Conventional wisdom in private equity has often gone like this: Performance persists across funds for the same partnership.
But the view over the last years is mixed. One 2014 study found that post-2000, there was “little evidence of persistence for buyout funds, except at the lower end of the performance distribution.”
The question was addressed again recently at A Roundtable Sponsored by the Notre Dame Institute for Global Investing and the Private Capital Research Institute. Here a group of limited partners, academics and general partners met to share their thoughts on performance and persistence in private equity investments.
Their conclusion: “the once robust persistence of performance across buyout funds has weakened, along the historical outperformance of private equity relative to the private markets.”
But what does this finding mean in terms of various important inputs, factors like: approaches employed in selecting fund managers, factors influencing performance in the current environment, industry trends and performance benchmarks, comparisons between venture and buyout investing, alignment issues, and the importance of culture?
I asked Dr. Josh Lerner, Chair of the Entrepreneurial Management Unit and the Schiff Professor of Investment Banking at Harvard Business School. He also serves as Director of the Private Capital Research Institute, a nonprofit devoted to encouraging access to data and research about venture capital and private equity. More honors: Josh is Vice-chair of the World Economic Forum’s Global Agenda Council on the Future of Investing and was named one of the 100 most influential people in private equity over the past decade and one of the ten most influential academics in the institutional investing world.
Here’s Part 1 of our conversation…
Chris Riback: So let’s start at the very top. How do you define persistence and more specifically, is it something that you still look for in private equity?
Josh Lerner: Well, perhaps the way to begin is to think about what historically made private equity and venture capital are different from other asset classes. And in particular, when we look at public fund investors, particularly mutual funds, what we see is that there is very little continued outperformance. In other words, if you have a mutual fund that beats its peers in a given quarter, the probability that it will beat its peers in the next quarter is pretty much 50%. The nature of public markets being what there are, it apparently is the case that there is very little demonstrated stickiness that essentially when you flip the coin the second time, it’s equally likely to come up heads or tails, win or lose.
Even in hedge funds which you might think are different in the sense they got the geniuses in the back room working on the computer models and so forth and are very secretive in terms of their strategies. You see that there is remarkably little persistence. In other words, it often is the case that a mutual fund that beats the market one quarter will beat the market the next quarter. If you look three, four quarters henceforth, there is very little evidence of continued outperformance by a winning hedge fund.
So it seems that in public fund investors, whether we’re looking at open ended mutual funds or more secretive hedge funds, there’s very little of this persistence that’s evident. When it comes to private equity and venture capital, historically, the academic literature has suggested there’s been a strong amount of persistence there, that by and large funds that have been top quartile ones have continued to be in the top quartile. And in particular, when you look at the evidence for instance that was compiled by one of the authors in the session, Rudi Stucke, who did work with Bob Harris, Tim Jenkinson, and Steve Kaplan.
Chris Riback: This was their 2014 report, Has Persistence Persisted in Private Equity, the evidence from buyout and venture capital funds. Really kind of a landmark report but yeah, please go on because I think that’s one of my questions is their pre 2000 and post 2000 findings.
Josh Lerner: You saw that prior to 2000, it seems there was a very strong on kind of persistence that was there. It was there for buyout funds and it was there for venture funds. Then something seems to happen and the question is what happens but that when we look at that subsequent period of 2001 and onward it seems that this very strong pattern of persistence seems to break down. In particular, it’s not really on the venture side where it breaks down. In the venture side, one still continues to have a lot of persistence going on but when it comes to the buyout world, it is a very different kind of story, that it seems than it whereas before if you were in the top quartile in a buyout fund, given fund, the next fund had a 41% chance of being in the top quartile or much higher than the 25% that you might expect by randomness.
When you look at the subsequent period, it’s much lower perhaps on the order of 30% in terms of probability of being in the top quartile. So it seems that there’s been this breakdown of persistence in the business.
Chris Riback: And what was Rudy’s take and what did he discuss in the round table, and this is now two years hence since his joint report came out? What did he kind of speculate or hypothesize around that something and what was your interpretation of that? Did you kind of agree with it and what was your view of what he had to say?
Josh Lerner: Well, I think this was an issue was discussed not just by the academics but also by the general and limited partners who took part in panels and I think it’s fair to say that there were a number of hypotheses offered for what we saw but no real certainty in terms of what it is that was driving it. And in particular, one of the hypotheses which was offered was that this was a reflection of the extreme amount of interest on the part of limited partners in private equity investing.
And in particular, what was argued is that in many instances we’ve seen a phenomenon where groups here are some an initial success and do quite well and then what happens is they attract a lot of interest on the part of limited partners who rush into the hot fund and what ends up happening is that the returns degrade. Essentially, as funds get larger, their ability to maintain the kind of success that they’ve had in the past seems to depreciate.
Again, there was a sort of variety of suggestions offered for why that might be. It might be a factor that simply they end up doing larger deals which are outside of the, which are more competitive or which are in an area that they’re less familiar with. They may have a strategy that works very well for modest sized transactions but when they get to doing much larger transactions, the same tricks, the same skill sets, the same consultants no longer work as effectively.
So certainly it may be that they move out of their skill set. The other possibility is that people get stretched too thinly. So essentially you get people serving on more boards of directors, doing more things and so forth and they become just simply less effective as a result and. That’s a sort of second explanation for what we might see.
Chris Riback: Do you have a third or additional explanation because otherwise I’ll follow up with you’re putting of as you would imagine, you know, many questions in my mind for follow ups. Do you have a third or additional potential explanations that you wanted to touch on first?
Josh Lerner: Another possibility is just that there is an element of bad timing around it, which is when you think about the venture capital industry and you say, when were the largest venture capital funds raised, well, they were basically raised in years like 1999 and 2000 and probably 2015 and ’16 and ’17, which I think people look back on at least in the case of ’99, 2000 period as being the high watermark of the industry.
So there is a bit of adverse selection that the time when LP’s find it most attractive to invest turns out to be with the benefit of hindsight to be the worst times to be doing investing. So there may be partially just this bad timing going on as well.
Chris Riback: And so, given those potential explanations and particularly and maybe even particularly the first two because the timing is always very clear in retrospect, maybe sometimes a little bit more difficult in advance.
But particularly on those first two, what does that mean, what do you see as well in terms of what that means for LP’s trying to evaluate the private equity firms and investment opportunities and in the other direction, what does it mean or what do you see in terms of private equity firms I don’t know if it would be positioning themselves or marketing themselves, that if persistence is declining as a key measure or a predictive measure perhaps, what are you seeing from the private equity side in terms of communicating to LP’s and attracting LP’s and what are you seeing from the LP side in terms of increased pressure for them to find new better ways to evaluate private equity funds?
Josh Lerner: Yeah. well I think that as they say is the $64,000 question, right? If you can put in a bottle What are the criterion for evaluating the best funds, it indeed is, it indeed is, you really do you have something magical. And in particular, one of the things that for instance people, the panel in terms of limited partners raised is that some groups were like in a way, we always used to rely on a strategy of same team, same strategy, same fun size. In other words, don’t change anything and we’ll be happy.
And in particular, the point that they raised is that given the dynamism in the market today, it’s not as clear that standing still is necessarily the best strategy and in fact, one can argue that in some cases it may actually breed complacency and that what you want is some degree of hunger in terms of groups, in terms of really adapting to different strategies and new approaches.
So, for instance, one of the things that a number of people pointed to is saying that we’re looking for groups that actually stumbled a bit and gotten into trouble and have undergone a turnaround and are really hungry to prove that they’re a once group great group which ran into difficulties but was able to right the ship rather than being one of these groups steps consigned to the dust bin of history. So that that might actually be a more attractive situation than just someone who is just chugging along at a good but not necessarily great kind of approach.
Certainly another criterion that was raised by limited partners is a ore familiar one which is really looking at incentive issues and I think that many of the LP’s expressed concern for instance with the recent trend towards sales of equity by general partners to investor groups arguing that that might lead to all sorts of problematic incentives.