Has Persistence Persisted in Private Equity?

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Monday April 21, 2014 at 9:34 am
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Editor’s Note: The following post comes to us from Robert Harris, Professor of Finance at the University of Virginia; Tim Jenkinson, Professor of Finance at the University of Oxford; Steven N. Kaplan, Professor of Finance at the University of Chicago; and Rüdiger Stucke of Saïd Business School at the University of Oxford.

In our paper, Has Persistence Persisted in Private Equity? Evidence from Buyout and Venture Capital Funds, which was recently made publicly available on SSRN, we use detailed cash-flow data to study the persistence of buyout and VC fund performance over successive funds. We confirm the previous findings that there was significant persistence in performance, using various measures, for pre-2000 funds—particularly for VC funds. Post-2000, we find that persistence of buyout fund performance has fallen considerably. When funds are sorted by the quartile of performance of their previous funds, performance of the current fund is statistically indistinguishable regardless of quartile. At the same time, however, the returns to buyout funds in all previous performance quartiles, including the bottom, have exceeded those of public markets as measured by the S&P 500.

Regression estimates on the full sample of funds find that current fund performance is significantly related to previous fund performance, but the magnitude of the relation is much weaker than in the earlier period and is associated with poorly performing funds, which have tended to repeat their poor performance relative to other funds. This results in a puzzle: what motivates investors to continue to fund buyout GPs whose past performance is well below that of their peers? Perhaps this occurs because investors do not know the ultimate current fund performance (which we can observe looking back at the data) when they make the decision whether to commit to the next fund. Whether there is a systematic difference between interim and subsequent performance for the poor performers—relative to the majority of buyout funds—warrants future research.

Our results have interesting implications for buyout fund investors. First, the decline in buyout fund persistence combined with a continuation of above public market returns for buyout is consistent with at least two explanations. It is possible that the buyout business has changed, with operating engineering becoming increasingly important (see Kaplan and Stromberg (2009)). Some general partners adjusted while others did not. Alternatively, it is possible that general partners learned from each other and that has led to the reduction in persistence. Second, the decline in persistence casts doubt on the industry rule of thumb to invest only in funds that were previously in the top quartile. Except for the bottom quartile, previous quartile performance is not a strong predictor of current fund quartile performance for buyout funds. Third, the lack of a performance-size relation suggests that buyout funds have been able to scale their performance as they have become larger. PMEs in the post-2000 period are not appreciably different from those in the earlier period despite much larger fund sizes.

The results for VC funds are markedly different. We find that performance remains statistically and economically persistent throughout the sample period. Partnerships whose previous VC funds are below the median for their vintage year subsequently tend to be below median and have returns below those of the public markets (S&P 500). Partnerships in the top two VC quartiles tend to stay above the median and their returns exceed those of the public markets. We also fail to find a negative relation between performance and fund size. These results imply much greater stability in the venture capital industry over time. Many of the same forces that operated in the 1980s and 1990s appear to still be in effect.

Our results on VC funds have two implications. First, the persistence of persistence in VC suggests that the industry rule of thumb to invest with GPs that have previously performed well and to avoid those that have not remains consistent with our results. The stronger performance persistence for VC as compared to buyout suggests that GP skills and networks for successful VC investing are harder to replicate than is true in buyout. At the same time however, VC funds with previous performance in both the top and second quartiles outperform the S&P 500. This is not consistent with the view that only very few VC funds outperform. In fact, previous funds that are above median appear to do so.

The full paper is available for download here.

 

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