Private equity for private clients?

Private equity for private clients?

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Anyone who’s had any involvement in investing for even a short period of time will be familiar with the warning that past performance is not necessarily a reliable guide to the future.  Even if you aren’t an investor but you watch Channel 4’s Formula 1 coverage, you will hear David Coulthard mention this point at some point in most seasons, albeit in relation to motor racing rather than investing.

It is a phrase of which financial services regulators are very fond but there is plenty of evidence to suggest that it is actually true, at least in terms of being useful for selecting future outperformers.  Over the years, a succession of academic papers has shown pretty conclusively that, once their portfolios are adjusted for their exposure to known risk factors, there is no outperformance that is reliable enough to be identified in advance.  Such studies do sometimes actually show evidence of persistent performance.  Unfortunately it tends to be of persistent underperformance, often linked to high costs.  I draw the distinction here between (peer-reviewed) academic papers and the ‘research’ which some product providers produce.  The latter is often at the behest of the marketing function and best regarded as such.

The above is true of listed assets, on which, it is unsurprising, most of the research is done.  But what about private equity and venture capital?  In these less well-studied areas, there has been some evidence of outperformance persistency.  So does that mean that investors should look for ways to become involved?

In general, once its greater risk is taken into account, private equity has underperformed public equity – that is also before allowing for their higher level of leverage (whether via borrowing or structural gearing) and the lower levels of liquidity than quoted funds.  If you can’t get your money out for six months, that implies an opportunity cost for which compensation needs to be provided in the form of a higher expected return.

However, a 2005 study found that the more experienced venture capital funds (which invest in startups) seemed to have not only better performance butt hat it was more persistent.  On that basis, selecting a manager with a long track record of outperformance would make sense.  The question then arises as to what is responsible for the outperformance.  One possibility is simply higher skill in identifying investments.  However another is that successful managers are able to charge a higher premium for their capital.  This allows them to acquire equity in investee companies at a discount compared to those without an established track record.  Since (all else being equal) purchasing at a lower price results in a higher return, this would be expected to result in a degree of future outperformance compared to their competitors.  In turn, when these managers compete for further deals in the future, their apparently superior record stands them in good stead with other potential investee businesses.

This may go some way to explaining why the phenomenon is seen in venture capital but not in public markets – managers investing in quoted assets, whether debt or equity, need not compete for deals as they do in the unlisted segment of the market.

The key question for investors is whether this information can be used to help to improve their chances of investing with a manager who will deliver above average future returns.

Last year, another study was published which looked at the extent to which persistence was maintained in both venture capital and buyout funds.  The latter invest in existing businesses with a view to selling later at a profit.  It looked at over 2,000 funds and considered the performance of their previous funds at the point at which managers were raising further capital.  Unfortunately, while there was still some persistency in outperformance, the information available at the time to new investors in buyouts was insufficient to use this as a guide to identifying them in advance.  As has been found in other studies, there was also persistency in the lowest 25% of funds.  Perhaps unsurprisingly, the latter also had a high rate of failure and then disappearance.

Overall, venture capital funds of funds (those which invest in other funds) appeared to earn their fees by being able to identify in advance the better performing investee funds.  However, buyout funds were particularly unpromising for private investors.  Compared to startups, buyouts tend to have higher levels of debt and lower liquidity, both of which require higher returns to compensate investors.  However, they also attract high costs, in the form of explicit annual fees, deal fees and the manager’s entitlement to a share of profits.  All of this tends to skew the opportunity to earn returns towards the manager rather than the other investors.

Professional investors in venture capital, whom we might reasonably expect to know what they are doing, adopt a pooled approach to their selection process.  For every 10 investee businesses, they expect several to fail completely, several to return the original investment, a few to return a profit and maybe one to deliver a substantial return.  However, even with their resources and experience, they don’t know in advance into which category an individual opportunity will fall.  Even the late David Swenson, who had considerable success with private equity as CIO of Yale’s endowment fund, concluded that for casual investors, the obstacles to overcome were insurmountably high.  Given that many professionals fail, accepting the risk inherent in the sector runs a significant risk of poor outcomes.

It is also worth bearing in mind that most private investors are just not going to be able to access the best opportunities because they have no shortage of available capital from the big players in the field.