Private equity has historically been among the most fragmented and secretive of asset classes. Fragmented, with well over 1,000 significant firms competing worldwide. Secretive, with no reliable published information disclosing the performance of these firms and funds. As such, it has stood apart from other asset classes, with investors facing a trade-off between the attraction of potentially high, uncorrelated returns, balanced by the drawbacks of the variance of such returns and the absence of the transparent, comparable data that is increasingly needed for effective governance.
Things are now changing rapidly. After a tremendous influx of new firms in the late 1990s the industry is clearly consolidating, with mergers and takeovers of private equity firms expected to become more commonplace. The trend towards greater transparency has also gathered pace, to the point where it is now arguably unstoppable. CalPERS set the ball rolling three years ago when it posted the returns of the funds in its private equity portfolio on its website. The listing was hastily withdrawn following objections from some of the GPs involved, but the baton was picked up by ourselves and others in the belief that there is a market for transparent performance information.
Since then GPs have become reconciled to the inevitability and desirability of transparency in the industry. Last month saw the publication of the first edition of the Private Equity Performance Monitor, a reference guide that discloses performance information for 1,722 funds managed by 522 firms worldwide. The Monitor is significant not only because of the sheer volume of data contained and the insights that it reveals, but also because of the support it has won from the industry. Twelve months ago Private Equity Intelligence’s database held information on 1,083 funds, all of it gathered from Freedom of Information Act requests in the US, much of it in the face of opposition from pension plans and GPs. Today the Monitor carries information on 1,722 funds, much of it contributed voluntarily by the GPs themselves. Already in the few weeks since publication we have had enquiries from GPs who are not in this year’s Monitor asking how they can be included in 2005.
Transparency is all well and good, but isn’t there a danger that greater disclosure might be driven more by its ‘political correctness’, rather than by real benefits to investors and GPs? Surely the acid test should be whether or not greater disclosure and transparency can help investors make better decisions, and thereby help the industry to prosper and grow?
The Monitor set out to answer these questions by comparing the performance of private equity investments. Some methodological notes are relevant:
- Scope: all comparisons relate to the performance of investment vehicles such as funds or investment companies. The analysis did not go down to the next level, that of the individual portfolio company. There are two reasons for this: a) LPs generally make investment commitments to the fund rather than individual portfolio companies (excluding co-investments for the time being); and b) disclosure of detailed financial information for individual portfolio investments could clearly result in commercial damage to those companies, which is not the case at the fund level.
- LP perspective: all comparisons have been made at the net level for the LP. All contributions, distributions, value multiples and IRRs are calculated after management fees and carry.
- Comparability: individual fund performances were compared against the most relevant benchmarks in each case. Wherever possible this means a vintage, geographic and fund type benchmark – e.g. 1995 European buyout funds. In some cases, however, there simply are not enough funds to make meaningful comparisons of this type – e.g. there simply aren’t that many 1990 European mezzanine funds. In these cases we compared against a more general private equity benchmark for vintage year and geography.
- Pre-2002: the ultimate performance of a private equity fund can only be determined when it is finally liquidated. However, investors and GPs alike need to make estimates of interim performance. Our analysis therefore assessed the performance of funds from vintage years 2001 and before, but did not assess performance of 2002 or newer funds. Such funds are at a too early stage in their life to be able to calculate meaningful performance measures.
- Quartile allocation: each fund was allocated a quartile ranking relative to its benchmark, based upon a combination of IRR and Fund Value, with equal weight put on each. Quartile allocation was mathematically determined, with no qualitative assessments applied.
- Listed companies too: the predominant investment vehicle available to investors in private equity is the limited partnership. However, there is also a significant number of listed vehicles – companies like 3i, Candover, Deutsche Beteiligungs and GIMV, to name but four. We analysed 53 such companies, and applied the same methodology as that used for limited partnerships: cash in, cash out and unrealised value resulting in an IRR. Whilst this methodology may not be the preferred one for listed vehicles in absolute terms, it is the most appropriate if one wishes to make comparisons between companies and limited partnerships.
So, what were the results? Overwhelming evidence that historical performance is a good guide to likely future performance in private equity. Furthermore, superior performance tends to persist from one fund to the next in private equity, to a greater extent than in other asset classes.
Many new firms have entered the private equity market over recent years. How well have they fared? The chart below shows that recent entrants have generally fared less well than more experienced firms. Naturally, there are newcomers who have done very well, but on average firms on their first fund tend to do a full quartile worse than firms on their sixth or later fund.
How good was their last fund?
If the firm’s last fund was in the first quartile, then the probability of their next fund being first or second quartile is nearly 70% – odds that most of us would be happy to take. Conversely, if the last fund was fourth quartile then the odds of the next one performing well are only 34%.
Sustained good performance
Many private equity firms succeed in sustaining above-average performance over the course of several funds – significantly more of them than could be accounted for simply by good fortune. We analysed firms who had managed three or more funds, and looked at the percentage of them whose funds on average made the first or second quartile. In other asset classes, the chances of maintaining this level of performance would decline the more funds you had – i.e. performance over a long period would tend to regress to the mean. Not so in private equity: fully 50% of firms with six or more funds manage on average to be first or second quartile – performance that would meet most investors’ objectives.
These are powerful conclusions: good sustained performance is possible in private equity, and past success is a good guide to future performance. The 2004 Private Equity Performance Monitor summarises the objective track record of 522 private equity firms, and identifies a group of 60 firms from around the world and across different fund types that have managed to deliver such sustained good performance.
The implications at a broader level are also clear: greater transparency is here to stay. It will be tremendously beneficial to the industry. Improved information will help investors to make improved decisions and to monitor their portfolios better. By doing this, it will help to unlock potential increases in allocations to the asset class. The best private equity firms will gain from a new ‘Gold Standard’ in performance monitoring.
To order your copy of the complete Private Equity Performance Monitor please call the order hotline on +44 (0)20 7906 1188 or click here.