A private equity firm’s prior performance is not a good predictor of its future performance primarily because LPs make selections while stuck in the haze of intermediate results.
Those were the findings of recent research by consulting firm Peracs.
The firm, led by Oliver Gottschalg, recently took aim at prior academic research into private equity performance which found that private equity fund managers who outperform with one fund tend to outperform with the next fund. The phenomenon is known as “performance persistence”.
Peracs noted that the prior research has compared only end-of-life performance data about private equity funds, meaning that performance data was used from funds to have been fully exited.
In its study, Peracs tried to simulate the experience of an LP making a decision about a new fund commitment opportunity with only the benefit of partially realised performance information from a prior fund. Using a control group of 212 private equity funds, Peracs selected a sub-group of 25 percent based on the best performing predecessor funds as indicated by the internal rate of return (IRR) at the time the selection decision would have been made. This decision point ranged from four years to eight years after the vintage year of the predecessor fund.
The study found that funds selected in this manner underperformed the average performance of the 212 funds by 3.3 percent IRR. A similar exercise involving a selection of the top 50 percent of predecessor funds resulted in the portfolio underperforming the average by 2.4 percent. “In other words, a random choice of the 212 focal funds would have been better than relying on the available information on the performance of the predecessor funds in both cases,” Peracs concluded.
Peracs did confirm that using only end-of-life fund performance information, the top 25 percent of selected funds outperformed the average by 27 percent. However the study described this assumption of “perfect foresight” as “entirely unrealistic”.