There’s a large body of sound, academic evidence (which is presented in my books, “The Only Guide to Alternative Investments You’ll Ever Need” and “The Quest for Alpha”) demonstrating that, in aggregate, private equity investments have represented the triumph of hype and hope over wisdom and experience.
The following is a summary of findings from some of the more recent research on the performance of private equity, and venture capital (VC) in particular:
- A 2005 paper, “The Risk and Return of Venture Capital” by John Cochrane, revealed that the returns to venture capital were similar to those of the smallest Nasdaq stocks; specifically, illiquid, thinly traded stocks with very small market caps. Cochrane’s study—which covered the period from 1987 through June 2000 and 6,613 rounds of financing that involved 7,765 companies—further stated that such stocks exhibit traits similar to venture capital (extreme skewness and high volatility). Despite its greater risks, venture capital didn’t provide returns any higher than comparable publicly traded equities. Cochrane concluded: “The fact that we see a similar phenomenon in public and private markets suggests that there is little that is special about venture capital.”
- Oliver Gottschalg and Ludovic Phalippou, authors of the 2007 study “The Performance of Private Equity Funds,” researched the performance of 6,000 private equity deals and about 1,000 buyout funds using data collected through investors in 852 private equity funds raised before 1993 (to ensure the funds had sold all their assets). They found that after accounting for fees, the average private equity fund underperformed the S&P 500 by 3 percent a year.
- The study “Private Equity Performance: What Do We Know?” was published in the October 2014 issue of the Journal of Finance and covered the period from 1984 through March 2011. The authors—Robert Harris, Tim Jenkinson and Steven Kaplan—found that while the median private equity fund outperformed the S&P 500 by 3 percent a year, small-cap value stocks returned an annualized 16.0 percent, outperforming the riskier private equity by 2.2 percentage points each year.
- Diane Mulcahy, Bill Weeks and Harold Bradley, authors of the May 2012 study “We Have Met The Enemy…And He Is Us,” examined the Kauffman Foundation’s 20-year record of investing in VC funds. They found VC returns have not significantly outperformed the public market since the late 1990s and that, since 1997, less cash has been returned to investors than has been invested. They also found that the average VC fund failed to return investor capital after fees, and that after fees, the majority of funds—62 out of 100—failed to exceed returns available from the public markets. Thus, investors were not compensated for taking the incremental risks of illiquidity and lack of diversification that are associated with VC.
The authors of the Kauffman Foundation study concluded: “The historic narrative of VC investing is a compelling story filled with entrepreneurial heroes, spectacular returns, and life-changing companies. The quest to invest in the next Google guarantees that VC will retain its allure and glamour, even in the face of the disappointing results we’ve just discussed.
Investors are still attracted to the ‘lottery ticket’ potential VC offers, where one lucky ‘hit’ investment like Zynga or Facebook can offer the potential to mitigate the damage done to a portfolio after a decade of poor risk-adjusted returns. The data suggest that such ‘hits’ are unlikely to salvage industry returns.”
The cumulative body of evidence is damning. That said, the June 2015 issue of the Journal of Finance contains a study, “Is a VC Partnership Greater Than the Sum of its Partners?” by Michael Ewens and Matthew Rhodes-Kropf, that provides some hope, although not for the overall VC industry.
Given the overall poor performance of the industry, and the riskiness of VC investments, it’s obviously important to determine whether it’s possible to identify the few future winners ahead of time. The authors cited research showing that 85 percent of returns come from just 10 percent of VC investments. From 1987 until 2012, only 12.8 percent of investments were able to achieve an initial public offering (IPO).
Ewens and Rhodes-Kropf did note there’s some evidence from academic research for the persistence in outperformance of VC. For instance, Steven Kaplan and Antoinette Schoar, authors of the 2005 study “Private Equity Performance: Returns, Persistence and Capital Flows,” concluded that the evidence suggests learning occurs—older, more experienced funds tend to have better performance—and hence there’s some persistence in performance. They recommended investors choose a firm with a long track record of superior performance.
The Search For Skill
By examining a unique data set that tracks the performance of investments made by individual venture capitalists across time and as they move between firms, Ewens and Rhodes-Kropf were able to investigate whether individual venture capitalists have repeatable investment skill, and to what extent that skill is impacted by the VC firm at which they work.
The authors employed the VentureSource database of VC investments, and their study covered the period 1987 through 2005. Following is a summary of their findings:
- There’s evidence of skill and exit style-differences even among venture partners investing at the same VC firm at the same time.
- Controlling for observable firm, partner and investment characteristics (such as time, dollars invested, industry, VC experience, investment round number and firm founding date) among investors who made at least three investments, a one-standard-deviation increase in past IPO rate implies an 18 percent higher probability of an IPO in their third investment. The authors write: “Given the rarity of IPOs, the strength of persistence at the partner-investment level is quite high.”
- On average, the same people who have IPOs will continue to have IPOs; those who achieve top exits through M&A will continue to do so; and those who fail will continue to fail.
- A VC firm’s past IPO success rate also correlates with a partner’s probability of achieving an IPO on his or her next investment.
- When comparing partners in the same firm investing at the same time, there’s persistence in their relative ability to achieve IPOs or top-M&A exits.
- Partners’ human capital is two to five times more important than the VC firm’s organizational capital in explaining performance.
The authors’ finding of skill among VC firms is certainly important. However, while skill in selecting investments provides a clearly plausible explanation for the persistence of outperformance achieved by successful VC firms, there may be another reason for their superior results.
In my next post, I’ll examine the ability of successful firms to charge a premium for their capital, and review an older study that analyzes the financing offers made by competing VC firms at the first professional round of startup funding.
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.