There were many changes to the private equity market over the years. In early research by Kaplan and Schoar, internal rates of return generated by private equity fund’s cash flows were calculated. They later compared the data to a public market equivalent.
This public market equivalent assumed that cash flows of funds were invested in the S&P500. Results have shown that there were rough similarities between private equity returns and that of the market.
This study also casts doubts about the value of the private equity industry. This is in light of the significant fees that private equity funds charge. But later research used a method similar to Kaplan and Schoar. And applied it to newer datasets and found returns in excess of the market return.
In their study, Kaplan and Schoar found that there were persistent private equity returns. They were persistent in the sense that the general partners who outperformed the market in a given year’s funds were more likely to continue to outperform in succeeding years. The researchers reached this conclusion using regression analysis. The analysis sought to determine if the coefficient in equation 9.3 was statistically significant and positive.
The Equation
The equation is
PiN =α+βPiN−1 + €iN
where
PiN = performance of fund N, which is managed by private equity firm i
PiN−1 = performance of fund N – 1, which is managed by private equity firm i
The Findings
The findings of the persistence of private equity fund returns are in contrast with the study on mutual fund managers. The study on mutual fund managers does not show the persistence of their high returns.
The later research focused on how long-term this persistence was. Researcher Chung regressed PiN on PiN−2 and found a weaker relationship.
Chung found that performance was persistent for the first follow-on fund but not subsequent ones. This may mean that the persistence is short-lived if there are any.
Another issue for LPs is whether the persistent performance of some private equity funds and specific managers is “investable.”
Investable persistence reflects on the ability of LPs to identify superior PE firms and managers. If LPs can’t do that, then the existence of persistence is not as valuable.
In 1969-2001, there was an analysis of the 1924 funds. 89 firms managed the funds. Researchers Korteweg and Sorensen made the analysis and saw a significant amount of persistence, even a long-term one.
However, they found that there were a lot of “noisy” past performances. And luck had a lot to do with it, especially for venture capital funds. Note that the sample included buyout funds and venture capital funds.
Are Private Equity Returns Persistent?
Although there is evidence from many studies that private equity returns tend to be persistent, there is a basis to believe that persistence has declined over time. For Braun, Jenkinson, and Stoff analyzed a sample of 13,523 portfolio investments by 865 buyout funds.
Researchers found a persistence, however, this soon declined, too. It declined when the private equity evolved and when there was more competition among PE firms. This is a very intuitive result out of Economics 101.
It is worth noting that there was less competition for more attractive company investments when there were fewer PE firms. But the PE firms succeeded and made persistent and more returns for their LP investors.
Then, new PE firms entered the market even though there was not necessarily any major increase in the number of attractive acquisition targets available. Money also continued to flow in the industry. And the obvious result was that they acquired less profitable targets and these acquisitions bring down the returns of many PE portfolios.
Valuations of private equity funds’ performance also face challenges. One of these is that there is usually not a liquid market for the assets of such funds.
Therefore, the investors, the limited partners of the funds, and researchers have to use the fund’s own estimates of net asset values or NAVs which are made in quarterly reports of these funds.
Another challenge is that they will only know an accurate value after they sell all the assets in the fund. In most cases, transactions like these can take years, even up to decades.
These kinds of problems provide opportunities for them to manipulate the asset values by some funds.
One of the solutions certain funds have been pursuing is to have NAVs determined by outside valuation consultants.
Private Equity Return Calculations
Scholars Phalippou and Gottschalg explored the private equity return calculations of previous research in order to shed light on actual PE returns. They used an expanded version of the dataset utilized by Kaplan and Schoar. However, they changed the way they treat the residual values.
While previous researchers accepted the residual values of unexcited investments as of the sample study period put forward by private equity firms and, therefore, treated them as positive cash inflows, Phalippou and Gottschalg pointed out that these investments had reached their normal liquidation date, and most of the time they had not generated positive cash flows for some time prior to that. For them, they should write off such values.
The average fund’s Profitability Index declines by seven percent when they write it off. They found that the average fund underperformed the S&P 500 by 3% after considering deeds even if gross of fees outperformed this index by 3%.
Continuous Growth
The Kaplan and Schoar 2005 study used a dataset by Venture Economics from the years 1980-2001. In the 1980s, the private equity industry was not that large even if it grew significantly in the 90s.
It continued to grow impressively in the 2000s, with the exception of the downturn associated with the subprime crisis and the Great Recession. This made many scholars ask, why would there be continued growth in monies in pursuit of private equity investments if returns were roughly only equal to the market? Could the returns in early research be lower than the returns experienced in later years?
In later research by Karris, Jenkinson, and Kaplan, they found that private equity funds consistently outperformed the market, as measured by the S&P500, by between 20% and 27% over the average fund’s life and by greater than 3% annually.
The concerns expressed by Phalippou and Gottschalg’s research tempered the findings of various studies. These studies showed that private equity returns exceeded the performance of the market.
Note that they also showed how inaccurate the valuations of some NAVs may result in overstatements of some fund returns.
© Image credits to Elina Krima