Selecting best in breed
As private equity grows to become more complex and varied, the questions of how it performs against public markets and how the risk-return profiles of different strategies and fund sizes compare are getting harder to answer. Can the findings of three new research papers offer some insight?
Private equity’s performance compared with that of public markets has been well studied in academic literature. But as the industry has expanded into broader private markets to include a myriad of fund structures, sizes, strategies, and asset types, determining where outperformance lies has become increasingly challenging.
The extent of a correlation between fund size and returns is a contested – but hot – topic, given the continued migration of capital towards the industry’s biggest managers. How specialisation affects performance is also pertinent to limited partners, in light of the proliferation of sector-focused vehicles. Meanwhile, the emergence of new distinct asset classes, including growth equity, raises further questions about the performance of specific strategies.
Here, a group of academics and LPs discuss some of the latest research on these areas to see how investors should be navigating today’s rich and nuanced private markets universe.
Chaired by Amy Carroll
Meet the panel
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Reji Vettasseri
Reji Vettasseri is lead portfolio manager, private markets funds and mandates, at Decalia. He previously worked in Morgan Stanley Alternative Investment Partners’ Europe, Middle East and Africa team, as well as Goldman Sachs and Bain & Company. |
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Luke Riela
Luke Riela is a principal and private markets research consultant at Meketa. With a primary focus on PE and infrastructure, he sources, conducts due diligence, and monitors private market investments on behalf of clients. |
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Sabrina Howell
Sabrina Howell is the MBA Class of 1954 Professor of Business Administration at Harvard Business School and a research associate at the National Bureau of Economic Research. |
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William Megginson
William Megginson is professor and Price chair in finance at The University of Oklahoma, Michael F Price College of Business. He is also visiting professor at the University of International Business and Economics (Beijing) and consulting editor for the Journal of International Business Studies. |
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Josh H Lerner
Josh H Lerner is the Jacob H Schiff Professor at Harvard Business School and co-director of the HBS Private Capital Project. He has co-directed the National Bureau of Economic Research’s Productivity, Innovation, and Entrepreneurship programme since 2010. He also founded and runs the Private Capital Research Institute. |
Using confidential SEC Form PF Filings of US PE funds, ‘The Performance of Private Equity: Evidence from Confidential Filings‘, by Arun Gupta (Federal Reserve Board), finds that, between 2004 and 2023, average IRRs for the largest 500 PE firms far exceed those for comparable stock investments in the S&P 500 (the overall average for PE is 21%, versus 13% for the S&P 500). The research further finds that PE investment concentrations have shifted significantly over time, towards information technology, manufacturing, and services, and away from transport, retail, and oil and gas.
Gupta also finds that PE seems to exhibit some diseconomies of scope. Compared with funds investing in fewer industries, funds that simultaneously invest in 10 or 11 industries earn roughly 6.4% lower annual IRRs for LPs, although the reduction in risk via industry diversification outweighs this loss.
Finally, the study suggests that PE returns and risk-reward ratios exhibit economies of scale. For LPs, a PE fund in the largest size quintile earns an excess premium of 4.9% every year compared with a similar PE fund in the smallest size quintile.
A second piece of research, ‘Does Fund Size Affect Private Equity Performance? Evidence from Donations to Private Universities‘, by Abhishek Bhardwaj (Tulane University, Freeman School of Business), Abhinav Gupta (The University of North Carolina at Chapel Hill, Kenan-Flagler Business School), Sabrina T. Howell (formerly NYU Stern School of Business, now Harvard Business School), and Kyle E. Zimmerschied (Robert J Trulaske, Sr College of Business, University of Missouri), also explores the relationship between fund size and returns, although it reaches a different conclusion.
Here, the research addresses the reality that higher quality GPs are often inherently better at attracting LPs and therefore also at raising larger funds—a selection bias that makes estimating the true impact of fund size challenging. This research attempts to isolate the causal effect of size on performance by using donations to universities as a proxy for fund size, as endowments are typically sensitive to donations and increases in endowment size usually result in more capital for fund managers with pre-existing relationships. Using this method, the research identifies that a 1% increase in fund size reduces net IRRs by 0.1 percentage points, with similar declines when analysing the effect using multiple on invested capital.
The research suggests that the primary driver of lower returns is larger deals, which tend to underperform. Specifically, the researchers find that a 1% increase in deal size reduces a deal’s gross IRR by 0.18 percentage points. Furthermore, the research finds no evidence that lower returns result from any issues of human capital constraint such as GPs stretched too thinly. Instead, its results suggest that larger funds may even allow GPs to enjoy a “quieter life,” as they can earn more fees that are not tied to performance.
The final piece of research, ‘Growth Equity Investment Patterns and Performance‘, by Paul Lavery (University of Glasgow, Adam Smith Business School), William L Megginson and Alina Munteanu (both The University of Oklahoma, Price College of Business), compares the post-investment performance of UK companies that have received growth equity investment with a matched set of companies that have not. The research finds that growth equity target firms dramatically outperform the matched company sample across sales and asset growth, employment, and earnings growth.
However, the research finds no evidence that productivity or profitability increases among target firms relative to the control group and concludes that much of the observed outperformance is financed by faster growth in leverage. As a result, growth equity-backed companies are often more vulnerable to financial distress than matching firms, although the former appear to navigate distress, including bankruptcy, with relatively greater success.
