London-based consultancy Preqin has published data showing correlations of relative performance among buyout and venture private-equity funds that can give investors an idea about whether a currently active strategy is bearing fruit.
The challenge in private equity is that strategies typically run for 10-12 years, as assets are raised, invested, managed and divested.
Although prospective limited partners (LPs) can look at how a particular manager’s previous fund performed, how a strategy of 1998 vintage fared may have little relevance to one today.
On the other hand, although performance can be measured for existing strategies, the long-term nature of the business means LPs cannot be certain that a fund will eventually outperform or underperform the industry. At least, that has been the assumption in the industry.
Preqin suggests this second statement is not true. It believes it has identified strong correlations in fourth- and sixth-year results with final outcomes.
By looking at net returns per LP among 5,300 private-equity funds worldwide (representing 70% of the total value of assets raised by the industry, ever), Preqin analysts believe they have found historical probabilities linking mid-cycle performance to final returns on investment. It began by analysing the historical record for funds’ fourth year of activity, at which point funds should have made initial investments but would have some capital still at hand.
(Preqin tells AsianInvestor that it was unable to include Asia-based PE strategies in its survey. The need for quoting figures from funds of at least 10 years of age precludes any Asia PE funds, all of which are too young.)
Its research suggests that if a buyout or a venture fund’s fourth-year performance is in the top quartile for that vintage, there is a 50% (for buyouts) or 60% (for venture) chance of the strategy concluding in year 10 or 12 within the top quartile.
The correlation is even stronger when measuring top half year-four performance: 75% of buyouts and 76% of venture funds that achieve above-average industry returns by year four go on to achieve above-average returns upon close.
If you start well, you’re probably going to end well.
The same is true for those in the bottom quartile: more than 50% of the funds rated in the bottom quartile in year four never got out of their rut.
It’s not completely cut and dry. For buyouts, 12% of those ranked in the bottom quartile at year four ultimately went on to have stellar performance and closed in the top quartile of their vintage. (But none in the venture space managed this trick.)
Preqin made the same measurements looking at six-year performance, at which point funds should be fully invested and are managing their portfolio companies and aiming for exits.
At this point, relative performance correlated even more strongly with final outcomes. All is not lost for funds still in the bottom quartile: 11% of buyout funds and 7% of venture funds ended up climbing above the median upon close. So LPs should not automatically write off underperformers at year six – but the odds are not good.
Preqin’s conclusion is that early performance counts for a lot in determining how a private-equity fund will fare relative to the industry. This is meant to be of use to investors either considering entering a young strategy, or upping their commitment to an existing one. Preqin says it will make its research freely available to private-equity professionals.