The Future of Private Equity: Evidence and Hypotheses
Josh Lerner Harvard Business School
Period of dramatic change
• • • • • Growth in fundraising. Emergence of diversified mega-funds. Entry of new groups. Expanding geographic scope. Regulatory scrutiny.
Scene from a road show
Natural questions
• Is this a bubble or a profound shift? • How will the industry evolve in the next decade? • What are implications for Abraaj?
This talk
• Will seek to answer these questions by looking backwards. • Traditionally, very hard to understand key drivers of private equity success. • In recent years, much more information. • Drawing on large-sample and case evidence. • Thoughts about future of private equity more generally…
• And particularly in new private equity markets.
1. Everyone does about the same
• Frequent claim among investors:
• Emphasis on balancing portfolio by:
• Type of fund. • Location of fund. • Vintage year.
• Similar to what’s seen in public market investing.
U.S. private equity returns
Source: Venture Economics
175% 150% 125% 100% 75% 50% 25% 0% -25% -50%
1974 1977 1980 1983 1986
Venture Capital
Buyouts
1989
1992
1995
1998
2001
2004
Recent work
• Has sought to understand how much difference is…
• Between fund classes. • Between funds.
• Seeking to distinguish importance of individual performance.
Evidence from the Yale endowment
Bond Funds
Equity Funds
Difference Between Top and Bottom Quartile
Private Equity
0%
5%
10%
15%
Source: Lerner [2003]
More general patterns
20% 15% 10% 5% 0% All Private Equity
Source: Kaplan and Schoar [2005]
Venture Capital
Buyouts
The reality
• The key difference is between different funds:
• Unlike public markets.
• Investing in the right categories is not nearly as critical as getting into the right companies!
2. “Regression to the mean”
• Frequently heard stories…
• “Our last two funds were a disappointment, but we’re getting back on track…” • “I considered investing in the fund, but I decided that their success must be a fluke...”
Recent work
• Has sought to understand nature of performance:
• Is there little continuity from quarter-toquarter?
• Many studies of public markets suggest little persistence:
• Mutual funds. • Hedge funds.
• Or is the reality different?
Persistence of performance
Bottom Medium Top
Bottom Tercile
61%
22%
17%
Medium Tercile
25%
45%
30%
Top Tercile
27%
24%
48%
Source: Kaplan and Schoar [2005]
• High likelihood that the next funds of a given partnership stays in the same performance bracket Persistence. • 1% boost in past performance → 0.77% boost in next fund’s performance.
The reality
• Performance seems to be very “sticky”:
• Good continue to do well. • Underperformers continue to do so.
• While exceptions, seems to be the basic rule:
• Seen in buyouts as well as venture.
3. Growth doesn’t hurt
• Numerous venture groups have grown dramatically.
• Mid 1980s and late 1990s.
• Recent dramatic growth by buyout funds. • Have typically argued that can sustain performance despite growth.
• But powerful incentives to grow may induce skepticism.
U.S. private equity fundraising
Billions of 2002 $s 150 125 100 75 50 25 0 Other Buyout Venture
Source: Venture Economics and Asset Alternatives.
19 69 19 72 19 75 19 78 19 81 19 84 19 87 19 90 19 93 19 96 19 99 20 0 20 2 05 E
Private equity fundraising outside the U.S.
Billions of 2004 $s 70 60 50 40 30 20 10 0 Canada Latin America Asia Europe
19 8 19 9 9 19 0 9 19 1 9 19 2 9 19 3 9 19 4 9 19 5 9 19 6 9 19 7 9 19 8 9 20 9 0 20 0 0 20 1 0 20 2 0 20 3 20 04 05 E
Asian data are investments rather than funds raised.
Source: Various national venture capital associations.
Fund sequence number
IRR and Fund Sequence Number
25
20
15
IRR
10
5
0 1 2 3 4 5 6 7 8 9 10 11 Sequence Number
• Positive relationship between IRR and fund sequence number. • First time funds perform especially poorly. • Regression results control for vintage year effect, fund category and fund size.
S o Source: Lerner and Schoar [2005] u
Fund size
Relation IRR and Fund Size
14
12
10
8
IRR
6
4
2
0 1 2 3 4 5 6 7 8 9 10 11 Fund size in $100 m illion
• Concave relationship between IRR and fund size. • Fund size is measured as capital committed at closing. • Regression results control for vintage year, fund category.
Source: Lerner and Schoar [2005]
Change in fund size
• Negative relationship between change in IRR and change in fund size for a given firm. • Fund size is measured as capital committed at closing. • Regression results control for vintage year effect, fund category, and firm fixed effects.
Source: Lerner and Schoar [2005]
Partner to size ratio
IRR and Partner to Size Ratio
30 25 20
IRR
15 10 5 0 0 0.2 0.4 0.6 Number of Partners to $100 million in committed capital
• Positive relationship between IRR and the ratio of partners to committed capital. • Regression results control for vintage year effect, fund category, and fund size.
Source: Lerner and Schoar [2005]
Partner to total staff ratio
IRR and Partner to total staff ratio
16 14 12 10
IRR
8 6 4 2 0 0.1 0.3 0.5 0.7 Number of partners to total staff
• Positive relationship between IRR and the ratio of partners to total staff. • Total staff includes associates, principals etc, excludes purely admin. positions. • Regression results control for vintage year effect, fund category, and fund size.
Source: Lerner and Schoar [2005]
Difference in deal success rate
3%
• Specialist firms are more likely to have successful deals.
• I.e., 30% vs. 32.1% vs. 33.1%.
2%
1% 0%
• Partners’ focus especially matters.
Specialized Generalist Generalist Firm with Firm with Firm with Specialized Specialized Generalist People People People
Source: Gompers, Kovner, Lerner and Scharfstein [2005]
Returns: Disparity between recent past and historical pattern
25% 20% 15% 10% 5% 0% 10/86-9/06 10/03-9/06
Source: Venture Economics
Small Funds Medium Funds Large Funds Mega Funds
Returns: One past episode
50% 40% 30% 20% 10% 0% 12/86-12/89
Source: Venture Economics
Small Funds Medium Funds Large Funds Mega Funds
One past episode (continued)
50% 40% 30% 20% 10% 0% 12/86-12/89 12/89-12/92
Source: Venture Economics
Small Funds Medium Funds Large Funds Mega Funds
The reality
• Funds with higher sequence number, i.e., established funds, perform better. • Larger funds have better performance—to a point. • Rapid growth in capital under management is associated with performance deterioration. • May be driven by less impact of partners:
• Funds with more partners per dollar managed have higher returns. • Funds with higher partner-to-non-partner ratio have higher returns. • Decline in specialization leads to poorer performance.
4. Anyone can play
• Lately, great deal of interest from new investors:
• Public pension funds. • Non-U.S. governmental entities.
• Attracted by high returns that established investors have enjoyed.
Recent research
• Has sought to understand the differences between investors.
• Does everyone do the same? • Or are there substantial differences?
• Key data:
• LP investment decisions. • Fund returns. • GP and LP characteristics.
Performance summary
• Substantial performance differences:
• ~13% differential in annual returns between endowments and next best.
• Entirely driven by early- and late-stage VC.
• Advisors and banks particularly poor.
• Patterns true when weighted as well.
Performance by investor type
Banks Advisors Public Pensions Insurance Companies Private Pensions Endowments -5% 0% 5% 10% 15% 20%
Source: Lerner, Schoar and Wang [2005]
Concerns with univariate tests
• Do these reflect other differences:
• E.g., endowments early investors and more heavily weight VC.
• Examine through regressions:
• Regress IRR on fund and LP characteristics. • Only include <1999 funds to insure meaningful performance numbers.
Regression analyses
• Differences persist:
• Endowments outperform; corporate pensions and banks underperform. • Proximity negatively associated with performance. • Younger LPs do worse:
• At least among advisors, banks, corporate pensions, and insurers.
Regression analyses (continued)
• Market inflows:
• Negative in general. • Especially for advisors, corporate pensions, and insurers.
• Hot markets appear to lead to more herding by these investors.
• Robust to other controls:
• Also excess IRR, all funds, and median regressions.
Reinvestment decisions
• Reinvestment decision should be made with better information and without access constraints. • Look at follow-on funds in our sample:
• Only look at same classes of funds.
Statistics on reinvestment
• Reinvestment rates differ:
• Public pensions, insurers higher. • Higher in VC than buyouts.
• More likely to reinvest when high IRR. • Next fund has higher IRR when reinvest.
Reinvestment (continued)
• Pension funds and advisors tend to invest when current returns are high. • But much more dramatic difference in future returns from endowments.
• Also smaller funds.
• Substantial differences in ability to identify or act on inside information.
Reinvestment and current returns
40 30 20 10 0 Reinvested Did Not Invest
Advisors
Banks
Corporate Endowments Public Pensions Pensions
Source: Lerner, Schoar and Wang [2005]
Reinvestment and future returns
40 30 20 10 0 -10 Reinvested Did Not Invest
Advisors
Banks
Corporate Endowments Public Pensions Pensions
Source: Lerner, Schoar and Wang [2005]
Is access an explanation?
• Do endowments do well because they were “there first”? • Other way to look at:
• Funds that were undersubscribed. • Funds which took a long time to raise.
• Same patterns appear!
The reality
• Huge disparities in performance. • Superior performance has been largely confined to endowments. • Raise substantial questions about ability of new entrants to succeed.
Summary
• Funds with higher sequence number, i.e., established funds, have performed better.
→Lesson: Being early is critical.
• Rapid growth in capital under management was associated with performance deterioration.
• May be driven by organizational challenges:
• Funds with more partners per dollar managed have higher returns. • Funds with higher partner-to-non-partner ratio have higher returns. • Decline in specialization leads to poorer performance.
• →Lesson: Managing growth is major challenge. • Investors have had wildly uneven returns.
→Lesson: Having right investment partners matters.
The special challenges of new private equity markets
• Lessons from Celtel, Skype and Shanda:
• HBS field cases written on all three
• Represent Africa, Europe and China
• The checks have cleared!
1. All markets are global
• Skype’s business model depended on consumers calling across borders.
• Celtel’s pan-African strategy attracted international telecoms equipment companies to become second largest source of financing. • Shanda’s revenues were more than 80% dependent on a game written and owned by a Korean company.
2. Expect deals to be massively more work intensive
• Skype’s code was written in Estonia, the management team was spread throughout Europe, the customers were all over, and the founders could not travel to the US. • Celtel needed to raise over $400mm from 2001 to 2004 during the meltdown of the telecommunication investing markets—all of it to be spent in Africa. • Shanda was threatened by a lawsuit from the Korean vendor whose game accounted for most of their revenue.
• Skype’s founders had control over a sale.
3. Back to basics: who are you in business with and are your interests aligned?
• Celtel had minority partners in all 15 of its operations (i.e.: 15 different groups in 15 different African countries). It also had an all common stock equity capitalization.
• Shanda management was furious that SAIF sold some stock after the IPO.
4. The real value added is transparency
• Skype owned its technology as a result of the VC investment
• Celtel had a prestigious board who insisted on transparency and openly refused licenses that had the taint of corruption
• Shanda’s settlement with its key vendor was negotiated by SAIF
5. Luck still counts
• (this space intentionally left blank)
Advice: Top tier firms must be global
• • LPs will prefer to go global with people they know, but will be skeptical about execution—so they will pursue a mixed model The top tier firms will need to be global to maintain top tier status—there is simply too much information they would otherwise miss, and the overseas growth and return rates will be higher than US return rates Global top tier firms will outperform local top tier firms over longer periods of time Brands will likely cross borders but are no guarantee of success.
• •
Advice: Tourist VCs will not be successful, you must be on the ground
Act global but think local.
Local, permanent, day in, day out presence is an absolute must.
Advice: The industry will not be replicate that in the U.S.
• •
•
Less developed PE markets require much more resource on each deal Investment strategy may vary from location to location:
Less of a premium for early stage investing in less developed markets
Advice: There are no settled models for running a global private equity firm
•
• • •
Lots of models to choose from:
Large PE firms provide useful models of satellite offices; There are interesting models of building an affiliate firm with different GPs and LPs (Accel, Benchmark); There are many examples of investment in independent firms (Chengwei, Argnor)
• •
But no set answers yet. Keys to success: communication among investing partners, expectation setting between offices, portfolio management globally.
Advice: You can’t do this on the cheap
Must be approached with the same intensity and vigor and commitment as your most important initiative.
Advice: The key company value builder is transparency
• Exits are through one global market, whether they are M&A or public floats (NY/London). • This is the lesson of the 60’s and 70’s all over again: don’t treat portfolio companies as small companies, treat them as large companies who happen to be small right now. • PE firms will need to stockpile management talent and keep overseas offices staffed well enough for frequent, persistent oversight of portfolio companies.
Five Easy Pieces (of Advice)
1. Top tier firms must be global
• Global top tier firms will outperform local top tier firms over longer periods of time
2. Tourist VCs will not be successful, you must be on the ground 3. Overseas industry will not be replicas of U.S.
• There are no settled models for running a global private equity firm
Must be approached with intensity, vigor and commitment. Teaching the culture of minority equity ownership may be the lasting legacy of US venture capital.
4. PE Firms can not go global on the cheap
• •
5. The key company value builder is transparency
Thank you