The question of whether track record is a reliable indicator of future returns is a question as old as the asset management industry itself. If all it takes to make money is backing last season’s winning horses, anyone can succeed. If only it were that simple.
Studies on private equity managers’ ability to repeat their performance began in earnest in the mid-2000s with MIT and University of Chicago economists Antoinette Schoar and Steve Kaplan, who showed that “returns persist strongly across funds raised by individual private equity partnerships.”
A recent analysis by Pantheon further contributes to this age-old debate. Taking a vast sample of funds stretching back from 1985 to 2012 (no more recent vintages, since younger funds are still in their value-gestation phase), the research shows compelling evidence of GPs’ repeatability.
If a fund manager’s fortunes were random, then there would be a one-in-four probability that their latest fund would land in the same quartile as its predecessor, since there are four quartiles. Pantheon demonstrates that, for both buyout and VC funds, there is a higher than “chance” likelihood of successor funds achieving the same quartile as their predecessor. The correlation is stronger for the first and fourth quartiles, there being a greater than one-in-three (just above 35%) probability that a top performer will persist. The data show that elite fund managers are more likely to maintain their performance, as are private equity’s laggards.
Understanding performance persistence has important implications and applications for the secondary market. Bulk buying a portfolio of secondaries is essentially an index play, risk spread wide enough across sectors, geographies, and vintages that lenders are willing to advance leverage on such diversified deals. Due diligence and risk analysis are, of course, necessary. However, the larger the trade, the less relevant track record becomes with price taking precedent. Conversely, for single-stake transactions, track record is far more critical.
Combined with scrutinizing the quality of underlying portfolio companies in a given for-sale fund, knowing that a GP who has delivered in the past is likely to repeat that success can provide a vital steer for secondary buyers and provides them confidence in their bids.
The reality is, however, that LPs must triangulate a number of data and softer indicators at their disposal — a fact that Pantheon rightly highlights. These include everything from whether a GP firm has an intelligent and relevant investment strategy, a carefully managed succession plan, a healthy and competitive yet cohesive deal team culture, a deep bench of talent, strongly aligned incentives, genuine value-creation capabilities, and well-embedded institutional values, to name a few clues to a GP’s ability to sustain their performance. But the first clue is a GP’s track record.
...Or is it?
Persistence in decline
This latest research shows that the persistence effect has itself persisted over time but is weakening. Looking at pre- and post-2000 vintages, top-quartile buyout managers had a 41% chance of staying in the upper league versus a 36% chance since the turn of the millennium, and this may be understating the issue. Schoar has recently shed new light on how this phenomenon has developed since her first paper was published 15 years ago. Her latest findings show that persistence may be a thing of the past. There is no sign of any paper, but data shared with industry media indicate that, across quartiles, performance repeatability between 2010 and 2013 is unlikely (22%).
Worse still, just over one in ten (12%) top performers maintained that first-quartile ranking for their next fund over the same time period. More recently, in other words, earlier strong performance has become an inverse indicator of sustaining that top-quartile position.
This, Schoar believes, is a function of capital accumulating with what were historically the best performers. When fund sizes increase, their returns fall, and this is against a backdrop of PE’s assets under management billowing in the last decade. Private equity’s elite have become victims of their own success.
If PE performance is less correlative than it once was, what does this mean in a secondary market context? In our Secondary Pricing Report Q4 2019, published last month, we show that the average age of funds sold over the last six months has lengthened from 6.8 years to 7.4 years.
This puts the average fund just within the value-gestation phase identified by Pantheon, vintages that were omitted in order not to bias the data, but just within Schoar’s latest sample, which has more granular time-frame segmentation. These more recent and granular samples then suggests that funds that are trading in the secondary market today may show no positive performance correlation with their predecessors — thus making the job of the secondary buyer all the more challenging. Thorough bottom-up analyses of portfolio company exit potential and identifying GPs’ alpha-generating abilities have, therefore, never been more critical.