The private equity industry has grown tremendously over the past decade. While less than $10 billion was committed to private equity partnerships in 1991, more than $150 billion was committed in 2000. However, unlike the heavily researched mutual fund industry, there are many unknowns about how private equity funds work. A recent study provides some answers.
Private equity is an asset class composed primarily of venture
capital (VC) funds and leveraged buyout (LBO) funds. Venture
capital funds invest in start-ups and early stage deals. Leveraged
buyout funds invest in buyouts, usually of mature companies.
One of the main obstacles to studying private equity has
been the lack of available data. Private equity firms are
largely exempt from the disclosure requirements governing
investments in public companies.
Using newly available data on individual fund returns, University
of Chicago Graduate School of Business professor Steven N.
Kaplan and Antoinette Schoar of MIT's Sloan School of Management
analyze the fundamentals of private equity partnerships in
the recent study "Private Equity Performance: Returns,
Persistence, and Capital Flows."
The study addresses three main questions:
1) What are the average returns on private equity funds,
and do these returns beat the market?
2) Is there "persistence" in private equity returns,
i.e. a relationship between a fund's past performance and
its future performance?
3) How does performance affect fund survival and future capital
These questions have already been answered for other asset
classes, particularly mutual funds. In contrast to private
equity, mutual funds hold public equities and information
about mutual fund performance is readily available. It has
been well documented that the net returns of mutual funds,
on average, do not beat the overall market. There is also
very little evidence of persistence in mutual fund performance.
In those cases where persistence has been detected, mutual
funds tend to underperform rather than outperform the market.
Kaplan and Schoar find that (net of fees) the average returns
on private equity funds for the sample period 1980 to 2001
approximately equaled those of the market. For this study,
the market is represented by the Standard and Poor's (S&P)
500. Before deducting fees, returns for both types of private
equity partnerships exceeded those of the S&P 500, with
venture capital funds performing slightly better than leveraged
While Kaplan and Schoar find that average returns are approximately
equal to the overall market, they also find that some funds
consistently outperform the market.
"Our key finding is that there is a great deal of persistence
in private equity performance," says Kaplan. "This
persistence suggests that well-managed private equity partnerships
exist. If you invest in a partnership that has done well in
the past, the odds are it will do well in the future."
In regard to fund survival and future capital raising, the
authors find evidence of a boom and bust cycle where capital
appears to chase returns. When the private equity industry
does well in general, money flows into the industry, and many
new funds enter the market. Returns then decline and the cycle
Private Equity Investing
Individual private equity funds are limited partnerships
involving two groups of people: 1) managers of the private
equity firm, who serve as "general partners;" and
2) investors, who serve as "limited partners," usually
consisting of institutions and wealthy individuals who provide
the bulk of capital.
When limited partners commit to providing capital, general
partners are able to create a fund. The general partners then
have an agreed time period in which to invest the committed
capital - usually 5 years. General partners also have an agreed
time period in which to return capital to the investors -
usually 12 years or so.
The general partners' compensation is an annual management
fee (typically 1.5 to 2.5 percent of the capital committed
to the fund), and a share of the fund's profits (typically
20 percent). Each fund is essentially a closed-end fund with
a life of 12 years.
When general partners exhaust a substantial portion of the
fund's committed capital, they typically try to get commitments
for more capital to start a subsequent and separate fund.
The second fund is usually started 3 to 5 years after the
What is different about private equity investing?
First, there are potential entry barriers for new funds.
Unlike mutual fund investors, private equity investors can
have proprietary access to particular transactions. Better
funds may have access to better information, and thus obtain
Second, private equity investors are typically much more
active than the average investor. They may, for example, serve
on the boards of companies in which they invest.
Third, private equity funds may have fewer "economies
of scale." Unlike mutual funds, it is difficult to double
the amount of money invested in a particular company.
Capitalizing on New Data
Kaplan and Schoar use data from Venture Economics, an organization
that creates benchmarks for venture capital funds and leveraged
buyout funds. Venture Economics collects quarterly information
on individual funds through the voluntary reporting of private
equity firms and their limited partners.
The study's final sample consisted of 580 venture capital
funds and 166 leveraged buyout funds that were liquidated
or had minimal residual value, were started prior to 1997,
and were worth at least $5 million in 1990. Because they are
largely liquidated, performance for these funds is likely
to be measured correctly and unlikely to be manipulated by
the general partners. The authors studied the cash flows of
each fund to determine fund returns, and compared those returns
to the S&P 500.
The authors used several measures of fund performance, net
of management fees and carried interest. Their analysis included
internal rates of return calculated by Venture Economics,
and calculated again by the authors using the fund's cash
flows. Their primary focus was on a measure entitled the "Public
Market Equivalent" (PME), calculated by the authors in
relation to the S&P 500.
The Public Market Equivalent reflects the return to private
equity investing relative to the alternative of investing
exclusively in public equities. A PME of greater than one
indicates that a fund's returns beat the S&P 500.
For all funds in the sample, the average Public Market Equivalent
is 0.96, implying a net performance roughly equal to the S&P
500. This calculation also implies that gross performance,
before fees, exceeds the S&P 500. While average performance
is close to that of the overall market, there are large variations
in realized returns across time and across funds.
A private equity fund's performance is closely related to
the performance of the previous two funds operated by the
same limited partnership. General partners whose funds outperform
the industry in one fund are likely to outperform the industry
in the next. Similarly, general partners whose funds underperform
the industry are likely to repeat this performance as well.
In addition, a fund's past performance serves as an indicator
of future capital flows and fund size.
The relationship between capital flows and past performance
differs for the mutual fund and private equity industries.
In the mutual fund industry, funds that outperform the market
tend to receive substantially more capital. Mutual funds with
above-average performance therefore tend to increase their
share of the overall mutual fund market. In private equity,
however, the better performing funds voluntarily grow more
slowly than the overall private equity market.
There are several reasons why a successful fund might choose
to stay small. A private equity investor cannot easily increase
investments by putting more money in any particular deal or
investing in more companies, because he or she provides other
less tangible inputs, such as time and advice. It may also
be difficult for a successful fund to hire additional partners
who are as skilled as the existing partners. Finally, top
general partners may choose to raise less capital than they
could because the number of good deals in the economy is limited
at each point in time.
Which funds are started in boom times? After periods of above
average returns, the authors find that a large number of new
funds enter the industry. Funds that are started during boom
times are less likely to develop a subsequent fund.
First-time funds tend to have below-average returns. Overall,
industry returns are lower after periods of increased market
entry by new partnerships. The authors suggest this effect
is driven mostly by the poor performance of new funds.
A Good Time to Invest?
"If history is any guide, many of the new private equity
partnerships formed in the last several years will disappear,"
The results suggest that private equity returns from recent
funds will continue to be poor, but the "good" general
partners, and particularly those whose funds did not grow
too much, will still outperform the benchmarks.
From 2002 to 2003, Kaplan notes that buyouts were in the
middle of the boom and bust cycle, while venture capital remained
in the bust cycle. If historical patterns hold, 2004 to 2005
is a good time for general partners to raise and invest in
venture capital funds, and for limited partners to commit
capital to modest size funds.