INVESTMENT

The Myth of Private Equity Performance: Part II


Internal Return (IRR) is not a scientific method for calculating performance. Far from it. Fund managers can manipulate their results, report inaccuracies, or create their results entirely, which makes them unreliable.

But a big question for potential investors is whether private fund managers have unique skills that can somehow provide certainty or, at the very least, predictability. A positive answer means that private equity (PE) fund managers have talent and do not rely on ruthlessness to deliver performance.

Myth II: Performance is predictable

Fund managers have long despised their reputable investment methods for wealth creation. Sadly, in my 12 years working as four separate fund managers, I have never encountered value-added growth strategies that practitioners often admire. In fact, three of my former employers, including Candover and GMT Communications, have stopped their activities in the wake of the Global Financial Crisis (GFC). (Before you make any guesses, these companies folded many years after my departure.)

So what explains the lack of forecasting in private equity performance? There are two main reasons. First, the sector is highly cyclical. This point is not surprising or controversial. By definition, PE professionals invest in all parts of the economy, and in most cases if all these industries do not face economic cycles. Therefore, PE investing, fundraising and portfolio realization are somewhat irregular activities.

Prediction requires perseverance.

But the second argument against predictability – the lack of perseverance in performance – is even more detrimental to the reputation of PE fund managers.

Potential investors may believe in access to limited partners or LP-top-level PE firms and the ability to ignore their underperforming partners. But the proverb, “Past performance is no guarantee of future results,” is as true for private capital as it is for the public equity market. The first-quarter PE performers differ from one wine to the next.

According to some researchers, persistence in PE may have existed in the 1990s, but the industry emerged in the late 1970s, and 20 years later most buyout firms raised only four to five vintages. The limited sample size has led many observers to make assumptions where there is none: Daniel Kahnmann and Amos Tavorsky, who have observed what is called “the law of small numbers” in Warren Buffett’s “Graham-and-Dodsville Superinvestors”, whether the results are the result of luck or skill. Coin toss in a series is not enough information to determine.

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Lack of perseverance in performance

Buffett is set to identify nine valuable investors who have lost their public stock benchmark year after year for decades. He concludes that these “super investors” help to undermine the academic view that markets are effective. The only talent for such extraordinary and concentrated success over time is explanation.

Unfortunately for potential LPs, if there is a superfund manager in private equity, there are a few. Recent studies have been consistent and unanimous on that front.

“Does perseverance continue in personal equity?” The authors report that performance in the buyout trade has shown less perseverance since 2000. In “How Percent Is Private Equity Performance” Rainer Brown, Tim Jenkinson and Ingo Staff, CFA, examined cash flow data in 13,523 portfolio companies by 865 buyout funds and also found little evidence of perseverance.

The analysis at McKinsey has reached the same conclusion, albeit with different numbers: the consistency of PE returns has declined over the last 20 years. Between 1995 and 1999, one-third of the funds were in the same quarter as their predecessors. Between 2010 and 2013, it dropped to 22%. “Visibility is declining,” observes Art Bushanville, founder and CEO of DSC Quantitative Group. “Now it’s almost random. You cannot look to previous funds for formulas.

In a random distribution of funds managers, 25% of the ingredients in each quarter should return one wine after another in the same quarter. Yet, in the real world, ratios are much lower. Antonet Schwartz data showed a deterioration in PE performance stability over time:


PE Performance: Top-quarter strength

1995-1999 31%
2000-2004 28%
2005-2009 13%
2010-2013 12%

Perseverance in underperformance

“Is there persistence in private equity?” An interesting side note of this: Researchers have found the absence of perseverance since 2000. Without funding at the lower end of the performance distribution. ”(Emphasis added)

The vintages of the fund show this in the years leading up to the GFC. There was little or no incentive for excessive performance among the leading PE groups, but specific funds consistently worked less from one wine to the next.


Quadrangle performance by Vintage

Apollo (Global) 2006 Third 200 Top
Blackstone (Global) 2003 Top 2006 Third
Bridgepoint (Europe) 2005 Below 200 Third
CVC (Europe) 2005 Top 2007 Below
KKR (Europe) 2005 Below 200 Third
Providence (America / Europe) 2005 Below 2007 Below
TPG (Global) 2006 Below 200 Third
Welsh Carson (America / Europe) 2005 Third 200 The second

Sources: Preqin, CalPERS, CalSTRS, Oregon PERF, WSIB, Sebastien Canderle Analysis


This stubbornly poor performance of many of these funds helps explain why their existing institutional investors decided not to participate in the subsequent fundraising.

For example, CalPERS KKR did not commit to European Fund IV (2015), Providence Equity Partner VII (2012), or TPG Partner VII (2015), although it did invest in the previous two funds of the three firms. Its California counterpart CalSTRS pulled out of Providence’s 2012 fund and TPG’s 2015 fund after investing in their previous two vehicles.

Sometimes investors give fund managers the benefit of the doubt: Oregon Public Employees Retirement Fund avoids KKR Europe’s 2015 vintage despite investing in previous funds, but capitalized on Providence’s 2012 fund with 5% and 3% returns from the previous two cars.

In other cases, time heals investors ’wounds the most and they return to a firm’s offers after dropping an alcohol or two. Callus, for example, promised TPG’s eighth fund after becoming its predecessor.

Laclaster PE fund managers can often raise funds by providing incentives to potential investors. KKR, for example, grants a barrier rate, or desired return to its 2015 vintage to attract punters. The company did not fund it for 2005 and 2008, which generated IRRs of 4% (or more than 1.2x) and 10% (1.4x), respectively.

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There are three reasons for the lack of perseverance

Although extensive research easily dispels the myth of predicting PE performance, it does not explain why perseverance is so hard to find.

There are several reasons for this at work:

  1. North American and European markets are additional intermediaries. Most transactions are done through auctions and all PE firms have access to the same contract flow. Many mid-market corporations have gained experience in leverage-buyout (LBO) transactions. In 2017, private equity supported about a quarter of medium and 11% large U.S. companies.
  2. PE firms also face a very mature credit market that provides dealers with the same debt package. Most transactions use Stapled Financing, Covent-Lite Structures, Correction and Extension Procedures, Equity Healing, Syndication, and EBITDA Advocates as standard tools.
  3. Over the past two decades, personal equity has become product-based. Thanks to rich fees and low barriers to entry, the number of PE firms worldwide has doubled in the past decade – more than 5,000. There is no real difference between most fund managers. They all hire the same kind of executives, mostly financiers প্র ex-bankers, ex-consultants with a master’s degree in economics or business administration, CPA and the like. So they end up with similar powers.

This last point may be the most important reason behind the lack of perseverance. In highly unpredictable environments such as finance and investment, experience often builds confidence in trained specialists. But it’s not sharpening skills. In order to achieve optimal results in such a rapidly changing context, extensive experience and diverse backgrounds are required among the staff. Yet marketers, entrepreneurs, operators, corporate executives, or people managers are a rare profile of most PE firms.

The economic environment is evolving rapidly and continuously. The dot-com boom and bust, the subprime mortgage bubble, the GFC, the era of quantitative easing, the unicorn and big tech bubble, and the ongoing Covid-1 – -induced recession িত্ব all represent very different market conditions. And the acceleration of technical disruptions increases uncertainty. So multidimensional and protein skills are needed across an investment organization.

David Epstein writes, “The ability to apply knowledge extensively comes from extensive training Range. “Relying on experience from a single domain is not just limited, it can be devastating.”

A narrow skill set among PE professionals will not accommodate them. Their financial skills may work wonders in a simple money recovery driven by cheap debt like 2014-2019, but their broad skills may be lacking in an environment like the current recession where effective or restructuring talent is needed. Officials who do well in bullfighting can do bad things in a recession.

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Fund managers insist they cannot disclose the method of creating their values. Otherwise competitors may replicate them. But the lack of diversity in the profile of PE practitioners creates a closed mindset that academic studies suggest may help explain their inability to deliver predictable, consistently positive results.

Some may conclude that the lack of perseverance in PE performance, or the inconsistent distribution of top-quarter results by fund managers, suggests that the private market is somewhat efficient.

But another explanation is more likely. Due to their weak risk / return management strategies, PE executives, unlike most sophisticated arbitrators operating in the public market, have yet to develop a systematic way to exploit market inefficiency.

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All posts are the author’s opinion. As such, they should not be construed as investment advice, or the opinions expressed do not necessarily reflect the views of the CFA Institute or the author’s employer.

Photo Credit: © Getty Images / Leopatry

Sebastian Candarel

Sebastian Candarel is a private equity and venture capital advisor. He has worked as an investment executive for multiple fund managers. He is the author of several books including N trap And Good, bad and ugly personal equity. Candarel also lectures on alternative investments in business schools. He is a Fellow of the Institute of Chartered Accountants in England and Wales and holds an MBA from The Wharton School.



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