The PE Performance Puzzle

Professor Chris Higson, Professor of Accounting at London Business School spoke at a seminar facilitated by the Coller Institute of Private Equity at City Week – the UK International Financial Services Forum.

Professor Higson’s speech addressed the puzzle relating to private equity performance. This speech was a follow up to his introduction in Issue 2 of Private Equity Findings to the article “The Point of No Return” which attempted to demystify whether private equity offers the outperformance necessary to compensate investors for illiquidity and risk. You can find a copy of the presentation and other research mentioned in this blog in our research library.

The issue of performance has become a question not only for investors but for broader society. While society is interested in whether private equity investors make businesses more valuable, in other words the gross returns to private equity, investors are interested in the net returns and how much of the return general partners (GPs) capture.

Chris Higson firstly summarised the various academic studies on the topic which looked at returns from buyouts from 1980 through to the early 2000s. Steve Kaplan, University of Chicago Booth School of Business and Antoinette Schoar, MIT Sloan School of Management obtained a large sample of US buyout funds using a Venture Economics database and assessed that average returns net of fees are roughly equal to the S&P 500. Ludovic Phalippou, University of Amsterdam and Oliver Gottschalg, HEC Paris, used a sample of global buyout funds, again obtained through Venture Economics. Their research showed returns are 3% below the S&P 500 and 6% below when adjusted for risk. Alexander Ljungqvist and Matthew Richardson, both from the NYU Stern School of Business, obtained timed cash flow data from a single limited partner (LP) and calculated returns to be an excess of 5 – 8% over the S&P 500.

Professor Higson pointed to the wide variation in performance between buyout funds, specifically noting that, based on BVCA figures, half of funds pay no carry and 10% of funds actually lose 50% of their capital. However, the top performers consistently do well and evidence suggests there is some persistence in top performing funds.

The measurement of private equity performance is difficult because there is no active market, unlike the market for quoted corporate acquisitions for which data is easily available. Furthermore, considering the way buyout funds are structured, it can take 10 years or more to wait for funds to exit their portfolio investments and pay out cash. To take the academic research mentioned above as examples, Ljungqvist and Richardson used data from a single LP, raising the question of selection bias where the other studies used data from Venture Economics which includes data on unrealised investments. Also, what is the appropriate benchmark? Chris Higson pointed to the S&P 500 as the default comparator but adjustments are required for illiquidity and leverage risk inherent in the private equity asset class.

So what is the research telling us? Chris Higson commented that despite the difficulties in performance measurement, the results are not inconclusive. Though we have to see research on private equity performance as work in progress, the evidence so far suggests an economy where private equity generates gross returns in excess of the market return but adjusted for fees, limited partners get at best a market return. GPs take most of the pie.

This begs the question – why do LPs continue to invest in the asset class when average returns are at best at market? If the top quartile funds consistently outperform then the remainder must be underperforming. The obvious answer is to invest only in the top quartile funds. However, this club is not easy to join. Chris Higson commented that the answer to this question continues to be a puzzle.

Professor Higson pointed to the 2 and 20 performance model and if GPs capture most of the economic rents through this model, the focus should be on performance attribution – what value the GP actually adds. Chris mentioned a recent study by Eli Talmor, London Business School, Florin Vasvari, London Business School and Oliver Gottschalg on this very topic. This research was able to access fund level cash flow data, net of fees for a single LP and attempted to quantify the outperformance of these funds compared with a public market equivalent (ie an ‘alpha’). In the sample analysed, buyout funds’ alpha was 4.47%. Leverage was the single highest contributor to returns, adding 7.71% to the return of the average buyout fund. LPs will look for their GPs to generate the highest possible alpha for them to justify their fees.

Looking to the future, Professor Higson believes there are two main drivers for PE continuing to maintain sustainable competitive advantage – better governance and possession of a powerful cluster of human capital with great intellectual capacity and strong networks. LPs will become more discriminating in respect of in which funds to invest and also will become more demanding. The industry will become smaller with the strong GPs surviving and thriving and the poor GPs falling away.