A warning shot has been sounded for private-equity investors. Not only can they no longer expect the stellar returns they are used to from the asset class, but also the reliability of top performers is slipping.
For investors in the US, the reliability of solid returns among top performers – known as persistence – has been one of the hallmarks of private equity, making it something to retain. But new research by academics at the Massachusetts Institute of Technology, in Boston, shows that persistence is no longer a reliable feature.
The new research, by Antoinette Schoar, chair of the finance department and the Michael M. Koerner (1949) Professor of Entrepreneurship at MIT Sloan School of Management, shows persistence of returns from private-equity funds has gone down in the last decade, undoing the seminal work she co-authored 15 years ago with the University of Chicago’s Steven Kaplan.
Schoar and Kaplan’s 2003 report, Private Equity Performance: returns, persistence and capital flows, found “returns persist strongly across funds raised by individual private-equity partnerships”. In contrast, Schoar’s new work shows that the variance in returns between the top and bottom quartile still exists, but the persistence at the top has decreased.
“Being in the top quartile is still as important as before, but because persistence is going down, you can’t rely on a top-quartile fund in 2000 [staying] top quartile,” she explained. “What this means for investors is your life is even more difficult.”
Some asset owners, such as the US$80 billion ($101.1 billion) Oregon State Treasury, which is the oldest private-equity investor in the US, are reacting to this by reducing their PE allocations.
Oregon, which first allocated to private-equity house KKR 37 years ago, is gradually reducing its PE portfolio from 25 per cent of total assets to 17.5 per cent. Chief investment officer John Skjervem said the fund can no longer expect what it once did from its private-equity portfolio, which has added US$9 billion above the public-equity equivalent since 1980.
The average allocation to private equity by US public pension funds, which collectively manage US$3.6 trillion, is 7 per cent, alternative assets research house Preqin states. The largest fund in the US, the California Public Employees’ Retirement System, has about 8 per cent of its US$357 billion allocated to private equity.
Locally, Australian MySuper products have about 5 per cent allocated to unlisted equity, on average, an Association of Superannuation Funds of Australia report states.
Oregon’s Skjervem said: “Private equity has been the lead guitar in our band, but we are now adding extra instruments, with the expectation that there is no substitute for the excess returns of private equity.
US$9 billion is a big number, but we don’t expect that to continue, so our efforts are focused not on a return replacement, but on adding instruments that are not correlated with the long-only approach in public and private markets.”
“The paper from Kaplan and Schoar, in 2005, was really impactful for me personally,” Skjervem recalled. “It was a significant proof paper for the asset class. I’ve had the feeling that persistence has been breaking down, and now we have another paper that validates our own experience.”
That isn’t just bad news for private-equity firms, he explained, it’s also not good for the limited partners who have done well investing with them in the past.
Skjervem was speaking at the most recent Fiduciary Investors Symposium at MIT, hosted by Conexus Financial, alongside MIT’s Schoar and Ares Management partner Nate Walton.
Structural change
In the last two decades, private equity as an asset class has undergone structural change, the decline in returns and their persistence reflects this.
During that time, Schoar explained, the capital under management in private equity, and the number of funds, have both doubled. In addition, the biggest and best-performing funds are getting bigger, and this means they need to expand their investment portfolios.
But the nature of venture capital and private equity, where illiquidity is greater and opportunities are tougher to scale, means that when funds become larger, the marginal returns to capital go down, even at the best funds.
Walton from Ares, a publicly listed alternatives manager with US$106 billion in assets, said it should be no surprise that private equity has evolved as an asset class.
“The data shows that the same thing cannot be repeated by the same people over and over,” Walton said. “For a long time in our industry, the same thing could be repeated; everyone could use the same strategies, go after the same inefficiencies, and create alpha through illiquidity and some of the other structural inefficiencies. But in any asset class, that will change, and in an asset class of scale [the ability
to do that] will be diminished.”
For Oregon’s Skjervem, the structural changes have put the asset class under more scrutiny. He is getting questioned by his board about the continued validity of private equity. Where it was formerly the star performer, more recently it hasn’t met its benchmark, which is the Russell 3000 Index plus 300 basis points, he said.
“We haven’t met our benchmark in at least five years, so we are starting to get questions about performance,” he said. “Is this a realistic benchmark? I would argue no.
“I could argue Russell 3000 plus 10 basis points is worthwhile because 10 basis points on a $16 billion portfolio is real money. But plenty of people want a more significant figure over public markets to justify the illiquidity you are taking on.”
More bad news
The recent trend of investors favouring co-investments, special-purpose vehicles and direct investment in private equity is a result of the changing trends in performance and persistence, Schoar said. It has tempted limited partners to get involved in the investment process.
“But our data suggests we should be very cautionary about it because we see massive variances in the performance of co-investment,” Schoar said, “and the timing [often] seems quite detrimental to the fund performance.”
In addition, the co-investment deals are particularly large, in some cases three times as large as the investment the same entity makes in its main fund.
Schoar stated that, in some ways, the large variance in co-investment returns should not be a surprise.
Much of the decision-making, she said, “goes back to the investment team at the LP…So one should be careful to see whether the LP is big enough, sophisticated enough and has the internal resources to make that trade-off.”
She also warned LPs to think about when general partners are most incentivised to include LPs in a co-investment. “The incentives might not be aligned,” she said.
Investor action
Schoar predicted private equity would not return to massive persistence in top performance. But she also had another concern.
“If LPs are not vigilant, we will start seeing persistence at the bottom,” she said. “We see so many LPs wanting so much to get into private equity that they are not sensitive enough to poor performance and keep reinvesting in partnerships that are not deserving.”
Walton went further, and jokingly observed it was “difficult to kill a private-equity fund”.
But there is some good news, he said. Even though funds have become larger, and returns have gone down, the top funds have still outperformed.
“I think the industry will end up with larger funds that can consistently outperform, and niche smaller funds that can find an advantage in the market,” he said. “And we’ll live in a barbell world.”
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