Wednesday, September 26, 2012

New Study on Private Equity: Buyout Funds Add Value

Steve Kaplan is Professor of Entrepreneurship and Finance at the Chicago Booth School of Business. He and his two co-authors have published a paper which tries to systematically measure the comparative performance of private equity and venture capital funds against a public investment equivalent.  Private equity returns are anything but transparent.  Time series are subject to all kinds of bias in performance measurement, survivorship bias, absence of cash flow data, and no performance standards equivalent to AIMR standards which govern most mutual funds. 

This aura of mystery helps no one but the sponsors of these funds.  The authors have done yeoman's work in putting together this study, which is not definitive but certainly an improvement over what is uncritically reported in the financial press.

Broadly speaking, here are some highlights of the findings.  It has long been contended that buyout funds add value when they take over troubled firms.  The authors data analysis confirms these prior studies.
"Using cash flow data from 598 buyout funds and 775 venture capital funds from 1984 to 2008, the authors calculate the average public market equivalent ratio for each vintage year. They find that buyout funds did better than public markets in most vintage years since 1984. The average US buyout fund outperformed the S&P 500 by at least 20 percent over the life of the fund, or by at least 3 percent per year."
Venture capital funds, on the other hand, have decidedly mixed results.  Again, this confirms the broad conclusions of several other prior studies.  The authors find,
"The average venture capital fund, on the other hand, did better than the S&P 500 in the 1990s but not in the following decade. Kaplan thinks this is not surprising. The tremendous success of venture capital funds in the 1990s attracted a huge amount of capital in the early 2000s that subsequently contributed to lower returns."
I believe that there are other factors at work in the inter-decade performance of venture capital funds.  Larger capital flows are one issue; declining quality of the sponsors and their paucity of top talent are also important, but difficult to measure.  Hot sectors--one might call it luck--play an important role.  Healthcare and medical devices had its heyday before FDA issues, reimbursement issues, pricing pressures, and greater emphasis on clinical value conspired to put an end to outsized returns.  Technology investments also had cycles of innovation, followed by a host of 'me too' companies which were not worthy of their multiples.

Broadly speaking the outperformance of buyout funds remains consistent over the most rigorous transformations of consistent industry data sets.  Those of venture capital funds show consistent value-added through the 1990's, but not thereafter. 

So,  from the point of view of the asset class, private equity firms that buy troubled or undermanaged assets seem to turn them around, providing demonstrable value-added to return profiles over the life of the funds. 


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