Data & analysis of persistence in returns at the fund level PitchBook is now a Morningstar company. Comprehensive, accurate and hard-to-find data for professionals doing business in the private markets. Credits & Contact Key takeaways Analysts NICO CORDEIRO Analyst BRYAN HANSON Data Analyst KORY HOANG Data Analyst Top-ranked firms outperformed bottom-ranked firms by an average internal rate of return (IRR) of 19%, signifying the degree to which manager selection affects returns. Contact PitchBook pitchbook.com RESEARCH reports@pitchbook.com EDITORIAL editorial@pitchbook.com Contents 78% of funds raised by top-ranked firms have delivered returns above the industry s median 47% of all their funds ranked in the top quartile. Meanwhile, 76% of funds raised by bottom-ranked firms failed to deliver returns above the industry s median, displaying consistent poor performance. As expected, top-ranked PE firms have outperformed public markets by a wide margin over all time horizons. With an impressive KS-PME score of 1.42, top-ranked PE firms have substantially outpaced public markets over a 15-year horizon. Despite much smaller returns relative to better-performing peers, bottom-ranked firms still outperformed public markets at the one and 15-year periods while performing nearly even with public equities over a three to 10-year horizon. Introduction 1 Key takeaways 2 Top vs. bottom performers Comparing performance to the public markets 2-3 4-5 Methodology 6
2 Introduction The sheer opacity of the PE industry and its history of operating in secrecy make examining industry-wide returns difficult. This note explores PE returns and the relative performance of PE against the Russell 3000 in order to examine the effect of performance persistence on returns. To develop a better understanding of how manager selection affects limited partner returns, we analyzed 1,300 funds across 310 different PE firms which have raised three or more funds with vintages between 1995 and 2013. Several academic studies, including the oftcited Kaplan-Schoar (2005) paper, found that while performance persistence exists among certain general partners, average returns net of fees for PE are roughly equal to the public markets. Our own research disputes this, showing a clear outperformance by the PE industry against comparable public equities. However, little has been done to examine performance against public markets when accounting for GP performance relative to its peer group. To separate firms based on performance persistence, we had to establish a ranking methodology. First, we organized all funds included in our dataset by their respective vintage. We then ranked the funds in each vintage group based on their IRRs and separated all funds into quartiles. Next, we transitioned to the firm level, grouping all funds in our dataset by their respective manager. We averaged all fund quartiles of a firm to arrive at a firm-level score. Lastly, we separated the firms into four groups based on that firm-level score, assigning a ranking of 1 to 4 with 1 representing top-performing managers who landed in the top quartile and 4 representing the worst performing. An example of this can be found on page six. A pronounced difference between top and bottom performers Of the funds that were analyzed, the highest-ranked firms delivered the most consistent performance, with 47% of their funds delivering top-quartile returns and another 31% of their funds delivering secondquartile returns. This equates to 78% of funds raised by top-tier firms delivering IRRs above the industry s median. Second and third-tier firms are the most inconsistent in fund performance, delivering returns more evenly distributed among different fund quartiles. Although it is expected that bottom-ranked firms consistently deliver poor performance the extent to which they do is surprising. 76% of all funds raised by these firms delivered below median returns. The contrast is
3 even more pronounced when examining average IRRs based on firm ranking, as top-ranked PE firms deliver average returns 19% greater than bottom-ranked firms. It is worth noting that this analysis suffers from survivorship bias since we required each PE firm to have reported fund returns for at least three funds. As such, poor-performing firms that only raised one or two vehicles were excluded. If these firms were included in our dataset, we believe the performance of bottom-ranked firms may be lower than what the visuals below suggest. PE fund quartiles by firm ranking % of PE Funds in 1st Quar le % of PE Funds in 2nd Quar le % of PE Funds in 3rd Quar le % of PE Funds in 4th Quar le 19% 3% 31% 40% 54% 31% 9% 13% 34% 28% 22% 47% 27% 17% 19% 6% 1 2 3 4 Firm Ranking Average PE fund IRR by firm ranking *As of 6/1/2017 4 3.1% 3 11.6% *As of 6/1/2017 2 13.0% 1 21.9% 0.0% 5.0% 10.0% 15.0% 20.0% 25.0%
4 Comparing performance to the public markets Our own benchmarking reports argue that PE investments outperform their public market equivalents; the vast amount of capital LPs have allocated to PE certainly corroborates this. However, given the current high-priced environment and saturated market, our previous research leads us to believe that PE IRRs will continue to trend downward. Therefore, it is useful to examine the performance of PE against a public market benchmark by firm rather than aggregating all fund IRRs. Comparing PE returns by firm rank against the Russell 3000 using a KS-PME calculation, we can see there is a wide difference in relative performance depending on the quality of the PE firm. Top-ranked firms consistently beat the public markets by a significant margin in every timeframe featured below. In fact, over a 15-year horizon, top-ranked PE firms outperformed their public market benchmark, boasting an impressive KS-PME score of 1.42. Top-ranked horizon PE KS-PME versus Russell 3000 1.50 1.40 *As of 3/31/2017 1.35 1.42 1.30 1.23 1.20 1.14 1.16 1.10 1-year 3-year 5-year 10-year 15-year 0.90 Interestingly, bottom-ranked firms also outperformed the market at the one-year and 15-year timeframes but the outperformance is minimal when compared to top-performing peers. Given the long-term horizon of such investments, it is especially important to assess whether a small outperformance with certain managers is worth the illiquidity. As mentioned, our previous research has shown a downward trend among PE IRRs, but even more concerning from an LP perspective is the widening gap between top and bottom performers, which has reached the highest split since 2004. As both these trends continue, manager selection becomes more important than ever.
5 Bottom-ranked horizon PE KS-PME versus Russell 3000 1.20 *As of 3/31/2017 1.10 1.06 1.06 1.02 1-year 3-year 5-year 10-year 15-year 0.98 0.96 To address wide variance in performance, the common practice among LPs is to diversify among a range of GPs to mitigate the possibility of underperformance. However, the dispersion of selection between strong and weak performers will greatly affect the type of realized returns an LP receives. Our data shows a significant number of poor-performing PE firms continue to raise follow-on funds despite poor performance. 41% of bottom-ranked firms have raised more than three funds and 9% managed to raise more than five funds despite consistent poor performance. LPs can increase PE returns by cutting ties to firms earlier on in the relationship and moving on to the next manager when an initial investment in a firm fails to deliver strong distributions throughout the life of the fund. By more aggressively culling poor-performing firms, LPs could move further toward the public market outperformance exhibited by top-ranked firms as opposed to the PE market overall. PE KS-PME versus Russell 3000 1.40 1.30 *As of 3/31/2017 1.28 1.22 1.20 1.10 1.06 1.07 1-year 3-year 5-year 10-year 15-year 0.90
6 Methodology Fund Quartiles: Calculated by comparing fund returns against all other PE returns in the same vintage year and breaking them into four quartiles, the first quartile includes the highest 25% of returns and the fourth quartile the lowest 25% of returns. Firm Ranking: We calculated rankings by averaging the quartiles of each fund raised by a firm to assign a placing of one through four. A ranking of one represents the best-performing firms, four the worst-performing firms. Example: 1. Average the quartiles of all funds raised by a firm 2. The averages are then quartered, giving each firm a rank between 1 and 4 KS-PME: PitchBook employs the Kaplan-Schoar method when analyzing PE returns relative to indices made up of traditional asset classes. A whitepaper detailing the calculations and methodology can behind PME benchmarks can be found at pitchbook.com. Kaplan-Schoar Method: NAV T distributiont T + S t=0 I PME t KS TVPI, T = T contributiont S t=0 I T ( ) ( ) I t