What constitutes an excellent exit? How should we identify the best-performing funds? Which GPs are more skillful than their peers? What is the right portfolio for an LP? These are some of questions I have been attempting to answer in my research at the HEC Paris business school.
Over the course of these investigations, a clear trend has begun to emerge: sector specialists in software, IT and healthcare appear to be dominating the top quartile.
Defining a sector specialist can be challenging. Marketing trends have led GPs to change the way they describe their investment and value creation strategies. The move away from “generalist” into sector specialism is perhaps more pronounced in marketing materials than reality and, as such, one cannot necessarily rely on a GP’s declared strategy as an indicator of actual investment characteristics.
To reliably identify what constitutes a sector-focused fund, one must analyse the actual catalogue of deals completed by a GP, rather than the name of a fund or a line from the private placement memorandum. With that definition in mind, our data shows that private equity funds that were overweight in tech and healthcare have gained significant market share over the past 20 years.
In the period 2002-06, they represented, on average, just under 8 percent by volume of funds. By the 2012-16 period, this had climbed higher than 24 percent, and the 2017-20 four-year period has seen the proportion rise to 36 percent.
The performance of these funds has outpaced this growth. Though only 4 percent of the top quartile was inhabited by tech- and healthcare-focused funds in 2002-06, this increased more than 12x for 2012-16-vintages, when half of top-quartile funds were tech and healthcare funds. Even with the growth of tech investing in private equity, this equates to an overrepresentation of 2x.
In an environment where an increasing number of GPs consider themselves sector specialists and many crop up in the top quartile, how can LPs ascertain whether a GP is particularly good at investing in this sector, rather than simply top-quartile as a consequence of its overweighting to high-growth industries?
Looking at 257 pairs of buyout funds raised by the same GP, and with the same strategy immediately following each other in the sequence of fundraises, our research found that the TVPI of an earlier fund tended to be a poor predictor of the investment performance of its successor.
A more reliable method of assessing relative manager skill is via the PERACS Relevant Peer Benchmarking methodology, which helps to identify a group of funds with similar strategy and investment timing. In the set of 257 fund pairs, a portfolio of successor funds of the top 25 performing earlier funds according to TVPI would have delivered a return of 1.73x. This compares with a greatly improved return of 2.03x when the ranking characteristic used to select 25 successor funds is their companion fund’s performance, according to our peer benchmark.
In other words, LPs are better off picking funds according to manager skill – as determined by this methodology – rather than simply participating in a sector that has historically demonstrated strong returns on a TVPI basis.
GPs, then, have a challenge. Traditional performance data, as we have shown, won’t enable tech or healthcare funds to differentiate in the eyes of LPs. A GP in this position must focus more on how its value creation is achieved rather than how much of it is created to convince LPs that it is ‘best-in-class’. It should also consider what else, aside from performance, is different about the firm, such as its brand and what the organisation stands for besides financial returns.
For those with a focus on other sectors, the situation may appear bleak: how, for example, does a financial services-focused GP convince investors that it is worth a look when the top quartile is stuffed with tech funds? It comes back to defining an objective peer group and demonstrating greater manager skill, ideally along with a more consistent risk profile, than these peers.
In essence, both GPs and LPs must shift their perspectives away from the obsession with being top quartile towards an appreciation of who is really best at what they do.