The internal rate of return (IRR) is not a scientific method to calculate performance. Far from it. Fund managers can manipulate, misreport, or altogether fabricate their results, making them unreliable.
But a larger question for prospective investors is whether private fund managers possess unique skills that can somehow provide certainty or, at the very least, predictability. An affirmative answer implies private equity (PE) fund managers have talent and don’t rely on serendipity to deliver performance.
Myth II: Performance Is Predictable
Fund managers have long trumpeted their well-honed investment methodologies for producing wealth. Sadly, in my 12 years working at four separate fund managers, I never encountered the peerless value-enhancing techniques that practitioners so often extol. In fact, three of my former employers, including Candover and GMT Communications, shuttered their operations in the wake of the global financial crisis (GFC). (Before you draw any inferences, these firms folded many years after my departure.)
So what explains the absence of predictability in private equity performance? There are two key factors. First, the sector is highly cyclical. This point is neither surprising nor contentious. By definition, PE professionals invest in all segments of the economy, and most if not all of these industries are exposed to the economic cycle. Hence, PE investing, fundraising, and portfolio realizations are somewhat erratic activities.
Predictability requires persistence.
But the second argument against predictability — the lack of persistence in performance — is more damaging to PE fund managers’ reputations.
Prospective investors — limited partners or LPs — might trust their ability to gain access to top-tier PE firms and ignore their lower performing counterparts. But the adage, “Past performance is no guarantee of future results,” is as true for private capital as it is for public equity markets. The first-quartile PE performers differ from one vintage to the next.
Persistence in PE may have existed in the 1990s, according to some researchers, but the industry emerged in the late 1970s, and 20 years later most buyout firms had only raised four to five vintages at best. The limited sample size leads many observers to draw inferences where there might be none: They fall victim to what Daniel Kahneman and Amos Tversky call the “law of small numbers.” As Warren Buffett observes in “The Superinvestors of Graham-and-Doddsville,” a series of coin tosses is not enough data to determine whether the results are the product of luck or skill.
Lack of Persistence in Performance
Buffett goes on to identify nine value investors who beat their public stock benchmarks year in and year out over several decades. He concludes that these “superinvestors” help discredit the academic view that markets are efficient. Talent is the only explanation for such extraordinary and concentrated success over time.
Unfortunately for prospective LPs, there are few if any superfund managers in private equity. Recent studies are adamant and unanimous on that front.
In “Has Persistence Persisted in Private Equity?” the authors report that performance in the buyout trade has shown low persistence since 2000. In “How Persistent is Private Equity Performance,” Reiner Braun, Tim Jenkinson, and Ingo Stoff, CFA, examine cash flow data on 13,523 portfolio companies by 865 buyout funds and also find little evidence of persistence.
McKinsey analysis reached the same conclusion, albeit with different numbers: The consistency of PE returns has decreased over the last 20 years. Between 1995 and 1999, one third of funds were in the same quartile as their predecessor fund. Between 2010 and 2013, that fell to 22%. “Persistence has been declining,” DSC Quantitative Group founder and CEO Art Bushonville observed. “Now it’s almost random. You can’t look to a previous fund for clues.”
In a random distribution of fund managers, 25% of each quartile’s constituents should return to the same quartile one vintage after another. Yet, in the real world, the ratio is much lower. Data from Antoinette Schoar demonstrated the deterioration of PE performance persistence over time:
PE Performance: Top-Quartile Persistence
Persistence in Underperformance
An interesting side note to “Has Persistence Persisted in Private Equity?“: The researchers found “absence of persistence post-2000 except for funds in the lower end of the performance distribution.” (Emphasis mine)
The fund vintages in the years leading up to the GFC demonstrate this point. There was little or no persistence to outperformance among the leading PE groups, but certain funds consistently underperformed from one vintage to the next.
Quartile Performance by Vintage
|Welsh Carson (America/Europe)||2005||Third||2008||Second|
Sources: Preqin, CalPERS, CalSTRS, Oregon PERF, WSIB, Sebastien Canderle analysis
This stubborn underperformance of many of these funds helps explain why some of their existing institutional investors chose not to participate in subsequent fundraises.
CalPERS, for instance, did not commit to KKR European Fund IV (2015), Providence Equity Partners VII (2012), or TPG Partners VII (2015) even though it had invested in the three firms’ two previous funds. Its Californian peer CalSTRS opted out of Providence’s 2012 fund and TPG’s 2015 fund after investing in their two previous vehicles.
Occasionally investors do give fund managers the benefit of the doubt: Oregon Public Employees Retirement Fund avoided KKR Europe’s 2015 vintage despite investing in the previous funds, but did allocate capital to Providence’s 2012 fund notwithstanding the 5% and 3% returns from its two previous vehicles.
In other instances, time heals most wounds for investors and they dive back in to a firm’s offerings after skipping a vintage or two. CalSTRS, for example, committed to TPG’s eighth fund in 2019 after passing on its predecessor.
Lackluster PE fund managers often can raise funds by awarding incentives to prospective investors. KKR, for instance, granted a hurdle rate, or preferred return, on its 2015 vintage in order to attract the punters. The firm had not done this for its 2005 and 2008 funds, which had only generated IRRs of 4% (or a money multiple of 1.2x) and 10% (1.4x) respectively.
Three Reasons for the Lack of Persistence
While extensive research easily debunks the myth of predictability in PE performance, it doesn’t explain why persistence is so hard to find.
There are several factors at work:
- The North American and European markets are over-intermediated. Most transactions go through auctions and PE firms all have access to the same deal flow. Many mid-market corporations have experienced leveraged-buyout (LBO) transactions. In 2017, private equity backed almost a quarter of midsized and 11% of large US companies.
- PE firms also face very mature credit markets offering deal-doers the same debt packages. Most transactions apply stapled financing, covenant-light structures, amend and extend procedures, equity cures, syndication, and EBITDA addbacks as standard tools.
- Over the past two decades, private equity has become commoditized. Thanks to rich fees and low barriers to entry, the number of PE firms worldwide has doubled — to more than 5,000 — in the last decade. There is no real differentiator between most fund managers. They all recruit the same sorts of executives, mostly financiers — ex-bankers, ex-consultants with master’s degrees in finance or business administration, CPAs, and the like. So they end up with similar capabilities.
This last point may be the most important factor behind the lack of persistence. In highly unpredictable environments like finance and investing, experience often breeds confidence in trained experts. But it does not sharpen skill. To achieve the best outcomes in such fast-changing contexts, a broad range of experiences and a diverse background among employees are required. Yet the marketeer, entrepreneur, operator, corporate executive, or people manager is a rare profile at most PE firms.
The economic environment evolves briskly and constantly. The dot-com boom and bust, the subprime mortgage bubble, the GFC, quantitative easing era, the unicorn and big tech bubble, and now the ongoing COVID-19–induced recession — these all represent very distinct market conditions. And the acceleration of technological disruption accentuates the uncertainty. Hence the need for multidimensional and protean expertise across an investment organization.
“The ability to apply knowledge broadly comes from broad training,” David Epstein writes in Range. “Relying upon experience from a single domain is not only limiting, it can be disastrous.”
A narrow skillset among PE professionals would not make them adaptable. Their financial expertise might work wonders in an easy-money recovery fueled by cheap debt as in 2014–2019, but their broader skills could be lacking in an environment like the current downturn where operational or restructuring talent is required. Executives who do well in a bull run are likely to do poorly in a recession.
Fund managers insist that they cannot disclose their value-creation methodologies. Otherwise rivals could replicate them. But the lack of diversity in the profiles of PE practitioners cultivates a closed mindset that academic studies suggest may help explain their inability to deliver predictable, persistently positive results.
Some may conclude that the lack of persistence in PE performance, or fund managers’ inconsistent delivery of top-quartile results, suggests that private markets are somewhat efficient.
But another explanation is more likely. Because of their poor risk/return management techniques, PE executives, unlike the most sophisticated arbitrageurs operating in the public markets, have yet to develop a systematic way to exploit market inefficiencies.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
Image credit: ©Getty Images / LeoPatrizi