Private equity managers promote their funds to potential investors based on (strong) historical performance. However, an age-old adage tells us that “past performance does not guarantee future results”. Still, a private equity manager’s track record can be indicative of the investment proposition. Early this century, for example, researchers established that so-called persistence exists within private equity. Strong relative performance in previous funds increased the likelihood of a successful follow-on fund.
Since then, the private equity market has developed rapidly with increasing competition, larger funds and a wide range of investment strategies. At the same time, leverage became commonplace and identifying ‘undiscovered’ companies became increasingly challenging. To stand out as a fund manager with a unique approach and as a result with performance became more challenging. The question then is what impact these developments have had on previously observed persistence. Recent research estimates a significant effect where the persistence of Buyout funds fell sharply. Since the turn of the century, top performers have a 10% lower probability of achieving the same strong (relative) performance (see figure).
Persistence is an abstract concept where a one-dimensional approach (based on historical performance) may fall short. Like Plato’s Theory of Forms, while investors can understand the ‘form’ of persistence, they cannot properly grasp it in practice. To appreciate the predictive power of a track record, one would do well to examine other influential factors of this idea in practice. In other words, the discussion regarding persistence of results requires a (much) broader view.
Professional investors will rarely base allocation decisions solely on returns. If they did, any competitive advantage would be marginal due to the decline in persistency. In contrast, research on institutional investors concludes that some consistently achieve better performance than would be expected based on chance, while others consistently selected underperforming managers.
After all, with a well-known and relatively simple recipe, it does not matter much which cook prepares the dish. It is therefore unlikely that consistently selecting good or bad managers can be explained solely by analyzing a track record. This implies that future returns will also depend on other (more difficult to observe) factors. Some potential candidates and considerations are outlined on the next page.
- Deal dependence – fund returns are a result of individual transactions (after costs). Further analysis into the distribution of returns within the fund provides insight into the extent to which fund performance depends on outliers. For example, it seems limiting loss-making deals is a stronger driver of persistence than realizing one or several homeruns that drive fund returns.
- Qualitative factors – the lower measurability of these factors leads to an increased degree of subjectivity. For example, assessing aspects such as cohesion within a team, organizational stability or robustness of internal processes is more difficult to generalize. Nevertheless, qualitative factors do affect a fund’s risk-return profile and are an indispensable part of the due diligence process.
- Data availability – during the selection phase, investors do not have the final fund performance at their disposal because the bulk of recent investments have not yet been sold. As a result, the figures available at that time can differ significantly from final returns. Even if the final performance of private equity managers is persistent, this intermediate uncertainty limits the practical usefulness for the investment decision.
In conclusion, clinging to historical performance is unwise when selecting fund managers. Persistence is influenced by many factors and depends on changes in the market landscape. The immutable and perfect ‘form’ of persistency thus turns out to be a concept that is more difficult to implement in practice.
Bluemetric Insight | Any persistence of results cannot be properly estimated solely based on historical fund performance. One can more accurately identify a fund’s risk-return profile by understanding, for example, (i) the dispersion of underlying transactions and (ii) qualitative factors. In addition, the information content of recent fund performance at the time of due diligence is limited. Because much of the holdings are still unrealized, interim data is only marginally informative of final fund performance. Moreover, managers are aware of interim results at the time of their fundraising and can capitalize on this through, for example, optimistic valuation methodologies.
Investors should constantly refine their understanding of the ‘idea’ or ‘form’ of persistency and look for parameters that provide practical guidance. Concrete ways of implementing this include continuing to look for relevant factors and attempting to measure elements that are difficult to quantify.
Ultimately, predicting persistency is only one part of constructing a successful private equity portfolio. Determining intended results and risk profile of the investor are also important starting points in the search for a suitable private equity manager. For example, an investor must weigh the desire to select only top performers against additional risks that this might entail. Excluding the bottom performers is an alternative framework for portfolio construction.
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