Changing the equation

Many limited partners evaluate private equity fund managers based on the internal rate of return of past funds, comparing them with funds of similar strategies, geographies or vintages. “But this level of due diligence is an extremely blunt instrument”, a recent white paper from Landmark Partners argues, noting that many LPs fail to take into account whether a fund has outperformed in relation to peers with similar industry concentrations and leverage levels.

“As a result, some investors think they’re committing to an ‘outperforming manager’ and buying alpha – but often they’re really making a levered beta bet on some industry, possibly investing in a negative alpha-generating manager who just happened to produce a higher, beta-driven IRR than a positive alpha-generating manager operating in a different market or industry.”

A fund is considered to produce “alpha” if its returns exceeded its risk and the investment outperformed benchmarks, while “beta” refers to performance relative to the broader market. Many industry critics, and some industry insiders, have alleged the majority of private equity funds are merely leveraged beta.

Landmark’s paper notes that the private equity asset class taken in aggregate and net fees and carry “does not have any appreciable amount of alpha” but acknowledges studies showing some managers are able to produce alpha and certain LPs, particularly endowments and foundations, are more skilled than others in selecting them. “Alpha is an elusive prey – it grows and shrinks, moves between markets and regions – and some limited partners appear to be more adept alpha hunters than others.”

Indeed, a recent study conducted by Paris’ HEC School of Management and London Business School – based on anonymous fund data provided by fund of funds Pantheon Ventures – found that net fees and carry, a unique alpha component contributed to 4.47 percent of a fund’s internal rate of return, representing roughly 23 percent of a buyout fund’s total return.

Academics independently examined 20 fully or mostly realised European funds whose vintage years were pre-2001 and studied their 455 underlying portfolio companies in great detail. Net of fees and carry, the funds’ performance was evaluated in relation to four factors: public market comparables, the differential of specific industry sectors, the effect of leverage and “residual intrinsic value generation”, or alpha.

The research “demonstrates very clearly that for a typical sample of a large and experienced investor … [buyout] funds generate real outperformance – and that outperformance is not attributable to just leverage and market riding,” says Oliver Gottschalg, a associate professor at HEC Paris and one of the study’s lead researchers.

The data highlights that institutional investors must understand exactly where and how managers create value, says Helen Steers, head of Pantheon’s European primary investment team. “In recent cycles a lot of people have benefitted from the rising-tide-lifting-all-boats-type syndrome,” she says. “My personal belief is we’re going to see much greater dispersion of returns going forward.”

Limited partners should feel heartened that good private equity managers do indeed create alpha, given recent controversy surrounding their performance relative to public markets, says Gottschalg. He adds that the findings could also help LPs that have been disgruntled over the fees paid to GPs.

“There’s a lot of focus on the magnitude of those fees,” he says. “I can understand the limited partner who is unhappy about the fund manager who got rich during very favourable conditions and generated high absolute returns but no alpha as compared to a manager like now, who may generate alpha but the overall level of returns is still so low that basically they do not get any rewards.”

Gottschalg hopes the research will be used by institutional investors as a starting point for discussions on integrating properly measured alpha into incentive schemes for fund managers.