Performance and Capital Flows in Private Equity Q Group Fall Seminar 2008 November, 2008 Antoinette Schoar, MIT and NBER
Overview Is private equity an asset class? True story lies beyond the aggregates Large variance and persistence in returns Idiosyncratic risk matters Implications for risk management
Aggregate PE returns are pro-cyclical Venture returns versus 6-year cumulative S&P Buyout and Venture Returns Relative to S&P Net Annualized IRR to Funds vs. 5 Year S&P 80 70 60 50 40 30 20 Buyout Returns Venture Returns S&P 5 Year 10 0-10 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000-20 -30 Source: Venture Economics
Multiples l are pro-cyclical l Venture multiples versus 6-year S&P Buyout and Venture Multiples Relative to Multiple on S&P for next 5 years 5 4.5 4 3.5 3 2.5 2 Buyout Multiples Venture Multiples S&P 5 Years 1.5 1 0.5 0 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 Source: Venture Economics
Not too surprising i Valuations are driven by exit markets IPO and M&A valuations are strongly gypro-cyclical Large capital inflows in years after high returns Funds raised in years with large capital inflows have poor subsequent performance and vice versa Young funds and funds with worse track record are especially negatively affected Established funds are better able to weather industry cycles
Idiosyncratic risk matters The three pillars of public equity markets Non predictability of returns Diversification Arbitrage All three are violated in Private Equity Entry limitations Ticket size Illiquidity of investments Large information asymmetries
Persistence of performance Bottom Medium Top Bottom Tercile 61% 22% 17% Medium Tercile 25% 45% 30% Top Tercile 27% 24% 48% Kaplan and Schoar, Journal of Finance, 2005 High likelihood that the next funds of a given partnership stays s in the same performance bracket Persistence Larger for the top quartile More persistence for top quartile funds in market downturns
Individual id funds returns All Funds VC Funds Buyout The average fund does not outperform the S&P 0.12 0.11 0.13 500 IRR (0.17) (0.17) (0.19) Enormous differences in [.04, 0.20] [.03, 0.19] [.06, 0.24] performance between the 0.74 0.66 0.80 top and bottom quartile (0.96) (0.96) (0.97) PME [.45, 1.17] 17] [.43, 1.13] 13] [.46, 1.14] 14] Skewness of returns Kaplan and Schoar, Journal of Finance, 2005
Sharp and persistent differences in LP returns over 1990s Banks Advisors Public Pensions Insurance Companies Private Pensions Endowments -5% 0% 5% 10% 15% 20% Source: Lerner, Schoar and Wang [2007]
But Idiosyncratic risk is lowest for high return investors Value at Risk: % of funds in lowest quartile Banks Advisors Public Pensions Insurance Companies Private Pensions Endowments Source: Lerner, Schoar and Wang [2007] 0% 5% 10% 15% 20% 25% 30% 35% 40%
Interpreting ti the differences Do these just reflect timing or investment mix? No robust to various controls. Are these differences due to fund access? Look at reinvestment process, where access is much less critical: Pension funds and advisors tend to invest when current returns are high. But much more dramatic difference in future returns from endowments.
Reinvestment and returns 40 30 20 10 IRR of next fund 0 Advisors Banks Corporate Pensions Endowments Public Pensions Reinvested Did Not Invest 40 30 IRR of previous fund 20 10 0-10 Advisors Banks Corporate Endowments Public Pensions Pensions Reinvested Did Not Invest
What do endowments know that others don t? Suggests differences in ability to identify or act on inside information. Systematically obey a few simple rules that can be observed by most investors Monitor fund size and partnership growth
Fund Size IRR 14 12 10 8 6 4 2 0 Relation IRR and Fund Size 1 2 3 4 5 6 7 8 9 10 11 Fund size in $100 million Concave relationship between IRR and fund size Fund size is measured as capital committed at closing Regression results control for vintage year, fund category
Change in Fund Size 0-20 -40-60 -80-100 Relationship of Change in IRR to Change in Fund Size 1 2 3 4 5 6 Logarithm of Size Negative relationship between change in IRR and change in fund size for a given firm Fund size is measured as capital committed at closing Regression results control for vintage year effect, fund category, and firm fixed effects
Fund Sequence Number IRR 25 20 15 10 5 0 IRR and Fund Sequence Number 1 2 3 4 5 6 7 8 9 10 11 Sequence Number Positive relationship between IRR and fund sequence number First time funds perform especially bad Regression results control for vintage year effect, fund category and fund size
I Partner to Size Ratio RR 30 25 20 15 10 5 0 IRR and Partner to Size Ratio 0 0.2 0.4 0.6 Number of Partners to $100 million in committed capital Positive relationship between IRR and the ratio of partners to committed capital Regression results control for vintage year effect, fund category and fund size
Summary PE differs from other asset classes Vast heterogeneity across funds Strong persistence of returns Top quartile funds have less idiosyncratic risk than the rest of the funds Focus on relationships with top funds not ex ante asset allocation Manage investment process opportunistically Manage investment process opportunistically Bottom-up approach rather than fixed asset allocation targets Incentives for deployment of capital are detrimental to returns
Thank you!