Back in 2015, when CalPERS held a one-day private equity workshop, which was a vehicle for justifying its loyalty to the strategy despite the SEC and major press stories revealing abuses and embezzlement, its star witness, Harvard Business School professor Josh Lerner, gave a surprisingly tepid defense. Lerner conceded that typical returns in fact didn’t justify investing in private equity, given its higher risks. It made sense only if you could get into top quartile funds.
A new study confirms that Professor Lerner’s, and most private equity industry investors’ aspirations aren’t worth pursuing since superior performance in private equity no longer persists. Or as a Bloomberg write-up of that paper put it, Private Equity Legends Are No Longer Living Up to Their Hype.
What is nevertheless surprising is that the academics act as if their finding is novel. It isn’t, as well demonstrate shortly. Yes, there was a time, before the 2000s, when top private equity fund managers could regularly out-do their competitors. The most likely explanation is that the private market was inefficient enough that there were arbitrage opportunities and some firms were better and finding and executing on them than others. Too many parties chasing too few deals have bid away a lot of the upside.
We’ll also remind readers shortly that even if you believed that there were private equity fund managers who could regularly beat the odds, it’s no different than saying, “It doesn’t make any sense to invest in stocks unless you can invest in the top 25% performers in the market.” Investors have accepted that they can’t all be the next Warren Buffett and expect to out-invest everyone else; it’s now widely held wisdom that you are better off to accept market returns rather than doing even worse via ovetrading.
But even back in 2015, we wrote that academic evidence was mounting that so-called persistence of top quartile performance in private equity was a thing of the past. A new, large-scale study puts another nail in that coffin. We’ve embedded this NBER paper by Robert S. Harris, Tim Jenkinson, Steven N. Kaplan, and Ruediger Stucke at the end of the post.
It is worth noting that the authors of this study include some of the top academic researchers into private equity. Sadly, private equity academics are almost entirely captured; they make far more money consulting to private equity firms than they do from their day jobs. And you can see signs of that in this paper. The authors repeatedly tout investing in private equity and venture capital by comparing returns to the S&P 500. But that’s bogus, as referring to their own past publications would reveal. Private equity is higher risk that public stocks due to its illiquidity and higher leverage; venture capital is even riskier. The authors never once acknowledge that private equity needs not only to out-do public stocks, but to do so by a meaningful margin, which historically was set at 300 basis points. Venture capital should be benchmarked against smaller-cap stocks and have a risk premium at least as high as private equity.
Implicitly, the repeated references to private equity and venture capital returns compared to the S&P 500 is an effort to counter the widely-reported findings by Oxford professor Ludovic Phalippou, that since 2006, private equity has performed pretty much on a par with the S&P 500, which means its performance is too poor to compensate for its outsized risks.
Their study is noteworthy for being more comprehensive than past studies on fund performance, and in particular, in relying on a non-cherry-picked data set, one from Burgiss, a data service for fund investors. The authors have also taken the critically important step of looking at the reported performance of fund managers’ most recent fund at the time they are raising a new fund, which is typically on a five-year cycle. That is the data investors have available to them when considering a new offering; past studies have looked at what ultimately happened to the predecessor fund, which is something no investor could know at the time when it makes a commitment.
Nevertheless, the study still has limits in that it relies on IRR, as opposed to the less-game-able PME (public market equivalent). But the latter can’t be properly calculated until a fund is wound up. Specifically, the authors fail to acknowledge the rise of subscription lines of credit and how they can render IRR computations utterly meaningless.
Before 2000, the authors found that a fund that looked like a top quartile performer at the time of a new fundraising would give you one-in-three odds of getting a winner again, but that vanished:
…using performance information available at the time of fundraising, the results differ. For buyout funds with post-2000 vintages, performance persistence based on fund quartiles disappears. When funds are sorted by the performance quartile of the GP’s previous fund at the time of fundraising, performance of the current buyout fund is statistically indistinguishable regardless of quartile. First-time funds perform at least as well as any of the groups based on prior fund quartile rankings.
The authors did find that if you looked at final performance, that did predict performance of the next fund, even after 2000. But that’s of no use to those deciding which horse to ride. The study also found, contrary to conventional wisdom, that new funds performed as well as established funds. They also determined that top venture capital funds are likely to deliver again.
What is disingenuous is the authors’ position that their finding is news. It isn’t. We been pointing to evidence of the lack of persistence of top fund performance for years. And we are hardly alone. From the transcript of public comments at the aforementioned 2015 CalPERS private equity workshop, by Rosemary Batt, co-author with Eileen Appelbaum of the landmark book Private Equity at Work:
And so I want to talk a little more about the performance data and just expand on Professor Lerner’s excellent presentation….
Professor Lerner then refers to another really important paper by Robinson and Sensoy who report, they actually report performance based on real returns, so liquidated funds. And here they find that the average fund does outperform the stock market by 1 to 1.5%, depending upon the index.
The median fund, however, just matches the stock market, which means that 50% of the funds do not perform as well as the stock market. It is the top quartile funds that outperform both indexes by 3 or 4%.
So, if we put this together, then, Professor Lerner also points out this problem of persistence of performance. And the studies he refers to show that prior to 2000, the private equity firm with a top performing fund had about that 50% chance of being in the top performing funds in the follow-on fund. But since 2000, that probability has dropped to 22%, and that is less than would be expected if the distribution were random.
In other words, all this new study has done is refine what ought to be conventional wisdom, save that private equity investors have staffs who have job incentives to believe that fund-picking is a productive exercise, and those staffs have industry consultants who also have strong financial incentives to perpetuate that fiction. The older studies found that private equity top quartile persistence was actually higher, 50% versus 1/3 now, but found that since 2000, you’d do better throwing darts than investing in a prior-period top quartile fund.
And that’s before getting to the elephant in the room, whether investing in top-quartile funds, even if they could be identified, is attainable in practice. As we wrote in 2014:
Rather than question the logic of investing in private equity at all, everyone in the industry has convinced themselves that it is reasonable to believe that they can be the Warren Buffett of private equity. The investment consultants go through the shooting-fish-in-a-barrel exercise of convincing their institutional clients that each of them is prettier, smarter, and more charming than average, and therefore capable of achieving sparking results. Needless to say, flattery is an easy sell….
Fundamentally, this is an intellectually dishonest exercise, and diametrically opposed to the way many public pension funds construct other parts of their investment portfolios. With public equity in particular, it’s almost certain that a significant majority of U.S. pension fund assets are invested in index funds. That’s because pension funds have recognized that, collectively, they cannot do better than average, and that after paying active management fees, actively managed public equity portfolios typically perform worse than the market average.
So it’s not as if these investors are so clueless that they can’t grasp the point that all of them cannot achieve above average results, let alone significantly above average results. Instead, with private equity, there is a desperate desire to be in the asset class for reasons that probably reflect a combination of intellectual capture by the PE managers, political corruption in legislatures that control public fund board appointees, and the need to have a strategy that could conceivably solve the pension underfunding problem over time.
So while it is gratifying to see our contentions about private equity reaffirmed, it’s discouraging to see investors desperately throwing even more money at it. Just like second marriages, it’s a triumph of hope over experience.
00 Nov 2020 NBER private equity returns paper
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Oh, PE does pick the winners. Anyone who receives the fees.
Quite!
When a grift is this successful, one shouldn’t allow pesky facts to get in its ways.
This is the reason behind the push for longer dated or even forever funds.
A 20 year guarantied income stream is better than a 10 year income stream especially when the annual management fee and carry remain the same. The longer life also means delaying the return of unearned excess carry paid on early exits.
This is just par for the course for Western societies that are largely engines for redistributing income gains to an elite class. Ignore the data on PE, well that’s really about hovering up pension, endowment, and 401k pools of capital for the private jet class. And just wait until we need PE to save Social Security because we need outsized returns! Or look to our environmental crisis while we throw good money after bad at fracking, which nets fossil fuels at negative returns. But it provides make-work for parts of the country and tremendous potential for riches for a precious few. Sadly to me the PE story looks like the story writ large everywhere in Western society. Not doing things because they make sense, but justifying the reasons to keep doing them so that rich people can get richer and further entrench their power via those same riches.
As I read this I couldn’t help but think about my experiences dealing with PE and VC firms from the capital raisers perspectives. I think there is a potentially more caustic side affect of their rise, which is there dominance in the capital investment process.
Having both advised and been CFO of firms dealing with the private capital complex I have repeatedly come across similar behaviors. First, they all think they know everything. Second, they all seek IRRs above 20%; this being despite where interest rates are and regardless of what type of firm they are (this includes many credit funds). Third, and very importantly, they want to achieve these returns without risks. That’s right without risks, as opposed to understanding the risks that have to be managed. One would expect nothing else from a group of MBAs who have never worked in an operating company, receive very high compensation and are really focused on raising the next fund — as we know they really get paid for having more AUM, as opposed to investment performance.
The impact this has is that firms that require and should receive capital have trouble accessing it. Equity markets have largely been closed off as a source; a combination of you need to be a unicorn with hype and the fact that the large firms have largely wiped out the small and mid sized broker-dealers who would otherwise raise capital for emerging companies.
Maybe I have it wrong. In a world awash with capital, both debt and equity, shouldn’t returns go down. Yet, all the PE firms I have been speaking to over the last couple of years are raising their hurdles to invest. The net of all of this is it is another factor cutting off the innovative portions of the economy from the lifeblood it needs to grow and develop.
Instead, with private equity, there is a desperate desire to be in the asset class for reasons that probably reflect a combination of intellectual capture by the PE managers, political corruption in legislatures that control public fund board appointees, and the need to have a strategy that could conceivably solve the pension underfunding problem over time.
I’d say that pretty much encapsulates california, at least for the meritocrats, and who would listen to anyone else? This collective state of mind may be why CalPERS was picked to be the thanksgiving turkey. There was a commenter over the weekend who decried those greedy (/s ) firefighters with 6 figure pensions, but nary a mention of the ridiculous cost of living in coastal cali.
Fleecing undeserving pensioners is AOK in cali, heck, fleecing anyone in cali is a basic requirement of living there…see prop 22 as a recent example.
You seem to forget who pays for the pensions. The more pensioners get the less taxpayers keep. Is it okay for a pensioner to reap a $100K per year pension on the backs of those who earn less than half that while working? Where is the fairness?
The pensions were negotiated in the context of overall wage and benefits bargaining, as in the wages were lower than they would otherwise be.
IRR: I had to look it up! Internal Rate of Return, from Investopedia.
Professor Lerner (who the IRS says makes the bulk of his income from Private Equity firms he advises, not Harvard) offered the secret to coming out on top in PE investing: “You have to have the Secret Sauce.” His clear implication was that the overpayment of fees and carry would garner investors to access to top-decile returns.
This is a classic confidence scheme — in which the “mark” thinks that they’re “in on the con.”
Unfortunately, the evidence is that Private Equity is fresh out of deals. The massive Blackstone funds ($26B and $8B respectively) that CalPERS’s conflicted ex-CIO had his hair on fire to enter have yet to call a dime of the $1.75B in commitments he made beginning nearly two years ago. Money that could have been deployed elsewhere, like maybe rebuilding manufacturing and infrastructure instead of trying to loot it.