LBO Funds: Even the Median Beat Stocks

New research from a trio of star academics bolsters what previous studies concluded – private equity, and in particular US buyout funds, have outperformed the public markets ‘for a long period of time.’

Wine lovers have at least two things in common with private equity market participants.

First, they tend to think in terms of vintage years. And second, each new research finding keeps delivering and better and better news about the effects of wine and private equity, respectively. Wine (in moderation) may well increase your lifespan. And private equity (placed properly within a broader portfolio) may well enhance your returns.

Although the results of the new study were hinted at in this interview, the draft version of “Private Equity Performance: What Do We Know?” came out just last month, and it includes some findings that further the case for private equity as a return-enhancing strategy. This is good news for anyone in the private equity industry, because credible evidence of private equity’s outperformance leads to new and increased allocations around the world, which leads to more money flowing into this asset class.

The findings are not necessarily going to help GPs who consistently fail to outperform their peers, but their challenges are already known.

The paper is being written by Robert Harris, Tim Jenkinson and Steven Kaplan, professors at the University of Virginia Darden School, Oxford University Said School and University of Chicago Booth School of Business, respectively. You can access the full draft of the study here.

Drawing on data from Venture Economics, Preqin and Cambridge, but significantly expanding the scope of inquiry with untapped data from private equity software and information company The Burgiss Group, the trio conclude that “average buyout fund returns in the US. . . have exceeded those of public markets for most vintages for a long period of time. In fact, the median buyout fund has outperformed public markets.”

The median finding could be significant because it could be viewed as softening somewhat the insistence among many asset class advisors that investors must access “top-quartile” GPs in order to succeed in private equity. In fact, at least in the case of US buyout funds, “middling” performance has at least tended to outperform average public equity performance.

Despite the frequent statistical battles between camps who claim small buyout funds tend to beat mega-buyout funds, and vice versa, the news from the new study is good for buyout funds of all sizes. The paper reads, “We do not find any reliable relation between performance and fund size for buyout funds.”

The news is not as rosy for the venture capital asset class. While average venture capital fund returns in the US outperformed the public markets in the 1990s, VC funds have underperformed the public markets in the 2000s. In other words, VC funds did unbelievably well in a bull market and disappointed during a decade in which public markets went sideways.

Interestingly, the study finds the venture capital funds in the bottom quartile of fund size tend to underperform while VC funds in the largest quartile “have the best performance.” The study does not offer any possible reasons why this is the case.

Maybe there’s one more similarity between wine and private equity – if you just start gulping it down, you can lose your judgment and sense of pacing and wake up the next morning with a bad hangover. Investors need to pace themselves and stick to the finest managers or they may earn the dubious distinction of having built a collection of sub-median GPs.