While all institutional investors strive to predict and select top quartile private equity funds, there is a significant cost of missing out on these funds.
According to various research studies, the difference between being invested in a top quartile and bottom quartile private equity fund has a significant impact on fund returns, reported at as much as 16.9 percentage points on IRR in one study.
What’s more is that achieving top quartile returns is crucial for investors’ private equity portfolios to justify their place as a return enhancer relative to other asset classes. In research from Vanguard using data from 1980 through 2012, only those funds in the top quartile have produced returns clearly over and above those of public markets when a three percent illiquidity premium is applied to the index (Figure 1).
Figure 1. Leveraged Buyout Returns vs. Public Markets, 1 January 1980 through 31 December 2012.
Source: The Allure of the Outlier, Vanguard, 2015
Annualised total return from 1 January 1980 through 31 December 2012, as represented by Dow Jones US Total Equity Market Index (formerly known as the Dow Jones Wilshire 5000 Index) through 22 April 2005; MSCI US Broad Market Index through 31 December 2012.
The Myths of Gaining Top Quartile Returns
Preferential access to brand name managers is often cited as a common driver in private equity portfolio returns. Investors that have missed out on debut funds, or investors with smaller allocations, often perceive that they are unable to get into these funds and thus capture those returns. However, research published in 2016 by Daniel Cavagnaro, Berk Senoy, Yingdi Wang and Michael Weisbach, has busted those myths.
Cavagnaro et al. analyzed a data sample of over 12,000 fund investments made by 630 limited partners (LPs), looking at the distribution of the returns. Their findings suggest that an investor’s skill level in fund selection is a more important driver of their returns than luck or access to managers.
An increase of “one standard deviation in skill” leads to a three percentage point increase in annual IRRs, according to the findings.
Simply put, the ability to boost private equity portfolio returns is in the LP’s hands.
Six Components to Enhancing Private Equity Fund Selection
With this finding in mind, eVestment has compiled research, analysis and insights from the institutional investment community in a new whitepaper: Enhancing Private Equity Manager Selection with Deeper Data. The paper provides valuable information on some of the key factors contributing to a truly skillful private equity manager selection process, including:
- Understanding the correlation between reported NAVs and final returns.
- The key metrics to use to predict performance.
- Verifying and standardizing GP performance numbers.
- Key value creation analysis approaches.
- Identifying alpha through public market equivalent analysis.
- Effective assessment of a manager’s team.