Berk A. Sensoy, Yingdi Wang, and Michael S. Weisbach
Limited Partner Performance and the Maturing of the Private Equity Industry
Journal of Financial Economics | Volume 112, Issue 3 (Jun 2014), 320–343

A fundamental question in delegated asset management is whether and why some investors, or classes of investors, have systematically different performance. One place where differences in performance between investors are potentially present is the private equity industry. In 1990, private equity was a little-known alternative asset class, with $6.7 billion in funds raised. By 2008, just prior to the financial crisis, the industry raised almost 40 times this amount, $261.9 billion. Over this relatively short period, the industry transformed from a niche investment to a standardized asset class that is important component of institutional investors' portfolios.

In this paper, we construct a large sample of LP investments in private equity funds, and investigate how different types of LPs performed over time. Our analysis focuses on the way relative performance has changed as private equity matured as an asset class. In addition, we evaluate the importance of access to the best funds, as opposed to investment selection skill, in explaining differences in performance. Did the changes in the private equity industry in recent years lead to corresponding changes in the fundamental relationships between limited partners (LPs), the investors in private equity funds, and general partners (GPs), the ones who manage private equity funds? How did these changes affect the relative performance of different types of investors? More generally, how does the relative performance of different types of investors depend on whether the investments in question are new innovations or established asset classes?

Industry changes and limited partner performance

Our sample consists of 14,380 investments by 1,852 LPs in 1,250 buyout and venture capital funds raised between 1991 and 2006. These LPs include endowments, pension funds, banks, insurance companies, etc. Consistent with the trends observed in prior work (see Robinson and Sensoy (RFS 2011), Harris et al. (WP 2014)), since the late 1990s there has been an industry-wide decline in both absolute and relative returns to venture capital funds. In addition, the cross-sectional variation in returns and the relations between GP experience and return have decreased.

During the 1990s, endowments investing in private equity funds did extremely well, and endowments outperformed other types of institutional private equity investors. On their investments in private equity funds raised between 1991 and 1998, endowments enjoyed an average 35.7% internal rate of return and 2.43 implied PME, the highest of any LP type. This finding replicates that of Lerner et al. (HBS 2007), who find that endowments outperformed other institutional investor types in their private equity investments.

However, in funds raised in the more recent 1999-2006 period, endowments did not outperform other types of investors. In this later period, there are no statistically significant differences in returns across different LP types. However, we do find using the implied PME that all investor types had private equity returns exceeding that of the S&P 500 in both periods. Broadly speaking, there are two possible reasons why endowments could have outperformed during the earlier period. First, endowments had could have had superior investment skill. Such skill could potentially lead them to be better at evaluating alternative investments, such as private equity, that were unfamiliar at the time to other investors. Second, endowments could have had superior access to the best-performing fund families. Historically, rather than expand or raise fees to market-clearing levels, the best private equity partnerships have rationed access to their funds, accepting investments from favored investors, such as prestigious educational and other nonprofit endowments.

We present evidence suggesting that the abnormal performance of endowments in the 1990s occurred largely because of their access to the best venture capital funds. The performance gap between endowments and other LP types in this period is driven entirely by endowments' investments in the venture capital industry, which benefited most from the 1990s technology boom. To the extent that endowments have special investment skill, one would expect it to affect both venture capital and buyout returns. However, endowment performance in buyout funds during the 1991-1998 period was no different from that of other types of investors.

A direct test of investor skill that is unaffected by differential access involves comparing the quality of reinvestment decisions, since all LPs are usually given the option of investing the subsequent funds of the partnerships in which they invest. Even within the venture capital space, LPs' reinvestment decisions do not suggest that endowments or any other any other type of investor has superior skill during any subperiod. Since endowments do not make consistently better reinvestment decisions compared to other LP types, their superior performance during the 1990s is likely explained by their access to the best venture capital funds.

We also show that endowments are no more likely to be able to pick out the best-performing first-time funds than any other type of investor, either before the technology crash or afterward. First-time funds do not tend to restrict access to LPs, as they have yet to establish a track record. Therefore, they represent a pure test of investors' selection skills. Compared with other types of institutional investors, endowments were more likely to invest in older partnerships, which not only were more likely to restrict access but also earned higher returns.

Finally, in the 1991-1998 period, endowments were more likely to invest in venture capital funds whose increase in size from the firm's prior fund was lower than would be expected based on the prior fund's performance. Such funds were likely limiting access and were particularly successful during that period. In the 1999-2006 period, such funds no longer outperform and endowments no longer invest unusually in them.

Implications

In 1978, the Prudent Man rule was modified to allow institutional investors to allocate part of their portfolios to alternative assets. Since then, the private equity industry has changed substantially. In 1980, the largest fund raised was the Golder-Thoma $60 million fund that invested in many different kinds of deals, including both venture capital and buyouts. At the time, institutional investors were somewhat skeptical of the industry; GPs, LPs, and portfolio firms were experimenting with different contractual structures; and “private equity” itself was not an accepted term. By the time of the 2008 financial crisis, individual funds of over $20 billion were being raised, and funds became specialized in particular types of investments so that renewable energy or infrastructure funds were commonplace. Contracts have become standardized, and private equity has become an accepted part of the financial world in which most major business schools teach courses.

We argue that the industry's maturing has had implications for the relations between GPs and LPs. The evidence presented here suggests that the huge inflows of capital and commoditization of the industry has lowered the rents to GPs. In addition, the evidence suggests that because limited access reflected the sharing of these rents, the importance of limited access decreased as well.

The private equity industry has become an important part of institutional portfolios. Yet, it has always been an industry that has been evolving at a rapid rate. Going forward, it is important for industry participants to understand the current state of the industry. Because of the industry's changes, past performance is unlikely to predict future performance. The enormous inflows of capital together with the increasing commonality of experience and knowledge of GPs have likely permanently changed the relations between GPs and LPs, and potentially investors' expected returns as well.


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