Persistence in PE: Looking to Past Performance to Predict Future Success

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A recently published research paper presents new evidence on the persistence of US private equity (PE) funds by examining cash-flow data from a large sample of institutional investors.

“There’s been the view that you want to get into the top performing funds because they are going to continue to be top performers,” explained co-author Steven Neil Kaplan, Neubauer Family Distinguished Service Professor of Entrepreneurship and Finance at the University of Chicago Booth School of Business and Kessenich E.P. Faculty Director of the Polsky Center for Entrepreneurship and Innovation.

The research challenges this industry rule of thumb to invest only in funds that previously were in the top quartile. “On the buyout side, the bad news is it’s very hard to find persistence when the fund is fundraising,” said Kaplan. “The positive news is that the returns have been quite good on average.”

For funds raised from 2001 to 2015, the average public market equivalent (PME) for buyout funds has been 1.15 – over the life of the fund the average fund outperformed the S&P 500 by more than 15%. This works out to more than 3% outperformance per year. “In fact, the average fund has equaled or beaten the S&P 500 pretty much every vintage year over that period,” explained Kaplan.

To the extent that buyout investors should look to past performance as an indicator of success, the research suggests focusing on previous fund PME, rather than previous fund quartile. Buyout investors also should avoid bottom quartile performers.

Conversely, the research did find persistence in venture capital, said Kaplan, so the conventional wisdom here holds true. “Venture is unusual,” he noted. Per the research, a VC fund whose previous fund was in the top quartile at fundraising did outperform funds whose previous funds were not in the top quartile.

So, while this strategy may work in venture capital, it doesn’t hold true for buyouts. As to why this is the case, Kaplan suggested that in buyouts the seller is often going to be looking simply for the highest bidder. This compares to a VC deal in which the seller still owns the majority of their company and, as such, has an incentive to choose the investor who can create the most value.

A VC firm with a reputation for creating value has an advantage in this scenario where the seller might take a lower valuation in order to work with a high performing firm.