Endowments outperform banks, pension funds and other institutional investors when picking private equity funds in which to invest. Their annual returns are nearly 14% greater than the average for limited partners, according to a study, “Smart Institutions, Foolish Choices?” to be published in The Journal of Finance later this year. Commercial banks’ returns looked especially bad, with average IRRs of -3%.
The report examines investment styles and the performance of 417 banks, corporate and public pension funds, endowments, advisors, insurance companies and other limited partners using return data from 1,397 private equity funds from 1991-2001. The average fund in the sample had an IRR of 6.7%. But funds in which endowments invested had an average IRR of 20%.
The authors, Josh Lerner and Wan Wong of Harvard University and Antoinette Schoar of the Massachusetts Institute of Technology, offered a few explanations for the wide variety in performance. Endowments, especially private universities such as Yale University, often have access to superior funds. So the authors looked at how endowments and others re-invested. Lerner said he was surprised to find that when corporate pensions drop a fund the next investment tends to do even worse.
They also looked at desperate funds, private equity firms that worked for more than a year to raise money or were unable to hit their targets. “They’re not in a position to turn anybody away,” Lerner said. “In that subset, the endowments’ picks are the ones that do the best among them. Whatever the secret sauce is, decisions made by endowments are better than others.”
Alternatively, limited partners don’t appear to be using their inside information to screen out the poor performers. Some reinvest despite weak returns and allow struggling private equity firms to survive. Maybe, Lerner ventured, it’s because of private equity funds’ long lives. In an 8-10 year investment, it might take longer to realize a dud.
Until recently, commercial banks invested in private equity in the hope of getting lending business with portfolio companies as well as returns. These mixed motives might explain why they stuck with firms despite lackluster performance, Lerner said. But when the authors looked at commercial banks’ investments in venture capital firms, whose portfolio companies have little use for bank debt, their investments were still worse than those of other institutional investors, but not as bad as their buyout picks, he said.