PE fund performance is set early in its life – study

The ultimate performance of a fund is determined as early as its fifth year, according to a study of 700 PE vehicles by Pantheon Ventures.

The destiny of a private equity fund in terms of quartile performance rankings is set early in its life, according to a report by Pantheon Ventures.

By their fifth year, the top quartile of buyout funds in the study of 700 vehicles had less than 13 percent chance of performing below median by their end, and a 60 percent chance that they would remain in the top quartile.

By their third year, the bottom quartile funds had less than 27 percent chance of eventually performing above median.

The study – Private Equity Performance: Carried Interest and the Persistence of Quartile Rankings – described the incremental internal rate of return (IRR), or incremental performance, as the IRR achieved by a secondaries investor who entered a mature fund at par value and held its stakes until liquidation.

“It’s very surprising to me that the final quartile of buyout funds can be largely determined by the age of five years, even during the investment period of the funds, before the general partner has had time to really work with the assets and allow their investment theses to develop,” Pantheon vice-president Ian Roberts told Private Equity International.

Early factors that could come into play included the GP’s ability to source good deals, ability to negotiate low multiples as entry points and spotting deals where the fund can enable enhancement in a portfolio company via corporate governance, Roberts added.

“These values can be activated in a relatively short time, creating value rapidly,” he said.

The findings perhaps reiterate the importance of initial manager selection in the asset class, where there is a large dispersion between the best and worst performers.

The study also observed the impact of carried interest on the alignment of interests between a GP and an LP, particularly in terms of generating performance at the later stage of a fund. It found that carry was a motivational factor for GPs to continue generating value for LPs and the carry proceeds for themselves.

Pantheon found that the median incremental IRR of funds in-carry was higher than that of funds out-of-carry – meaning their carried interest threshold had not been crossed – for funds in seventh to 10th years. For example, those funds in-carry in their ninth year generated at least 3 percent to 7 percent per annum more in median incremental IRR than those funds out-of-carry, also in their ninth year.

“Whether or not that’s surprising is debatable, but it does seem to suggest that since carry is the opportunity to earn performance-related fees, it is a motivating mechanism that can spur general partners to improve,” Roberts said. “Once the fund is in carry, their incentives are aligned with their limited partners to create as much value as they can, to reach the highest incremental performance they can.”