The private equity industry has grown tremendously over the past decade. While less than $10 billion was committed to private equity partnerships in 1991, more than $150 billion was committed in 2000. However, unlike the heavily researched mutual fund industry, there are many unknowns about how private equity funds work. A recent study provides some answers.
Private equity is an asset class composed primarily of venture capital (VC) funds and leveraged buyout (LBO) funds. Venture capital funds invest in start-ups and early stage deals. Leveraged buyout funds invest in buyouts, usually of mature companies.
One of the main obstacles to studying private equity has been the lack of available data. Private equity firms are largely exempt from the disclosure requirements governing investments in public companies.
Using newly available data on individual fund returns, University of Chicago Graduate School of Business professor Steven N. Kaplan and Antoinette Schoar of MIT's Sloan School of Management analyze the fundamentals of private equity partnerships in the recent study "Private Equity Performance: Returns, Persistence, and Capital Flows."
The study addresses three main questions:
1) What are the average returns on private equity funds, and do these returns beat the market?
2) Is there "persistence" in private equity returns, i.e. a relationship between a fund's past performance and its future performance?
3) How does performance affect fund survival and future capital raising?
These questions have already been answered for other asset classes, particularly mutual funds. In contrast to private equity, mutual funds hold public equities and information about mutual fund performance is readily available. It has been well documented that the net returns of mutual funds, on average, do not beat the overall market. There is also very little evidence of persistence in mutual fund performance. In those cases where persistence has been detected, mutual funds tend to underperform rather than outperform the market.
Kaplan and Schoar find that (net of fees) the average returns on private equity funds for the sample period 1980 to 2001 approximately equaled those of the market. For this study, the market is represented by the Standard and Poor's (S&P) 500. Before deducting fees, returns for both types of private equity partnerships exceeded those of the S&P 500, with venture capital funds performing slightly better than leveraged buyout funds.
While Kaplan and Schoar find that average returns are approximately equal to the overall market, they also find that some funds consistently outperform the market.
"Our key finding is that there is a great deal of persistence in private equity performance," says Kaplan. "This persistence suggests that well-managed private equity partnerships exist. If you invest in a partnership that has done well in the past, the odds are it will do well in the future."
In regard to fund survival and future capital raising, the authors find evidence of a boom and bust cycle where capital appears to chase returns. When the private equity industry does well in general, money flows into the industry, and many new funds enter the market. Returns then decline and the cycle begins anew.
Private Equity Investing
Individual private equity funds are limited partnerships involving two groups of people: 1) managers of the private equity firm, who serve as "general partners;" and 2) investors, who serve as "limited partners," usually consisting of institutions and wealthy individuals who provide the bulk of capital.
When limited partners commit to providing capital, general partners are able to create a fund. The general partners then have an agreed time period in which to invest the committed capital - usually 5 years. General partners also have an agreed time period in which to return capital to the investors - usually 12 years or so.
The general partners' compensation is an annual management fee (typically 1.5 to 2.5 percent of the capital committed to the fund), and a share of the fund's profits (typically 20 percent). Each fund is essentially a closed-end fund with a life of 12 years.
When general partners exhaust a substantial portion of the fund's committed capital, they typically try to get commitments for more capital to start a subsequent and separate fund. The second fund is usually started 3 to 5 years after the first fund.
What is different about private equity investing?
First, there are potential entry barriers for new funds. Unlike mutual fund investors, private equity investors can have proprietary access to particular transactions. Better funds may have access to better information, and thus obtain higher returns.
Second, private equity investors are typically much more active than the average investor. They may, for example, serve on the boards of companies in which they invest.
Third, private equity funds may have fewer "economies of scale." Unlike mutual funds, it is difficult to double the amount of money invested in a particular company.
Capitalizing on New Data
Kaplan and Schoar use data from Venture Economics, an organization that creates benchmarks for venture capital funds and leveraged buyout funds. Venture Economics collects quarterly information on individual funds through the voluntary reporting of private equity firms and their limited partners.
The study's final sample consisted of 580 venture capital funds and 166 leveraged buyout funds that were liquidated or had minimal residual value, were started prior to 1997, and were worth at least $5 million in 1990. Because they are largely liquidated, performance for these funds is likely to be measured correctly and unlikely to be manipulated by the general partners. The authors studied the cash flows of each fund to determine fund returns, and compared those returns to the S&P 500.
The authors used several measures of fund performance, net of management fees and carried interest. Their analysis included internal rates of return calculated by Venture Economics, and calculated again by the authors using the fund's cash flows. Their primary focus was on a measure entitled the "Public Market Equivalent" (PME), calculated by the authors in relation to the S&P 500.
The Public Market Equivalent reflects the return to private equity investing relative to the alternative of investing exclusively in public equities. A PME of greater than one indicates that a fund's returns beat the S&P 500.
For all funds in the sample, the average Public Market Equivalent is 0.96, implying a net performance roughly equal to the S&P 500. This calculation also implies that gross performance, before fees, exceeds the S&P 500. While average performance is close to that of the overall market, there are large variations in realized returns across time and across funds.
A private equity fund's performance is closely related to the performance of the previous two funds operated by the same limited partnership. General partners whose funds outperform the industry in one fund are likely to outperform the industry in the next. Similarly, general partners whose funds underperform the industry are likely to repeat this performance as well. In addition, a fund's past performance serves as an indicator of future capital flows and fund size.
The relationship between capital flows and past performance differs for the mutual fund and private equity industries. In the mutual fund industry, funds that outperform the market tend to receive substantially more capital. Mutual funds with above-average performance therefore tend to increase their share of the overall mutual fund market. In private equity, however, the better performing funds voluntarily grow more slowly than the overall private equity market.
There are several reasons why a successful fund might choose to stay small. A private equity investor cannot easily increase investments by putting more money in any particular deal or investing in more companies, because he or she provides other less tangible inputs, such as time and advice. It may also be difficult for a successful fund to hire additional partners who are as skilled as the existing partners. Finally, top general partners may choose to raise less capital than they could because the number of good deals in the economy is limited at each point in time.
Which funds are started in boom times? After periods of above average returns, the authors find that a large number of new funds enter the industry. Funds that are started during boom times are less likely to develop a subsequent fund.
First-time funds tend to have below-average returns. Overall, industry returns are lower after periods of increased market entry by new partnerships. The authors suggest this effect is driven mostly by the poor performance of new funds.
A Good Time to Invest?
"If history is any guide, many of the new private equity partnerships formed in the last several years will disappear," says Kaplan.
The results suggest that private equity returns from recent funds will continue to be poor, but the "good" general partners, and particularly those whose funds did not grow too much, will still outperform the benchmarks.
From 2002 to 2003, Kaplan notes that buyouts were in the middle of the boom and bust cycle, while venture capital remained in the bust cycle. If historical patterns hold, 2004 to 2005 is a good time for general partners to raise and invest in venture capital funds, and for limited partners to commit capital to modest size funds.
