Low-plains drifters

Private equity remains a relatively non-transparent industry, in part because extracting performance information from individual fund managers is difficult, and in part because the numbers that are available have only begun to be given the sophisticated scrutiny they deserve.

David Snow

Private equity is therefore full of anecdotal evidence for why things turn out a certain way. The anecdotes are full of incentives of all kinds, perverse and otherwise. Non-founding partners are more likely to quit if they don’t get a big enough piece of the action. GPs who keep deal fees for themselves are more likely to gouge portfolio companies. And firms that creep into new industry verticals tend to get walloped.

This last story has been observed many times: the consumer services firm that lost money in an internet startup; the logistics investors who got food poisoning from a restaurant chain; the value investors who drank the paradigm-shift Kool-Aid. Anecdotally, market participants are able to explain why it is that these GPs are tempted by strategy drift and why it is that they lose money. But there haven’t been any real numbers behind these assumptions until now.

Oliver Gottschalg, a professor at HEC Paris and founder of consulting firm Peracs, recently decided to stress-test the oft-told story that “focused” private equity firms tend to produce good returns and those that expand their focus tend to drift into the lower quartiles.

Gottschalg has found that firms that maintain an industry focus tend to outperform more-diversified firms by about 2 percent annually. Just as importantly, he has found that firms that strayed into new industries tend to underperform non-drifters by about 2.2 percent.

In conducting his study, Gottschalg first had to “score” more than 200 firms on a scale of 0 to 1 as to how diversified they were in their deal activity. Those firms that invested in a single industry over a five-year window received a 1; firms that stuck with exactly two industries over the period studied received a score of 0.5.

Gottschalg then had to determine to what extent each firm’s score had changed from one five-year window to the next (he studied three – 1991 to 1995, 1996 to 2000, 2001 to 2005). Many firms saw evolving industry mixes, but some changes were more pronounced than others. The study identified populations of GPs that had “drifted” by a standard deviation of two or more over the “average” drift. It then looked at investment performance directly following those years, measured as the average rise in value of the portfolio companies.

Confirming conventional wisdom, those firms that had been prodigious adders of targeted industries over the prior five years had a lower average performance over the subsequent years. And in a finding that will no doubt delight specialist firms, those GP groups that had diversity scores near 1 (in other words, no industry diversity) tended to be the best performers.

Overall, Gottschalg says his research confirms that “it’s really good if you’re focused. It’s harder to be unfocused, and if you recently became unfocused, that’s the most difficult.”

In reviewing the findings, it is important to note the difference between a firm with a long-term commitment to a set number of industries, and one that adds industries over the years. A firm that has always backed healthcare and information services investments and not deviated from that dual strategy will fare better, on average, than one that stuck to healthcare for years and then did a couple of one-offs in information services.

Which leads us back to the ongoing private equity plotline. While I haven’t seen any statistics on this trend, I can tell you that anecdotally, about 100 percent of buyout firms now say they are considering growth deals and low-leverage deals. Fair enough, but it should be noted that companies that produce returns by “growing” are not always the same companies that produce returns by consistently servicing debt loads. You may find these companies in roughly the same industry, but they will likely be from different corners in the industry. A firm that had success doing an LBO of a widget distributor in 2003 cannot claim full expertise in backing a widget iPhone application platform in 2010. And yet, because the game has changed so fundamentally through the Great Recession, many GPs are being tempted to put capital to work in whatever the market offers.

When the market shifts, beware of drift.