A recent study by Franceso Cornelli and two associates indicates that there is a positive relationship, in the private equity industry, between managerial turnover and fund performance.
Cornelli is Professor of Finance, London Business School, and a fellow at the Center for Economic Policy Research. The other authors are: Elena Simintzi (of the University of British Columbia) and Vikrant Vig (like Cornelli, of London Business School). They propose, as explanations of the positive relationship, two causal connections.
First, as a short-term connection, they suggest that the turnover means that bad performers are shown the door, which improves performance. Second, as a longer-term matter, “turnover helps teams to adapt and replenish their skills in response to shifting external demand.” In other words, valuable new blood comes on board.
There is a “common belief,” though, that “team stability” is a good thing for the investors. Cornelli at al are not kind to that common belief. Sometimes the consensus is just plain wrong.
The notion of “team stability” isn’t merely arbitrary or sentimental. The academic literature has recognized, or presumed, since at latest 1979, when The American Economic Review ran Steven Salop’s article on the “natural rate of unemployment,” that low turnover can encourage individuals to invest in relationship-specific ways. In other words, if I understand that I’m going to be dealing with the same people in my workplace tomorrow, and likely next year and the year after that, as the folks I meet today, then I am likely to work harder to get along with them than otherwise.
Why should one expect that to improve performance? Well … it might allow for an improved allocation of tasks.
Turning specifically to the private equity world, team stability is widely viewed as a selling point. Cornelli et al. quote from PE firm websites, which boast, “We have one of the most experienced and stable teams in the private equity industry” or “The Manager has one of the most stable private equity teams in Asia,” etc.
But hypothesizing is one thing, measuring is another
Cornelli and her team collected data on 138 fund managers, involving 5,772 individual deals. They did this via the cooperation of a large fund of funds which had done its due diligence on the managers involved, and which had been concerned about team stability. The scholars then augmented the data with biographical information about the individuals involved.
Cornelli et al define “turnover” as the average number of team members who leave a PE firm, normalized by the size of the team, and they look specifically at the initial five years of a given fund. That choice is “driven by the typical structure of PE funds, according to which the money is invested within this initial five-year period.” Also, the five year stretch is used with the understanding that the first signs of performance are usually apparent within the five years “and it is quite plausible that the fund manager can identify underperformers” within that period, and show the underperformers the door.
They get robust statistical results out of their data, indicating that “turnover has a positive short-term effect on performance due to getting rid of underperformers.”
What about longer term effects? To get at these, the scholars stick with a five year horizon, but move it. Instead of studying the five years starting with a funds’ creation, they looked to the five years before the initiation of a given fund. These are the years “wherein managers talk to investors about their new investment proposals and prepare their teams to reflect the changing needs and skills required to better respond to shifting external conditions.”
Here, too, there is a positive effect from turnover – from planning a team for the next fund that will have a different composition from the one that one had used for earlier funds. This improvement is driven not so much by who leaves as by who comes on board. It is the benefit of “hiring new individuals who bring in fresh ideas and skills to the team, or who are better suited to source and run new investments.”
The actionable nub if this research, then, is that investors shouldn’t focus on team stability and will make less-than-optimal investment decisions if they do.