Santa Clara University

 Big Spread in Performance

Picking the Winners Among Private Equity Funds

Image of Prof. Hendershott

    For years, private equity funds have raised capital by pooling a group of limited partners to invest in privately held companies — either startups or non-public firms needing capital for specific reasons. The pitch to investors is that the risks are greater, but so are the potential rewards.

    Over much of that time it’s been difficult to monitor the performance of these funds, however, increased disclosure requirements developed over the last few years have made information more readily available. Robert Hendershott, associate professor of Finance, has been mining the data and already sees some surprising trends.

    “With private equity funds, you’re locking up your investment for a long time, usually five to eight years, with no liquidity,” he says, explaining the rationale for his study. “The only reason to do that is if you’re getting really high returns.”

    Using the Private Equity Intelligence (PEI) database, which goes back to 1969, as well as more recently available information, Hendershott has looked at more than 3,400 private equity firms. He hasn’t yet reached the point of writing a paper, but some things have jumped out.

    “One thing that surprised me is how many poorly performing funds there are,” he said. “A lot of funds are losing money. Before, you never heard about the real losers, but they’re out there.”

    Because of the long time that private equity funds hold investors’ money, the effects of a loss can be significant. Hendershott points out that if an investor were to put money into a private fund that lost 30 percent over five years, as opposed to a safe bond that returned 30 percent over the same period, that investor would end up with half as much money as if he’d taken the conservative approach with the bond.

    Another trend he’s observing is that, unlike mutual funds and other investors in public stocks and bonds, private equity funds do continue to do better or worse over the long haul. In the stock market, results tend to even out over a ten-year period, as most investors feel the impact of good and bad times. In private equity, funds that start out poorly tend to continue to do poorly.

    Of course luck and general market trends also play a role. “In 2004-06, almost everyone was making money,” Hendershott says. “Now, it’s hard to make money. Even Warren Buffett didn’t do well in 2008.”

    With private equity funds, it can take time to sort out the winners and losers. If a fund, for example, invests in a startup business, the result of the investment may not be known until that business goes public or goes broke. But with the wealth of data now available, Hendershott says it’s clear that some equity funds consistently do better than others.

    That’s critical information for investors, because private equity funds typically raise capital for a new fund, investing in new ventures, every few years. While past performance is no guarantee of future results, it’s a better indicator with private equity funds than it is with mutual funds. One of Hendershott’s findings is that the return on a private fund whose previous fund was in the top quartile in performance is up to double the return of a fund that was in the third quartile.

    The tendencies Hendershott is finding in the data should be of interest both to academics and investors, he says. For the latter, there’s a clear message:

    “Investors who have to make these decisions should be careful and selective and rarely go against what past performance suggests,” he says. “You’d have to be really smart at seeing the exceptions to bet against that performance.”

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