Dispersion in private markets funds and why it matters

Fund return dispersion is a very important concept to understand, particularly in the context of private markets. In simple terms, dispersion describes the spread of potential return outcomes over the life of a fund.

The potential range of outcomes from investing in a private fund is typically much wider than that from investing in mutual funds or exchange-traded funds (see charts below).

Why is the dispersion so much wider? There are several reasons, most prominently:

1. Limited information: With less available information, private markets are less “efficient” in terms of setting valuations. What that means is that fund managers may be able to find much greater value in an underpriced asset, but also leaves greater room for error when making that assessment.

2. Active not passive management: Private fund returns are often a result of active value creation strategies at the companies or assets invested in. That leaves a lot more space for either adding or losing value over time depending on the quality and approach of the fund manager.

3. Less diversification: Private funds are often narrowly focused on a particular sector, industry, or geography, which can make them more vulnerable to industry-specific or regional risks. In addition, private funds generally invest in a less numerous portfolio of assets than most public funds.

Wide dispersion vs public markets

Comparing apples-to-apples from public to private markets is difficult. Private funds invest and return cash gradually over many years, while public funds price and trade at least daily. But comparisons are possible, using a measure called internal rate of return (IRR). IRR is a calculated annual rate of return that takes into account both the timing and size of the different cash flows in private funds.

The first chart illustrates the contrasting dispersion between relatively comparable categories of public and private funds over the 20 years to June 2022. The bars illustrate the range of outcomes from the 25th percentile (or lower quartile) to the 75th percentile (or upper quartile) performing funds in each category - with the 50th percentile (or median) marked.

As the chart shows - and ignoring for now absolute performance - the range of outcomes for comparable private and public funds is clearly very different.¹ The gap between top- and bottom-quartile funds in the US large-cap and small-cap growth categories is tiny when compared to their closest private analogues: private equity buyout and multi-stage venture capital funds, respectively. The interquartile range (the difference between a bottom- and top-quartile manager) for US small-cap growth funds was just 1.2 percentage points (pp) annually over the last 20 years.² For multi-stage venture capital the equivalent interquartile range was 18.2 pp.³

Varying dispersion within private markets

Before we discuss the implications of this dispersion for your investment decisions, it is informative to take a quick look at the varying dispersions of different private market strategies (see chart below).

Returns from each of these private fund strategies have been more varied than those from public funds over the last 20 years, but to different degrees.⁴ Senior private credit, for example, has an interquartile range of just 4.3 pp, while for early-stage venture funds the range is 22.4 pp.⁵ Private market strategies vary widely, and each have different attributes and different roles to play in your portfolio.

Investment implications of performance dispersion

So what does this wider dispersion mean for your investment decisions?

Clearly, if the range of outcomes is so much wider, there is the risk that you end up at the wrong end of that range. You should always be aware of potential risks before you commit to a fund - this could include geographic, sector, manager-specific, or time-related risk. There are ways you can reduce and manage these risks - primarily by diversifying across each of these parameters - but you should always bear them in mind.

The flipside is, of course, that greater dispersion includes the potential for much greater upside. An upper-quartile early-stage venture fund has returned 28.4% annually over the last 20 years.⁶ The right fund could therefore have a significant positive impact on your portfolio.

This means that it becomes way more important for you to select the right fund manager. And unlike in passive public market funds, there are advantages that certain private fund managers may be able to leverage consistently, in terms of access to the best deals, their ability to actively create value, and access to information. This can create persistent performance advantages, particularly among venture capital funds.⁷

Identifying the right fund manager is therefore a critical (if difficult) task. However, it is also insufficient, because it can be very difficult - particularly for individual investors - to access funds from the best managers. There is a limit to the amount of money that private fund managers raise. This is by design and reflects their capacity to invest that cash, the size of checks they plan to write, and the number of investments they plan to make. They therefore tend to offer preferential access to those that have a track record of being reliable investors and/or can write large checks up front.

You may therefore want to find a partner to help you select, diligence, and access funds from coveted managers.