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Using a comprehensive survey, we show that investors with a larger capital allocation to private equity are more specialized − measured by the degree to which the investor focuses on private equity rather than other classes of investments − and have a wider scope of due diligence and investment activities. Other investor characteristics (experience, type, location, compensation structure, number of funds under management) play no role. In particular, Endowments are not special according to the survey measures. These results are consistent with the changing LP-GP relationship in private equity as capital is increasingly concentrated in the hands of large investors.
We document the wide dispersion of private equity investment returns and examine performance determinants using a newly constructed database of 7,500 investments worldwide. One in ten investments does not return any money, whereas one in four has an IRR above 50%. Quick flips are associated with some of the highest returns. Performance does not appear scalable: Investments held by private equity firms in periods with a high number of simultaneous investments underperform substantially. Results are consistent with the theoretical literature on organizational diseconomies linked to firm structure. Private equity firms’ actions do not appear to be mechanical or easily scalable.
Target acquisitiveness stands out as one of the primary drivers of all the key aspects of the market for corporate takeovers: acquisition announcement returns, probability of deal success, propensity to acquire and be acquired. In addition, acquisitive targets, though a small proportion of the sample, are responsible for half of the overall negative announcement returns. Our results consistently support the view that the motivation behind acquisitions of acquisitive targets is defensive: acquirers ‘eat in order not to be eaten’.
Buyout funds increasingly sell their portfolio companies to other buyout funds. These secondary
buyouts (SBOs) underperform primary buyouts. Yet, only SBOs made late in the investment period
underperform, consistent with funds using SBOs to sometimes “go for broke”. After a fund invests
in late SBOs, investors appear to shun the follow-on fund. Differences in risk do not explain these
results. SBOs bought by specialized funds and those bought from a fund-raising seller perform
better. Some companies seem better suited to private equity ownership as we find persistence in
both returns and exit channels between successive buyout transactions.
This article shows that publicly available data on buyout fund returns are sufficient to replicate the recent findings derived from superior but proprietary datasets. The average buyout fund outperforms the S&P 500. However, this study shows that buyout funds mainly invest in small and value companies; and the average buyout fund return is similar to that of small-cap indices and that of the oldest small-cap passive mutual fund (“DFA micro-cap”). If the benchmark is changed to small and value indices, and is levered up, the average buyout fund underperforms by 3.1% p.a.
Private equity has traditionally been thought to provide diversification benefits. However, these benefits may be lower than anticipated as we find that private equity suffers from significant exposure to the same liquidity risk factor as public equity and other alternative asset classes. The unconditional liquidity risk premium is about 3% annually and, in a four factor model, the inclusion of this liquidity risk premium reduces alpha to zero. In addition, we provide evidence that the link between private equity returns and overall market liquidity occurs via a funding liquidity channel.
We develop a new methodology to estimate abnormal performance and risk exposure of non-traded assets from cash flows. Our methodology extends the standard internal rate of return approach to a dynamic setting. The small-sample properties are validated using a simulation study. We apply the method to a sample of 958 private equity funds. For venture capital funds, we find a high market beta and underperformance before and after fees. For buyout funds, we find a relatively low market beta and no evidence for outperformance. We find that self-reported net asset values significantly overstate fund values for mature and inactive funds.
Much of the historic controversy around private equity has focused on the relationship between private equity managers and the companies they control. Yet there is little evidence to support the notion that private equity managers, on average, harm the companies they control. Meanwhile, a different aspect of private equity has received too little attention: the relationship between private equity managers and their investors. The private equity market shows signs of the “price shrouding” that economists have described in consumer markets. This is counter-intuitive for anyone who automatically assumes that “sophisticated investors” write optimal contracts. It is also potentially troubling for regulators and policymakers, because they use the “sophisticated investor” assumption as a building block in the way they organise financial markets. We propose two explanations for why price shrouding may affect even “sophisticated investors” and suggest some remedies. Although this discussion is framed purely in terms of private equity, we believe it is relevant to other complex investments that are popular with “sophisticated investors”.
As an asset class, private equity has generally enjoyed very favorable coverage in the financial media. Academic studies indicate, however, that private equity’s performance is not as robust as the media suggest. In addition, investing in private equity carries unique risks.
This paper finds that venture capital funds that are expected to be backed by more skilled investors show no performance persistence but a significant flow-performance relationship. In contrast, funds that are expected to be backed by less skilled investors show performance predictability and have a non-significant flow-performance relationship. These results suggest that only skilled investors use all available information to adjust their capital allocation and, as a result, eliminate performance predictability as argued theoretically by Berk and Green (2004). Results also show that Kaplan and Schoar (2005) overstate the persistence in fund performance by not using an ex ante measure of the performance of earlier funds. Whether or not an ex ante measure is used, however, the persistence is largely due to unsophisticated investors. When investors are sophisticated, the performance of earlier funds, sequence and fund size do not help predict the performance of the focal fund.
This article describes compensation contracts in private equity. It shows that they may not align interest between the investors and fund managers as much as commonly thought. Certain clauses appear as potentially hazardous for investors and others exacerbate conflicts of interest.
The performance of private equity funds as reported by industry associations and previous research is overstated. A large part of performance is driven by inflated accounting valuation of ongoing investments and we find a bias toward better performing funds in the data. We find an average net-of-fees fund performance of 3% per year below that of the S&P 500. Adjusting for risk brings the underperformance to 6% per year. We estimate fees to be 6% per year. We discuss several misleading aspects of performance reporting and some side benefits as a first step toward an explanation.
As a step towards understanding whether a private equity governance structure reduces overall agency conflicts relative to a public equity governance structure (as is often argued), this paper describes the contracts between private equity funds and investors, and the returns earned by investors. The paper sets the stage with a puzzle: the average performance of private equity funds is above that of the Standard and Poor's 500 - the main public stock market index - before fees are charged, but below that benchmark after fees are charged. Why are the payments to private equity buyout funds so large? Why does the marginal investor invest in buyout funds? I explore one potential answer (and probably the most controversial): that some investors are fooled. I show that the fee contracts for these funds are opaque. Considering this and the way that compensation contracts bury, in details, costly provisions that are difficult to justify on the basis of proper incentive alignment, it would be premature to assert that the agency conflicts are lower in private equity than in public equity.
Most of the investments in asset classes such as real estate and private equity (include buyout, mezzanine and venture capital) are made via private partnerships. Measuring performance in these partnerships is important for investment allocation decision as well as for compensation. The main performance measure that is used in practice is the Internal Rate of Return (IRR). However, it is known that the effective Rate of Return (RoR) experienced by investors differs from IRR. This difference means that the incentives of the asset managers partly differ from the objective of the investors.
This article makes two main contributions to the literature on performance evaluation. First, it shows the problems that arise when IRR is used as a performance measure in the context of private partnership investments. It shows that in addition to the well-known pitfalls, IRR leads to a number of issues. First, it provides severely distorted incentives for the timing of cash flows and grouping of funds. Second, it biases upward volatility estimates. Third, at least for venture capital and buyout investments, simple average performance measures are significantly upward biased. Fourth, in a situation where "kick-backs" can happen, the use of IRR provides incentives to alter significantly cash flow amounts. The second contribution is that it describes in details a solution. While it is known that using Modified IRR (labeled MIRR), or, equivalently, Net Present Value, (labeled NPV) largely tackles the well-known pitfalls of IRR, its practical implementation in a private partnership context is not obvious. I show how MIRR can be implemented at the investment level and at the fund level in order to not only tackle the well-known pitfalls of IRR but also provide the right incentives to the fund managers.
Depuis quelques années, la croyance en une surperformance du capital-investissement est alimentée par les articles élogieux sur les rendements de cette classe d’actifs qui paraissent régulièrement dans la presse économique et financière. Les statistiques de mesure des performances publiées par Thomson Venture Economics, qui servent de standard dans la profession, suggèrent que, sur longue période, les performances du capital-investissement se comparent favorablement à celles des indices boursiers. En dépit de ce consensus apparent, le point de vue d’une surperformance du capitalinvestissement vis-à-vis d’un placement dans le coté est erroné. En utilisant les données les plus complètes sur le capital-investissement en Amérique du Nord et en Europe, nous montrons que les performances du capital-investissement ont été, en moyenne, inférieures de près de 3 % par an à celles des grands indices de marché.
The value premium is driven by 7 percent of the stock market. The 93 percent of market capitalization held most by institutional investors is value premium free. In contrast, in stocks held most by individual investors, the value premium, even when the stocks are value weighted, reaches a staggering 185 bps per month. In addition, the value premium is a long-side anomaly. It is a value premium puzzle, not a growth discount puzzle.
The article reports that calculating the performance of private equity funds with a modified internal rate of return (M-IRR) results in a more accurate performance yield or true return. The problem with the internal rate of return (IRR) method is that IRR overstates the fund's performance and misrepresents its relative ranking, which misleads investors about the reinvestment of cash proceeds and makes it difficult to compare fund managers. An example is given showing how M-IRR better represents the rate of return for private equity funds.
This paper shows that some of the most prominent risk-based theories offered as explanation for the value premium are at odds with data. The models proposed by Fama and French (1993), Lettau and Ludvingson (2001), Campbell and Vuolteenaho (2004), and Yogo (2006) can capture the cross-section of returns of portfolios sorted on book-to-market ratio and size, but not of portfolios sorted on book-to market ratio and institutional ownership. These models generate economically large pricing errors in all the institutional ownership quintiles and each statistical test indicates that these pricing errors are significant. More generally, these results show that a minor alteration of the test assets can lead to a dramatically different answer regarding the validity of a given asset pricing model.
This literature review covers the issues faced by private equity fund investors. It explores what has currently been established in the literature and what has yet to be investigated. In particular, it reveals the many important questions to be answered by future research. This literature survey shows that the average investor has obtained poor returns from investments in private equity funds, potentially because of excessive fees. Overall, investors need to gain familiarity with actual risk, past return, and specific features of private equity funds. Increased familiarity will improve the sustainability of this industry that plays such a central role in the economy.
Investors in private equity funds must get comfortable about the economics of the partnership. In today's market place, are managers being overcompensated, ask Oliver Gottschalg, Bernd Kreuter and Ludovic Phalippou.
Private equity plays an important role in the financing of the corporate sector. An important issue is the attractiveness of this asset class to investors. That is, how well have private equity funds performed for their investors?
The importance of private equity is undeniable, and the returns that are available to investors will in part determine its future success. Against this backdrop the Amsterdam Center for Corporate Finance (ACCF) has decided to devote this issue of its discussion series "Topics in Corporate Finance" to this important topic.
Ludovic Phalippou, an associate professor of the University of Amsterdam, is one of the key researchers in this area. His research, reflected in this booklet, raises some points of concern. In particular, he concludes that the average private equity fund performs below reasonable (i.e. risk-matching) benchmarks. Fees paid by investors are high even when performance is below these benchmarks. Moreover, the contracts between private equity firms and their investors do not align interests, i.e. induce potential conflicts of interest. Professor Phalippou proposes some carefully crafted general guidelines for regulation.
I cover the different methods to measure risk and return of investing into private equity (also called buyout). However, the reader may bear in mind that the challenges and methods are very similar for other assets classes such as venture capital, real estate or mezzanine. In terms of vocabulary, I call a (portfolio) company the entity receiving the financing from a private equity fund, and private equity firm the organization running private equity funds (e.g. KKR funds, Bain capital funds).
The capital committed to private equity funds increased from $3.5 billion in 1984 to over $300 billion in 2007 and more than $1 trillion of assets are estimated to be in the hand of private equity funds in 2007. This growth has often been attributed to a widespread belief of stellar performance and low risk but no rate of return has even been shown in support of this belief (only some multiples or IRRs) and no risk measure has been computed. Recent academic evidence which I document below is at odd with this belief.
In this chapter, I review studies of risk and return of private equity which I complement with original empirical work. I distinguish between four types of data. Each represents a different level of challenge for measuring risk and return. From the easiest to the most difficult: i) publicly traded vehicles, ii) round valuation data [the econometrician knows the initial and final value of the investment but does not know the time-series of investment values; there is no intermediary cash-flows], iii) investment level [cash flows realized by the fund from an investment], and iv) fund level [cash flows faced by investors for their stake in a fund]. In the last two cases, the econometrician does not have a correspondence between each amount distributed and invested. These two cases require the same method, are most challenging and are the most relevant in practice.
A less known fact about private equity is that General Partners (GPs) enter ‘service agreements’ specifying fee payments by companies whose boards they control. We describe these contracts and find that related fee payments sum up to $20 billion evenly distributed over twenty years, representing over 6% of the equity invested by GPs on behalf of their investors. Fees do not vary according to business cycles, company characteristics, or GP performance. Fees vary significantly across GPs and are persistent within GPs. Once these fees became public information GPs charging the least to companies raised significantly more capital. GPs that went public distinctively increased their fees. We discuss how results can be explained by optimal contracting versus tunneling theories.
Using a comprehensive survey, we show that investors with a larger capital allocation to private equity are more specialized and have a wider scope of due diligence and investment activities. Smaller investors tend to free ride on decisions made by larger investors. Other investor characteristics (experience, type, location, compensation structure, number of funds under management) play no role. These results are consistent with increasing returns to scale for due diligence, and with the savings generated by increased scale going into increasing scope rather than into cost reduction. Our findings provide an explanation for the observed outperformance of larger investors when it comes to investing in private equity.
We introduce a methodology to estimate the historical time series of returns to investment in private equity. The approach is quite general, requires only an unbalanced panel of cash contributions and distributions accruing to limited partners, and is robust to sparse data. We decompose private equity returns into a component due to traded factors and a time-varying private equity premium. We find strong cyclicality in the premium component that differs according to fund type. The time-series estimates allow us to directly test theories about private equity cyclicality, and we find evidence in favor of the Kaplan and Strömberg (2009) hypothesis that capital market segmentation helps to determine the private equity premium.
On December 13, 2013, two days after its IPO, Hilton hotels traded above $22 a share. This meant that the 2007 take-private transaction of Blackstone had produced the largest gain ever in private equity at about $10 billion. In addition, Hilton had become the largest hotel group in the world by number of rooms up from 4th position 6 years previously, when Blackstone bought the company. How can such success occur with a cyclical business during the worst financial crisis since 1929-1933? Somebody definitely deserves a big box of chocolates; but who? The answer is surprising and offers a detailed insight into the life-cycle of real estate private equity transactions.