Persistence in Fund Performance in the Private Markets

Introduction

The world of private markets has been expanding at an astonishing pace since the global financial crisis. Not only has there been a surge in capital being deployed, but the landscape has also grown increasingly diverse. With the number of active fund managers, or GPs, swelling from 3,700 in 2007 to a staggering 13,000 by the end of 2022, the realm of private markets now encompasses over 20,000 strategies across various asset classes such as private equity (PE), venture capital (VC), real estate, infrastructure, and private debt. This surge in options for capital allocators presents both opportunities and challenges, especially when it comes to evaluating fund performance.

Private market investments are inherently active, making access to deals and operational expertise uneven across GPs. As a result, the performance of these funds tends to vary widely, which can significantly impact the economic returns for Limited Partners (LPs). Consequently, LPs are tasked with the critical responsibility of identifying top-performing fund managers. The challenge lies in discerning whether past performance is a reliable indicator of future success, a question that has long intrigued investors.

?

The Theory of Performance Persistency

The theory of performance persistency suggests that some form of innate and sustainable manager "skill" exists within private markets, leading to predictable performance. This idea has garnered support from both theoretical discussions and academic studies over the years. For instance, a 2005 paper by Kaplan and Schoar found evidence that prior fund performance was correlated with a manager's next fund's performance. This notion is further reinforced by our own analysis, indicating that top-quartile predecessor PE and VC funds were more likely to translate into top-quartile successor funds. Similar findings have emerged from studies analyzing deal-level venture data and qualitative characteristics of PE firms.

?

However, not all research points to the same conclusion. Subsequent studies have reported a weakening of performance persistency, especially in post-2000 vintages, particularly for buyout funds. Nevertheless, the discussion persists, with some evidence suggesting that performance persistency is more robust in specific segments, such as venture capital and private debt.

?

The Importance of Track Record Analysis

Despite the ongoing debate, track record analysis and accurate benchmarking remain essential components of LP due diligence. LPs use track records to not only assess potential returns but also to understand investment styles, return attribution, sector focus, and more. Identifying top and bottom performers is not without its challenges, given the ambiguity in peer grouping that allows more managers to claim top-quartile rankings than theoretically possible.

?

A New Approach: Manager Scoring

In response to these challenges, a new framework called "Manager Scoring" has been introduced to objectively measure a manager's fund family track record in a more interpretable and comparable way across vintages and strategies. This framework aims to provide LPs with a robust track record and benchmarking tool, addressing some of the shortcomings of traditional quartile ranking methodologies.

?

Testing for Performance Persistence

PitchBook conducted a deep analysis of its dataset of historical private fund performance to test the elusive question: Is past performance indicative of future results? The analysis covered 1,418 fund families with at least two constituent funds across four asset classes: private equity, venture capital, real estate, and funds of funds. The study leveraged PitchBook's Manager Scoring framework, providing insights into performance persistency.

The results of the analysis were intriguing. When using data available at the time of fundraise, there was little-to-weak performance persistence across asset classes, with some exceptions. Venture capital and real estate exhibited weak but statistically significant persistency, while private equity and funds of funds showed no significant persistency. The bottom line was that interim performance data of predecessor funds at the fundraising stage did not provide substantial information for LPs to make informed investment decisions.

However, when analyzing the most recent available performance data, the results changed. Top-quartile fund families were more likely to produce top-quartile successors, while bottom-quartile families had a higher probability of continuing in the bottom quartile. There was evidence of moderate performance persistency across all asset classes, with the strongest persistency found in funds of funds. Still, it's important to note that even with future performance data at their disposal, LPs may miss out on the best cohort of successor funds more than half the time.

Takeaways for LPs

The findings from this analysis offer several important takeaways for LPs navigating the complex world of private markets:

1.?Past Performance:?While performance persistence does exist in private markets, past performance alone does not provide a definitive indicator of future success. LPs should exercise caution and avoid relying solely on historical performance when selecting managers.

2.?Diverse Strategies:?Different asset classes exhibit varying degrees of performance persistency. LPs should consider the specific characteristics of each asset class when evaluating persistency.

3.?Red Flags:?Poor-performing funds tend to have greater persistency, signaling that LPs should closely scrutinize underperformers. Managers with weak track records should provide clear explanations and strategies for improvement.

4.?Broad Due Diligence: Beyond performance analysis, LPs should focus on broader aspects such as investment theses, processes, personnel, and alignment of interests when selecting fund managers.

?

Conclusion

As the private markets continue to expand and evolve, LPs must adapt their due diligence processes to account for the nuances of performance persistency. While there is evidence that past performance plays a role, its predictive power is limited. A more comprehensive approach to evaluating fund managers is crucial to identifying top performers and ensuring successful private market investments. Performance persistency is just one piece of the puzzle, and LPs should take a holistic view when making allocation decisions.

?

See full the PitchBook report: https://files.pitchbook.com/website/files/pdf/Q3_2023_Allocator_Solutions_Evaluating_Persistence_in_Fund_Performance.pdf

#PrivateMarkets #FundPerformance #InvestmentAnalysis #PrivateEquity #VentureCapital #AssetManagement #LPDueDiligence #ManagerScoring #PerformancePersistency #InvestmentStrategy #FinancialResearch #AlternativeInvestments #InvestorInsights #AssetAllocation #FundManagement #InvestmentDecisions #AssetClasses #InvestmentStrategies #FundBenchmarking #InvestmentRisk

Offer Dischon

Co-founder & CEO

PBO-OBS Global Group

www.pbo-obs.com

www.pbo-international.com