Podcast: Power of Persistence — Does It Still Exist in Private Equity? Josh Lerner, Harvard Business School & PCRI (Part 2)

Josh Lerner, Harvard Business School and Private Capital Research Institute

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.

Yesterday we ran Part 1 of our conversation. Here’s Part 2…

Chris Riback: Obviously, we live in a data driven world and we seek to measure everything and we seek, many folks and certainly on the investment side, many investors seek to reduce investment decisions down to tight measurement capabilities and data. Is it possible, are you potentially, advocating might be too strong of a word but is the potential rise for subjectivity in this area and in investment decisions from LP’s particularly into the PE world, are you potentially seeing that and reduction of the ability or not importance but kind of the legitimacy of objective data or know that you would see that the challenges, we need to find new sets of objective data if measuring persistence is no longer indicative of future of performance, then we still need to base our investing decisions on data and something we can measure but we now better find some new and improved way things to measure?

Josh Lerner: Great question, not an easy answer. I certainly am somebody who has hung my hat over the years on the proposition that you can see interesting things in data around venture capital and private equity which allow you to better understand both the industry as a whole as well as individual investors. So I am certainly not going to be one who argues that data is useless for these decisions.

At the same time, I think it is worth pointing out that the relying on the wrong kind of data mechanically is unlikely to lead to the right decisions. When Antoinette Schoar and I did a paper a number of years ago looking at investment decisions by a number of classes of institutional investors, one of the things we looked at is decisions, we up with groups. We’re saying conditional on you being in a group, in a fund do, you end up investing in the next fund or not.

What we found is that for the public pension funds for instance, we could predict if they were going to reinvest or not with a very high degree of accuracy. And you might say, how could we be so, do we have a crystal ball to do it, no. What was really the crucial consideration for those public pensions or for their gatekeepers and other consultants who were advising them is what was the past performance of the fund and if you had a group whose past performance was above the median, it was very likely that the pensions were going to re-up with the groups.

Meanwhile, when it came to the endowments for instance which have historically had considerably more success in terms of both picking which LP’s to invest with, which GP’s to invest with, for the first time as well as in reinvestment decisions, we found that we could predict their decisions to reinvest or not much more poorly. Essentially what we realized is that they were using, I suspect that they were using a combination of a much richer data set as well as considerably more soft or qualitative information in making their decisions.

So, I don’t think the answer is that data is unhelpful. I think data can be very helpful in thinking about issues but just simply mechanically saying we want to reinvest with the people who have done the best in the past is unlikely to get you to where you want to be. Rather you’re going to have to look at a variety of information both including quantitative information for instance about which partners actually did the deals and are they still there. How is the carried interest being allocated across the partners in particular? How does it map up to who is actually done deals that have created the most value as well as the softer information that can only be gleaned through a series of conversations with these groups.

Chris Riback: Have PE firms caught up on this and are you seeing a difference in the way they are telling their stories or are they behind the LP’s perhaps in terms of what LP’s are looking to understand in terms of evaluation? Is there balance there? Are you seeing a change in the way PE’s present themselves?

Josh Lerner: Well, I think the answer is that it’s not a unit, there’s not a one answer here. I think that when you look at some of the largest and most established groups in the industry, one has to take one’s hats off and say these are fund raising machines, they’ve practiced a lot and they have very good people and they’ve figured out how to go and sell their various products that they’re offering.

As you move to middle market funds, I think you see that in many cases the performance is much poorer in terms of doing this kind of storytelling. And in particular, what strikes me is that many cases, you talk to managing general partners who are extremely smart people, who are very thoughtful, extremely good deals people. But when you get them talking about their own fund and what makes their fund unique, it’s remarkable how little ability they have to really articulate what those things are.

You see these conferences right, where you’ll have four middle market guys on a panel. You ask them to introduce themselves, each for two minutes and at the end of the ten minutes of introductions, you’ll be like these guys each took the same set of words rearrange them slightly differently and spewed it out and I have no ability to really distinguish how any of these four groups are different from each other.

And certainly one of the things that I’ve encouraged general partners to do is to think very carefully about how to position themselves strategically which is partially quantitatively, quantitative exercise in terms of saying how does the data tell a story of what it is that we are doing that’s unique but it’s also more of a qualitative story of a process of storytelling and where actually getting case studies and other kinds of things out there can really convey some of the richness as to what’s going on.

Chris Riback: Yeah. It would seem to be just such a central opportunity and with your findings and what you heard about persistence, it certainly opens a new door to opportunity for that. I want to remain respectful of your time. I know that we’re running tight here. Couple of the things that really struck me about the round table that I wanted to ask you about, one was technology innovation. There was some discussion about the role of technology innovation in terms of persistence. What was your take on that?

Josh Lerner: Well, I think this is an area which is extremely interesting for a couple of reasons. One of which is that it is clear that business as usual approach is unlikely to work going forward. In other words, if you’ve just got a couple of 55 year old industry executives and you’re investing in all these industries and expecting things to do as they’ve always done, it seems it’s unlikely that that strategy is really going to work anymore. We’ve seen this in retail right, where we’ve seen a whole blood bath of private equity backed companies which tried to basically do business as usual in terms of their approach. But we’ve also seen it in many other sectors as well.

So, certainly one implication of technological changes that groups have to retool and redesign their ways in which they add value and due diligence on portfolio companies to reflect the fact that this is a new world and the impact of technology on even industries which seem to be very removed from the front lines of IT and social media are very much impacted.

That’s certainly one lesson that I take away from the discussion. One other point to emphasize is that the range of industries in which private equity are likely to be playing going forward is likely to change as well. We’ve seen a number of examples for instance of deals in which private equity groups have bought companies out of the portfolios of venture capital groups which was a kind of transaction that was almost unheard of even five years ago. I think we’re going to likely see more blurring of private equity and venture capital in the years to come as technology [extends] its reach and impact.

Chris Riback: Well, that’s a fascinating topic. That may be the topic for another podcast with you at some point because that’s really a fascinating trend. Is that a trend you’re keeping your eye on?

Josh Lerner: Yeah, absolutely. It’s obviously early going so it’s hard to do much in terms of analytics yet but fully expecting that we’ll be doing a variety of research around that area. We’ve done some work in the past about private equity and innovation and it seems like the way in which things are changing is extremely interesting today.

Chris Riback: Okay. I’ll follow up with you on that in the future. Last question I have is anything that surprised you in the discussion on persistence. Anything you didn’t expect. Was there a particular headline that struck you from the discussion that that we haven’t discussed?

Josh Lerner: Yeah. I think that certainly to me at least, one of the most interesting discussions was the one out of the general partners themselves. And the way in which they for instance emphasized the way in which successful people that they had mentored and developed had basically begun by what they described it as sitting in the broom closet. In other words, starting at the real bottom of the pyramid at their firms and working their way up and how much that was critical in terms of building and retaining a firm culture.

It’s not that we don’t know this at some sense. I mean obviously you look at a firm like Blackstone for instance where you know so many of the key leaders and the next generation are people who joined right out of working or something like that and they’ve been with the firm for decades but I think the point which each of these firms which has been you know I’m going very successful firms over the decades emphasized is how much engineering goes into that creation and maintenance of a firm culture in a way that I don’t think that either academics or limited partners have fully gotten credit for in terms of in terms of understanding while analyzing firms.

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