about mega funds here. RCP has some data out over almost 10 ,000 individual deals. They looked at like an individual deal that returned over 10 times, right? A real, just absolute banger, which every great fund has a total banger in it, right? On the private equity side, not as high of a power law as in venture capital, but certainly that could really drive a fund, one outlier deal.

38:01Again, hard to predict, hard to have persistence of that from one fund to the next. But in almost 10 ,000 individual transactions of deals that were 10 times cash on cash return, zero of them came from large funds. So they would say kind of a billion plus or a billion below. Zero times did a very large deal return a massive outlier cash on cash return. So let's go to the next chart on middle market performance, kind of in the pooled vintage IRR. So for people listening to it, you can see this on Spotify, Apple. We've got video, but also go to YouTube. You'll be able to see the chart here. This one may be harder to explain.

38:46But a lot of number, a lot of bars going down, a lot of bars going up. So what are we looking at here? and what does it say about the middle market? Yeah, so this just looks at the middle market fund IRR relative to these mega managers on a vintage-by-vintage basis. And the big takeaway is that for the last 10-plus years, there's some underperformance pre-GFC, but for the last 10-plus years, the middle market doesn't have a performance problem, I think. And that kind of goes back to what we've talked about previously on kind of the structural issues facing the middle market and that the larger LPs wanting to write larger check sizes, it just might not make sense for them to allocate to a bunch of middle market managers.

39:34And what we haven't touched on too is this concept of over diversification. And so if you're a large LP and you can say, okay, I want to allocate to the middle market, but I don't want to be overly concentrated in a single fund. I don't want to make too much of a, be too important of an LP in an individual fund. I might have to go out and commit to 10 plus managers every year. Well, as you start increasing that, the law of large numbers will say that your performance is going to go to the average or to the median. So now you're spending a bunch of time to underwrite these managers. And then you're actually paying active fees and getting something in the middle.

40:18And so I think just structurally, it's a real challenge for some of these large LPs to allocate to the middle market. Yeah, totally. And so this says the middle market actually over the last, you know, since 2009 has largely performed better than the larger funds. Like four times since 2009, the middle market on average underperformed marquee or large funds. And that was a pretty small underperformance as well. Yeah. Um, so like you said, yeah, we can see the numbers. We know the middle market on average is going to perform better, but I can't deploy that much capital there. And I need to pick a lot more managers than just picking one or two, uh, on the large side.

41:01So again, like, uh, I've got a problem. I have too much money. I need to, and I have a small team, right? I mean, that's why you see consultants and others helping people out, uh, with these things. Cause the state of Minnesota doesn't have as many people as, uh, you know, a middle midsize college endowment. to manage their entire program. And I imagine you saw a lot of that on the allocator side. To put some numbers on the extreme, I looked at before this, CalPERS, obviously an extreme here, their private equity program is now, rough estimate based on their last filings, $110 to$120 billion. So if you're talking about a rough pacing schedule of maybe needing 15 % to reallocate of that every year to keep that private equity program funded, you're talking about putting 15 to$20 billion into private markets a year.

41:58Like the numbers are pretty staggering and it kind of starts to make sense of, okay, if I'm a GP and I can offer you a big, take a big chunk of that, that's a huge benefit to them. Yeah. And Hey, look, you know, I may not be your best fund when things are ripping, but I'm certainly not going to be your worst fund when things are bad. Like, you know, kind of what we call schmuck insurance, you know, or the rainy day fund. It's like, hey, I'm not going to blow up on you. And a lot of people say like, yeah, I'll take it. I don't want, I can't, I don't want to blow up. And I'm okay to take, you know, 3 % net when things are really bad rather than minus 13 % when things are really bad.

42:35So I want to get into more of the detail of the companies. And what I found most fascinating in the report was around these individual things, around that the bigger the deal, the more people pay for it as a multiple. And the same size deal, bigger funds pay a higher multiple than smaller funds, even for the same size deal. We'll get into leverage later, and I'll spoil it for you. It's the same. They put more leverage on every deal across funds. So you've got the biggest companies, the most optimized, the biggest funds buying the most optimized biggest companies and paying the highest prices for them with the most leverage.

43:26So something's got to give, right? Usually the leverage gives. And when the leverage gives, back to our early conversation, that a lot of this is beta with leverage, you're not making the business better. You're getting multiple expansion and you use leverage. So what happens when things crack and the debt isn't as available? Stephen and I, your colleague, talked recently on the show about the first half of 2026. Multiples are the same and leverage is lower. is less available because everybody's a little freaked out about the AI trade and the economy and oil shocks and dropping bombs and things like that, the midterm.

44:06So the lenders have tightened things up. They're underwriting a little bit. But still, the deals are going for 2021 prices. So that would point to your chart, the bubble chart of things going down, probably go down, right? If you're not making the businesses better, and you found in this report that from 2020 to 20, sorry, 2000 to 2021. So that 20 year stretch, Stepstone, I think had some of this data with you guys, is that in nine of those 21 vintages, the largest deals had EBITDA margin declines. Nine of 21 times, the biggest deals, the companies were worse than when they were they were acquired.

44:53That happened a couple times in smaller deals over that 2021 vintage. So we've got a chart up here for people who are listening. It basically shows by company size, you know, transaction size, what's the entry multiples across small to very large funds. And yeah, Andrew, you know, react to what I just said and what your data shows. well i think the the big thing for me on this one is is part of it's just a quality adjustment right as these larger companies as larger funds get larger they invest in larger companies like if you're already a billion dollar company you've had to have some success right the number of poor operating billion dollar companies on average is gonna be less than you know 500 million 250 million if we just plan all that to the don't tell that to the funds that were taking things privates and thinking they're all broken, but that's not to say.

45:46Yeah. Yeah. Right. That's not to say you can't have a billion dollar company that's poorly managed. There's not a lot of, there's not a lot of lemons out there. Right. Juice to squeeze, you know, that you can go fix up at that size. A hundred percent agree. All right. Right. So there's a quality adjustment and two, we've talked about before, like the competition is much higher. How, how many private companies or even public companies that are viable, take private targets that are generating free cash flow that they can lever up are available. And with all that we talked about previously, the capital flowing into these larger funds, they have to buy these larger companies.

46:20So there's just a lot more competition for the deals. And then, you know, you kind of start thinking, well, one of the tenants of private equity has always been value, right? We buy companies that are poorly run, that are undervalued, we lever them up, we fix their operations, and there's your 15 to 18 % net IRR. If you're looking at these multiples, these for these larger funds, this does not scream value to me. We talked about the larger funds moving more into tech. So starting to kind of paint a picture of these look a lot more like levered growth funds than I think what you would think of when you say buyout equity.

47:06And so I think that's part of the the trend and the takeaways from the trends that what we're seeing is this kind of idea of bifurcation in that, you know, we can get a dog later, whether this is good or bad, but we think the top end of the market is almost a different asset class. It's, it's, it's a different thing than, than the middle market right now. And this is one of the key examples. Yeah. I read, I wrote a piece again on our subject called small is the new big, basically making that case, which is what Blackstone KKR and the big, big funds do. It's hard to call private equity as people understand it, right?

47:41People think private equity is, oh, you buy a company, put leverage on it, you bring in a new management team, you optimize the business, you sell it to somebody else. A very small percentage of those very big asset allocators business these days, they're playing a completely different game, right? The middle market, lower middle market game is like, hey, I got to make money on the buy. I bought it well. We make money on the build. We ran it better, and we make money on the exit. We got multiple expansion, right? And there's some leverage thrown in there as a sweetener. What was interesting about this chart is when big funds buy smaller deals, they put more leverage on them.

48:15If we go to the next chart, not only do they pay more for them, so bigger funds pay more for deals the same size of a middle market fund would pay for that same company, right, in that same transaction size band, and they put more leverage on it. my argument is, well, they probably have better versions of Excel that show the EBITDA is higher, or they get away with more ad backs, I guess. And they have better relationships with very big banks who are like, oh, you know, we're underwriting the brand, not necessarily this one company, so we can get you that extra half a turn or turn, which makes a huge difference if nine of the 21 times of, you know, like I just said, you're making EBITDA margins worse.

48:54So maybe you're growing bulky EBITDA, but the margins are getting worse. So I would say that's a worse business. So you need the leverage to work and you need multiple expansion. And while you say like there aren't that many companies to buy, there aren't that many big companies to buy, right? So the competition is like, well, there aren't that many funds to compete with you, right? There's a few thousand middle market, lower middle market funds that are cold calling every founder and every private, small private equity business out there. You'd think that these bigger funds would have a little more buying power, given there aren't that many of them who could stroke that big of a check.

49:29But it appears to be everybody sees the same deals maybe. So let's talk about the leverage thing, right? This is the big scary thing in private equity. We go in, we lever these businesses, we blow them up with leverage, Toys R Us, go down the list of companies that leverage really got in the way of. Medallia, Toma Bravo, recent big blow up in the spring. With$5 billion of equity and a few billion of debt, you know, put at risk here. So what's the leverage story? If they're paying higher multiples for deals and even the same size deals as other brands, what are they doing on the leverage front?

50:05Well, it's interesting, right? Because you associate more leverage with more risk. But it actually runs counter to what we saw earlier, right? That they don't tend to underperform. So I think to their credit, at least over this time period, they've been able to manage the leverage well. I think part of that too goes back to like the quality of the businesses are higher. So you can put more leverage on a company. But I think the takeaway for me on this one is what you've been talking about. They're not growing margins on average. So they've relied on revenue growth. They've relied on multiple expansion.

50:44And they've relied on leverage. So how many of those tailwinds do we think are going to keep moving this ship forward? I think it's hard to argue against that the last 10 to 15 years or so, post-GFC and maybe 2012 to present. Could you imagine a better period for this type of strategy? Like multiples have gone up. Revenue has gone up. Debt has been cheap. And financing has been abundant. So the fact that you go back to what we just talked about, they've actually underperformed in a lot. And performance has been trending down. So what does that mean going forward? I think you could certainly make the argument that, you know, some of those tailwinds switch to headwinds.

51:35And I would be a little bit skeptical if they're going to not see additional performance degradation. Well, again, anecdotally, because we don't have all the data in, but given, you know, the default rates going up and the headlines on some very big deals, especially on the tech side, you know, getting taken over. by the banks or in workout or you can see the public debt trading. I don't feel like when you roll these charts forward with 2025, 2026 data, it's going to look better than the 2010 to 2020 time period would be my guess to MIT. And I think that dispersion, hey, big funds don't have big blowups, right, at the fund level.

52:22I've seen some, I mean, maybe a little early, five, six years in on some of these, you know, a lot of these big funds, you know, you can see their DPI, you can see their net IRRs from some of these big pension funds in the public disclosures. Like they got, there's some wood to chop there. I mean, you're going to see some rough vintages at the very big, big side that you haven't seen. Now, again, you're going to see some rough vintages on small funds too, given people are paying 12, 15 times revenue for businesses rather than 12, 15 times EBITDA with too much leverage. All right. So let's go into act three here.

52:57You were an allocator. You publish a lot of data. A lot of people rely on the data and the research that you and your good friends at PitchBook do. So if you were giving people advice, though we don't give financial advice on the podcast, but you're pointing out kind of what you're seeing in the data and maybe some things they should go research, what would the advice be? The advice would be more to ask what the exposure is. My old CIO had a line who says, it's not what it is, it's what it does, which sounds kind of obvious. But when we go back to talking about these large private equity, okay, it's equity, it's private equity, but what does it do to your portfolio?

53:38What type of exposures? If we're talking about betting on these kind of billion plus dollar tech buyouts, right? We think a lot of that exposure, like we've mentioned, is beta. It's levered beta. And then when you take into account the fees on top of that, like, are there better ways to kind of get the same exposures? So then we're just talking about too, the tailwinds kind of switching right now on the macro side of things as well. I would be cautious of, you know, on the institutional side, piling into, you know, kind of these core managers, large managers as a, you know, complete private equity program.

54:18I think the same thing can be said on the retail side to an even greater extent because their options are more limited. And that seems to be where these managers have shifted their distribution focus. So thinking about, you know, what exposures is this adding to my portfolio? And can I get them elsewhere for cheaper? And you, in our prior conversations, you've talked about that the industry really wants to like index private markets. Obviously, Morningstar's taking a cut at that with an index. I think you and your team help pull together. Like, what do you mean? Like, there's a Russell 2000 of private equity.

54:57What does that mean? Like, what goes into that? What would that be used for? How does that help allocators make decisions? So I think there's a couple things to unpack here on the indexing private markets. And are we talking about an index that is used as data, as how are private markets performing? Could we get that on a daily basis? That's kind of the holy grail. Can we answer that? And I think that obviously is very useful to allocators. And we do some of that stuff too, because right now you get closed in fund performance with at least a quarter lag, potentially more. So we do some tools to say, at quarter end, what do we think these funds have returned before they report?

55:39And so getting that data earlier, I think, helps make decisions. When we start talking about the indexing private markets as a product is where kind of the red flag starts to raise for me. First of all, I think indexing is a clear misnomer in this sense, right? Indexing, I think it's synonymous with passive on the public side. There's nothing passive about the buyout universe. Like by definition, right? You enter the buyout universe when a deal maker makes a deal and takes over the operations of a company. So in what sense in like the public market manager, would you have a manager that says, I want to add this stock to my universe because I'm going to invest in it?

56:24It doesn't make any sense. And then like the second question I have is, would it actually be a good investment product if you just fully allocate across private markets? I think most of what our data shows and a lot of the academic research now shows is that if you just blindly allocate to all funds, even if it was feasible across private markets, it hasn't necessarily been that much of an outperformer relative to public markets, if at all. And so the question of whether it would be a good investment product, I think, is one that hasn't been answered. And then two, on the passive side, passive means to me lower fees.

57:09Well, we're not going to get rid of the funds, right? The funds are still the operators. So really what we're talking about is a layer on securitization, whether there's some financial innovation. But you're still paying the operators on the fund side. And then you're going to have to pay for the infrastructure to, you know, index or create this separate product. So that's just going to be a layered fee. So I don't see the fees coming down like you'd expect from an index product on the public markets. And so to me, it just doesn't doesn't make sense as in even an idea, let alone the kind of challenges to put it together in practice.

57:47All right. Well, let's show one more chart and then we'll bring it home for everybody, Andrew. Uh, we've got fund dispersion, right? So IRR dispersion across vintage year, we're going to show everybody 2005 to 2020, given, you know, not a lot matters on IRR early in the, in a fund life. So we'll go to 2000. So this is showing kind of the top end, the bottom end and kind of what's in the median. When you look at this chart, right? Uh, it goes up, it kind of comes back down. Like What do you see here when you just stare at the high level? Well, I think this is one, the chart you see a lot as an example of the value of manager selection in private markets, right?

58:31If you could always pick the 90th percentile, even the top quartile fund, that would be a slam dunk, you know, allocate more and more to private equity. So I think that's the first thing. The challenge I would make to that is that, like we've talked about, manager selection is hard. You are not going to pick the top quartile manager. Top quartile managers are not persistent, as we've talked about as well. So just saying you found a good manager and you're just going to re-up for every fund doesn't necessarily mean you're going to experience top quartile returns. The other thing about this chart is what we're seeing is a little bit more of a contraction in the spread.

59:13in that there's still a big difference between your top and quartile, but less so than there has been. So the value, the marginal value of manager selection has declined a bit. The caveat there, as the earlier caveat, these might widen a bit as funds start to realize more and more of their nav. Like we mentioned, DPI has been very low, particularly we see the tightest spread is on the most recent year that we're showing in 2020. So that might widen a bit. But it does, I think, again, put another point towards the value of manager selection being maybe not as great as it once was. And the hard part about manager selection is that by the time I come around to raise another fund, it used to be every five years or so, four or five years back in the golden age, right, when I started my career.

1:00:11You'd raise a fund. You'd fully invest. You'd get some money back. You'd get pretty close to a DPI of one or so, and then you'd go raise the next fund. You certainly could show a lot of progress towards getting everybody's money back before you ask for more. uh that yeah the gfc extended fundraising uh cycles and then everybody just started ripping from 2019 to maybe 2023 2024 and now it seems to kind of slow down a little bit and then these bigger funds getting bigger and then kind of you know no new funds like you know emerging managers and things are kind of in the dumps as steven and i've talked about you don't know how the manager's doing until by the time they come back for the next fund in a year, two years, three years, even five years, it's a bit of a toss up.

1:00:58So that's why, to your point, this persistence issue is hard. And manager selection is hard because maybe they had a good run. Maybe they got a little lucky. Maybe the economy was different. Maybe it was a less competitive market. When we raised our first fund as Parker Gale in 2015, there weren't a lot of small tech funds, right? Tech-only funds. There were a lot of, you know, Vista and Tomo were getting bigger and bigger, but there weren't a lot of$250,$300 million funds. The ones that were had early success and got to a billion, two billion as fast as they could. So now it's highly competitive, right?

1:01:31So, you know, we've had to change some things to differentiate or save itself in a meaningful way. And private equity has gotten generally more competitive. And as it's gotten more competitive, I think that band of outcomes is tightening because it's gotten more professional. Like you don't have just three guys and a golden retriever doing deals anymore, which some of those guys and gals do some of the best deals when you use three people and a golden retriever because you can move fast and maybe you get some funky thesis or something. That's hard to scale. It's hard to deploy capital into people like that.

1:02:01These fundless sponsors and, you know, kind of pledge funds and things. But as the industry professionalizes, I think, you know, everybody's got the same plays. People have done this before. Maybe they came from bigger funds. They kind of know how to manage a business, how to manage gross to net spreads and things. A lot more products to manage gross to net spreads than there used to be, like bring the net up through fund lines and other things. So I think you're just going to see a tightening of outcomes. And again, you need privates to outperform. And it's hard to look at this bull market we've had for so long and say, you're going to go consistently outperform that in an illiquid product.

1:02:36But like you said, on the indexing side, Morningstar started to bring transparency, as Joe Mansueto, to the closed-end mutual fund market. I think we're headed towards that version of it for the private markets would be my guess, which will be very good for the retail investor. We'll expose a lot of people that have had brands without the returns, but also we'll force small funds to do things from the need to have the plumbing and the transparency and the tools and the sophistication and be able to disclose as much as a KKR is required to disclose, just like the compliance regime of 20 years ago worked its way down to small funds.

1:03:18So it's a lot for small funds to think about as the industry consolidates above them. Before we get to the lightning round, I mean, is this like, is asset gathering? Like, is these funds consolidate? Is the industry consolidates? You saw the mutual fund industry consolidate. saw the wealth management industry consolidate like why doesn't just private equity consolidate and then like massive asset gatherers and go big funds go pick up you know some of the best small and mid-market funds that they don't have a product they don't want to build they should go buy somebody is this where we're headed i think to an extent right like we're already seeing that and i think some of that's natural like you mentioned we saw it in mutual funds and And as we're talking about, it's a$9 trillion market.

1:04:02We're not talking small potatoes anymore. And part of that maturation, we get more efficient and we scale up. That said, I still think there's a market there for middle market managers to operate. So we talked about scale. We talked about, oh, 60 % of what's been raised so far in 2026 has gone to the top 5%. Well, that other 95 % was over a trillion dollars. so i i do think there is room there especially on the match with certain size of lps i think it fits nicely that if you're a mid-size lp that you have this option like we talked about scale can be a challenge for lps and and they're kind of forced to be in these large managers and hey if they're not the best performing ones like that's an advantage to be a smaller lp and i think they should you know potentially look into that as opposed to you know i'm small maybe not have the manager research budget.

1:04:56So we'll just default to these large managers. I think it's at least worth exploring. So I don't think this is by any means the beginning of the end for middle market. I think it's still an absolutely a place for it in portfolios. The fit just has to be right. And I think the trends, again, will continue on the higher side. There will be consolidation. but there's plenty of capital, I think, to go around. The growth might not be what I think some would like to see, but there's certainly still, I think, business to be made there. Well, it's where all the fish are in the middle market and lower middle market, so that's where you should put your boats.

1:05:39And I know LPs who are committed to the middle market and lower middle market want to have an impact on the fund they're in. They want to be a meaningful allocator. Maybe they can allocate$30 million, so why be in a$30 billion fund that doesn't make any sense, be a$30 million allocator to a$600 million fund, then maybe you're on the LPAC and you've got a seat at the table and you feel like you're part of the business rather than just a number on a spreadsheet. All right, two quick questions to end. Is there something you're working on in your research that you're really excited about? Is there a theme you're mining pretty hard?

1:06:11There's some stats that you're seeing and things you're working on that you want to preview for the audience? I think where we want to go next is to look more into the specialization aspect of it. And we've recently partnered with StepStone and gotten a lot of great data, quality data, right? At PitchBook, we see a lot of top-down fund metrics on a quarterly basis, whereas StepStone, obviously, an LP and a lot of different funds, They see things on a deal-by-deal-level basis with financials. So we've been limited on that side. I think we're really interested to see, does the concentration play out at the manager level?

1:06:54Does that expertise actually lead to alpha? We've done some work on that in the past using our fund data to kind of didn't really get to a conclusion. But we're looking to dig into that some more. Yeah, I'm fascinated to see what you guys can do with that transaction level data, portfolio company level data, anonymized, obviously. But yeah, and then see kind of funds with fascinated by like funds that are kind of a democracy, you know, where everybody's an equal partner versus funds kind of dominated by one, you know, investor at the top, everybody kind of runs his or her playbook. funds with lots of operating partners versus funds that are more old school private equity of just kind of deal doers and things.

1:07:40And they let management run the companies. There'll be some really fascinating stuff you can glean out of that when you have the transaction level data. And then, hey, about a prediction about private equity. Is there something you believe about private equity? Haven't been on the allocator side and now on the data side and research side. Is there something you believe about the industry that other people you know aren't quite there yet or disagree with you about? I don't know if people disagree, but what I'll say is after going through this research, I think the trend should continue on the performance side.

1:08:13So I would say the funds that have been raised so far this decade, I think on a capital-weighted basis, middle market will outperform the marquee mega managers. All right. Take it to the bank. Sounds great. Andrew, thanks for joining me. I'm sure we'll be on again sometime soon to cover more of your research. Everybody should go to pitchbook.com. We're a big PitchBook user in the portfolio across Parker Gale. We're using the MPC server. We're building it in. I'm probably talking to PitchBook through Claude a lot. And then I'm in the application a lot too, grabbing stuff. I think the data is getting better.

1:08:53The partnerships you're doing with Stepstone and other things is making things really interesting. and in a very opaque industry that's moving super fast. As a GP, we get a ton of value out of the product and it's kind of hardwired into a lot of our operating systems. So yeah, thanks for doing what you're doing. Really appreciate it. Yeah, thanks for having me on. If you like this and you want to share it with a friend, that would be great. We'd also love if you hit the subscribe button, which is the only way other people are going to find us. So please do that and bye for now. Technology issues, middle market PE-backed companies.

1:09:25They bicker with each other and they don't take themselves too seriously. It's not venture capital. It's private equity. It's the private equity fun cast. Pour yourself a drink and have a seat.