Red Flags in Alluring Private Equity Track Records

How to parse skill from luck in the top (and bottom) quartiles.

Illustration by II

Illustration by II

Past performance of private equity and venture capital managers can give investors a strong sign of how they’ll do in the future.

But new research from alternatives firm Pantheon finds that future performance can be dramatically influenced by a number of other factors as well, including how well a manager has dealt with the succession of its founders.

“As always, the truth is likely to be nuanced: not all track records are created equal. In some cases, track records can be a poor indicator of future performance,” according to the report published Tuesday. “This tends to be the case when past performance is skewed by deals where luck has played a disproportionate role, when the GP [general partner] is shifting strategy, or when there is a misalignment of interests, organizational change, or succession is mismanaged.”

Pantheon reported that managers in the top quartile of performance have a more than 35 percent probability of successor funds also be in the top quartile, according to the report. For the study, Pantheon considered probabilities greater than 25 percent as evidence of persistence.

“Persistence is also strong for bottom quartile VC funds (42 percent probability of remaining in the bottom quartile), suggesting that it is highly unlikely to see underperforming venture capital GPs rise again in the rankings,” according to the report, called “Persistence Pays Off.”


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In an interview with Institutional Investor, Andrea Carnelli-Dompé, head of research at Pantheon in London, said, “The issue of performance persistence is a key one. It’s about trying to figure out how much people should pay attention to track records.” He added that there is robust research showing that performance persistence among managers in the mutual fund industry is weak.

But that’s not the case in private equity. “There is something stickier in private equity that is probably linked to the way firms create value that endows the track record with more persistence than in other asset classes,” Carnelli-Dompé told II.

“Most of the performance of private equity is delivered through value creation, meaning all the operational improvements that PE managers implement to make the company’s sales grow faster, or make margins become healthier,” he added.

By definition, private equity firms aim to expand a portfolio company’s growth potential by, for example, changing management teams, setting up acquisitions, or upgrading systems and other infrastructure. These activities require highly skilled people, Pantheon noted.

“The really good managers have learned to do that well and have acquired the right talent with the right experience. If those teams and strategies remain stable, then the same trick is likely to generate similar results in the future,” he said.

Pantheon also analyzed whether persistence changed pre-2000 and post-2000, when investors flooded the industry with new capital. Top quartile managers were essentially consistent between the two time frames. The main differences showed up in the third and fourth quartiles.

After 2000, the persistence of performance in buyout funds decreased, but increased for VC funds.

Track records are not all the same. Pantheon warns investors to analyze for lucky deals and lucky timing — stumbling on the right asset, at the right moment, or in the right geography or sector. Track records should be parsed deal-by-deal, the firm advised.

Another red flag to look out for is succession issues. Carnelli-Dompé said investors need to question whether mid-level teams have been appropriately mentored and incentivized, and whether results came from operational improvements or financial engineering.

The study analyzed U.S. and European buyout and venture commingled funds launched between 1985 and 2012, the latest vintage for which results have finalized.