How do returns from 1st Generation funds compare against 2nd and 3rd Gen funds over time?
When the market is hot, it is not surprising to see more GPs in the market raising capital for their next fund. However, it’s not only those well-established GPs with long track records but also newly formed GPs who are pitching to LPs for their new 1st generation fund, seeking to raise capital during a time when investor sentiment is positive. There is that old saying that new GPs are more “hungry” and eager to prove themselves compared to their established peers, and therefore, more willing to take calculated risks to potentially achieve higher returns, while perhaps also charging LPs lower fund management fees and carried interest. For LPs, the bet is that because of these attributes, this first-time GPs with their 1st Gen funds will deliver superior returns, but is that really the case?
Keeping in mind that newly established GP firms usually don’t mean that these are inexperienced teams; in fact, it’s usually the other way around whereby seasoned investment professionals with their own personal track records decide to leave their firm and step out on their own. So how do returns from these 1st Gen funds compare against 2nd and 3rd Gen funds? Specifically, what are the differences when we break them down across fund size ranges and also during different market conditions, e.g. Pre-/Post-GFC?
In terms of median Net IRR for those funds with vintage years prior to the Global Financial Crisis between 2001 and 2008, Figure 1 shows that 1st Gen funds in the range of $50-250m only have a marginal edge over 2nd Gen but outpaces 3rd Gen by more than 2%-points. In the next larger fund size segment of $250-500m, the picture is similar where 2nd Gen leads ever so slightly over 1st Gen while both are some 2%-points ahead of 3rd Gen. At the middle to the upper end of the market where funds are ranging from $500m-$1bn, it is 1st Gen funds that are lagging behind. Finally, at the $1bn+ segment, 2nd Gen edges out 3rd Gen while there are too few 1st Gen funds in the data sample to provide a comparison.[1] Overall, we can see that in the Pre-GFC era, there was an incremental advantage to investing in 1st Gen funds when fund sizes were below $500m.
Figure 1: Pre-GFC, Median Net IRR, Source: ©CEPRES Investment Platform, August 2020
Interestingly, for upper quartile Net IRR funds during the Pre-GFC era as shown in Figure 2, 1st Gen clearly outperforms in the lower mid-market and middle-market segments where fund size is in the ranges of $250-500m and $500m-$1bn, respectively. If LPs were able to select those new GPs that delivered top quartile returns compared to other new GPs, then they were rewarded with handsome returns of 25.3% and 33.1% Net IRR for those two fund size ranges. These Net IRR returns are a considerable 4-9%-points ahead of 2nd and 3rd Gen fund peers within their same respective categories. When it comes to the smallest fund size range, the 1st Gen upper quartile Net IRR is mid-pack at 24.4%.
